SFAS 115: a victory for fair value accounting.

Statement on Financial Accounting Standards No. 115 (SFAS 115), Accounting for Certain Investments in Debt and Equity Securities, represents another victory for proponents of fair value accounting. Accounting for financial instruments i general has recently been a priority of the FASB. Previous standards have focused on disclosures of fair value. SFAS 115 focuses, however, on accounting matters as well as disclosures.

Five problems regarding the accounting and reporting for debt and equity securities are identified in SFAS 115. These problems are:

* Literature is inconsistent. Authoritative literature regarding debt securities is inconsistent among different industries and has resulted in diverse reporting practices.

* LOCOM is not even-handed. The lower-of-cost-or-market (LOCOM) method required for debt securities that are held for sale and for noncurrent marketable equity securities recognizes the net diminution in value but not the net appreciation in the value of those securities.

* Fair value information has greater relevance. Some believe that fair value information regarding debt securities is more relevant than amortized cost information in helping users and others assess the effect of current economic events on the enterprise.

* The current requirement permits the recognition of holding gains (gains trading) through selective sale of appreciated securities. There is, however, n requirement for concurrent recognition of holding losses.

Current requirements are based on management's plans for holding or disposing o the investment rather than on the characteristics of the asset. Intent-based accounting impairs comparability.

The FASB's project that led to SFAS 115 initially attempted to consider all of these issues. However, the Board concluded that it would not require the comprehensive use of fair value accounting. Its response does resolve the first two problems above, partially addresses the third issue and leaves the last two problems unresolved, although required disclosures at least will highlight situations where gains trading exists. This article discusses these issues and outlines the Board's response.

Background

In May, 1986, the FASB added to its agenda a project to reexamine the accountin for financial instruments. The Board initially focused on disclosures in SFAS 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, and SFAS 107, Disclosures about Fair Value of Financial Instruments. Regulators and others have expressed concerns about the recognition and measurement of investments in debt securities, particularly those held by financial institutions.

In 1988, the Office of the Controller of the Currency identified investment practices that it deemed unsuitable. In the same year, the Federal Home Loan Bank Board released a proposal statement of policy that addressed the classification of securities that were held for investment, held for sale, and held for trading. Those regulators questioned the appropriateness of using the amortized cost method rather than the LOCOM method when trading and sales practices were inconsistent with the amortized cost method. They expressed specific concerns about "gains trading" by financial institutions. The practice of "gains trading" suggests that rather than being held for investment, the securities in the portfolio are being held for sale, in which case the LOCOM method is usually considered more appropriate. Some regulators were also concerned about the ability of an institution to "defer" the recognition of losses by using the amortized cost method.

These concerns, as well as inconsistent guidance on the reporting of debt securities held as assets in the AICPA Audit and Accounting Guides, prompted AcSEC to undertake a project on the measurement and reporting of debt securitie held as assets by financial institutions. That project led to the exposure of a proposed Statement of Position (SOP), Reporting by Financial Institutions of Debt Securities Held as Assets, in May, 1990.

In September, 1990, the SEC criticized the practice of reporting investments at amortized cost and indicated that banks and thrift institutions should give serious consideration to reporting all investment securities at market value. I October, 1990, AcSEC concluded that the FASB could best undertake the project o debt securities held as assets by financial institutions and urged the FASB to consider the issue of recognition and measurement of investment securities. In November, 1990, the major CPA firms advised the FASB that they endorsed AcSEC's recommendations.

As an interim measure, AcSEC issued SOP 90-11, Disclosure of Certain Informatio by Financial Institutions About Debt Securities Held as Assets. That SOP required disclosure of the estimated market value, gross unrealized gains and gross unrealized losses, by pertinent category, for debt securities held as assets by financial institutions. Although AcSEC's focus was on the accounting for debt securities, AcSEC suggested that the FASB could conform the accounting for debt and equity securities by amending SFAS 12, Accounting for Certain Marketable Securities, to include debt securities.

Early in the project, the Board and staff members held meetings with representatives of banks, thrifts, insurance enterprises, industrial enterprise and regulators to better understand why investments in debt and equity securities are held and how they are used in managing interest rate risk. The Board also consulted with the Financial Accounting Standards Advisory Council, the Financial Instruments Task Force, professional groups, regulators, users of financial statements and other interested parties.

In September, 1992, the Board issued an Exposure Draft, Accounting for Certain Investments in Debt and Equity Securities, for a 90-day comment period. Approximately 600 organizations and individuals responded, many with multiple letters. The Board also conducted eight field visits to discuss the exposure draft. Public hearings on the proposals in the exposure draft were held in December, 1992, and January, 1993. In March, 1993, the Board's Financial Instruments Task Force met and discussed the exposure draft and possible revisions to it. In May, the Board issued SFAS 115.

Scope of SFAS 115

SFAS 115 establishes standards of financial accounting and reporting for all investments in debt securities and in equity securities that have readily determinable fair values except that:

* It does not apply to investments in equity securities accounted for under the equity method nor to investments in consolidated subsidiaries.

* It does not apply to enterprises whose specialized accounting practices include accounting for substantially all investments in debt and equity securities at market value or fair value, with changes in value recognized in earnings (income) or in the change in net assets.

* It does not apply to not-for-profit organizations; however, it does apply t cooperatives and mutual enterprises, including credit unions and mutual insurance companies.

As used in SFAS 115, a security is a share, participation or other interest in property or in an enterprise of the issuer or an obligation of the issuer that

* either is represented by an instrument issued in bearer or registered form or, if not represented by an instrument, is registered in books maintained to record transfers by or on behalf of the issuer;

* is of a type that is commonly dealt in on security exchanges or markets, when represented by an instrument, is commonly recognized in any area in which it is issued or dealt in as a medium for investment; and

* either is one of a class or series or by its terms is divisible into a clas or series of shares, participation, interests or obligations.

A debt security is any security representing a creditor relationship with an enterprise. It also includes preferred stock that by its terms either must be redeemed by the issuing enterprise or is redeemable at the option of the investor and a collateralized mortgage obligation (or other instrument) that is issued in equity form but is required to be accounted for as a nonequity instrument regardless of how that instrument is classified in the issuer's statement of financial position.

An equity security is any security representing an ownership interest in an enterprise (for example, common, preferred or other capital stock) or the right to acquire (for example, warrants, rights and call options) or dispose of (for example, put options) an ownership interest in an enterprise at fixed or determinable prices. Table 1 gives examples of debt and equity securities.

Table 1:
Examples of Debt and Equity Securities

Investment Security                           Debt      Equity

Call Options                                               X
Collateralized Mortgage Obligation              X
Commercial Paper                                X
Common Stock                                               X
Convertible Debt                                X
Corporate Bonds                                 X
Interest-Only and Principal-Only Strips         X
Municipal Securities                            X
Preferred Stock                                            X
Put Options                                                X
Real Estate mortgage Investment Conduits        X
Redeemable Preferred Stock                      X
U.S. Government Agency Securities               X
U.S. Treasury Securities                        X
Warrants                                               X

This Statement supersedes SFAS 12, and related FASB Interpretations No. 11, Changes in Market Value After the Balance Sheet Date; No. 12, Accounting for Previously Established Allowance Accounts; No. 13, Consolidation of a Parent an Its Subsidiaries Having Different Balance Sheet Dates; and No. 16, Clarificatio of Definitions and Accounting for Marketable Equity Securities That Become Nonmarketable. In addition, there are numerous amendments to existing pronouncements as summarized in Table 2.

As used in SFAS 115, fair value means the following:

* The fair value of an equity security is readily determinable if sales price or bid-and-asked quotations are currently available on a securities exchange registered with the SEC or in the over-the-counter market, provided that those prices or quotations for the over-the-counter market are publicly reported by the National Association of Security Dealers Automated Quotations systems or by the National Quotation Bureau. Restricted stock does not meet this definition.

* The fair value of an equity security traded only in a foreign market is readily determinable if that foreign market is of a breadth and scope comparabl to one of the U.S. markets referred to above.

* The fair value of an investment in a mutual fund is readily determinable if the fair value per share (unit) is determined and published and is the basis fo current transactions.

Classification of Debt and Equity Securities

When debt and equity securities are acquired, an enterprise should classify eac security into one of three categories: held-to-maturity, available-for-sale or trading. At each reporting date, the appropriateness of the classification should be reassessed.

Investments in debt securities should be classified as "held-to-maturity" only if the enterprise has the positive intent and ability to hold those securities to maturity. An enterprises's asset-liability management policies may encompass consideration of the maturity and repricing characteristics of all investments in debt securities, and an enterprise may choose to designate certain debt securities as unavailable to be sold. SFAS 115 permits the enterprise to accoun for those securities at amortized cost on the basis of positive intent and ability to hold them to maturity.

Debt securities should not be classified as held-to-maturity if the enterprise has the intent to hold the security for only an indefinite period. For example, a debt security should not be classified as held-to-maturity if that security would be available to be sold in response to:

* Changes in market interest rates and related changes in the security's prepayment risk;

* Needs for liquidity, such as due to the withdrawal of deposits, increased demands for loans, surrender of insurance policies or payment of insurance claims;

* Changes in the availability of and yield on alternative investments;

* Changes in funding sources and terms; and

* Changes in foreign security risk.

However, certain sales of securities may be considered as maturities for purposes of the classification of securities if:

* The sale of a security occurs near enough to its maturity date (or call dat if exercise of the call is probable) that interest rate risk is substantially eliminated as a pricing factor.

* The sale of a security occurs after the enterprise has already collected a substantial portion (at least 85%) of the principal outstanding at acquisition due to either prepayments on the debt security or to scheduled payments on a debt security payable in equal installments (both principal and interest) over its term. For variable-rate securities, the scheduled payments need not be equal.

Circumstances may cause an enterprise to change its intent to hold a certain security to maturity without calling into question its intent to hold other deb securities to maturity in the future. Thus, the sale or transfer of a held-to-maturity security due to one of the following changes in circumstances should not be considered inconsistent with its original classification:

* Evidence of a significant deterioration in the issuer's creditworthiness.

* A change in tax law that eliminates or reduces the tax-exempt status of interest on the debt security (but not a change in tax law that revises the marginal tax rates applicable to interest income).

* A major business combination or major disposition (such as sale of a segment) that necessitates the sale or transfer of held-to-maturity securities to maintain the enterprise's existing interest rate risk position or credit ris policy.

* A change in statutory or regulatory requirements significantly modifying either what constitutes a permissible investment or the maximum level of investments in certain kinds of securities, thereby causing an enterprise to dispose of a held-to-maturity security.

* A significant increase by the regulator in the industry's capital requirements that causes the enterprise to downsize by selling held-to-maturity securities.

* A significant increase in the risk weights of debt securities used for regulatory risk-based capital purposes.

* In addition, other events that are isolated, nonrecurring and unusual for the reporting enterprise to sell or transfer a held-to-maturity security withou necessarily calling into question its intent to hold other debt securities to maturity.

Debt securities that are not classified as held-to-maturity and equity securities that have readily determinable fair values should be classified as either trading securities or available-for-sale securities. Securities that are bought and held principally for the purpose of selling them in the near term should be classified as "trading securities." Investments not classified as trading securities or as held-to-maturity securities should be classified as "available-for-sale securities."

For trading securities, trading generally reflects active and frequent buying and selling, and trading securities are generally used with the objective of generating profits on short-term differences in price. Mortgage-backed securities that are held for sale in conjunction with mortgage banking activities, as described in SFAS 65, Accounting for Certain Mortgage Banking Activities, should be classified as trading securities. Other mortgage-backed securities not held for sale in conjunction with mortgage banking activities should be classified based on the positive intent and ability to hold to maturity criteria that apply to other debt securities.

Accounting Method

Investments in debt securities that are classified as held-to-maturity should b measured at cost in the statement of financial position. Debt securities that are not classified as held-to-maturity and equity securities that have readily determinable fair values should be measured at fair value in the statement of financial position.

Debt and equity securities may experience holding gains or losses. According to SFAS 115, a holding gain or loss is the net change in fair value of a security exclusive of dividend or interest income recognized but not yet received and exclusive of any write-downs for other-than-temporary impairment. Unrealized holding gains for trading securities should be included in earnings. However, unrealized holding gains and losses for available-for-sale securities should be reported as a net amount in a separate component of stockholders equity until realized rather than included in earnings. The tax effects of unrealized holdings gains and losses included in stockholders' equity should be accounted for in accordance with SFAS 109, Dividend and interest income, including amortization of discount or premium arising at acquisition, for all three categories of debt and equity securities and realized gains and losses for securities classified as either available-for-sale or held-to-maturity should b included in earnings.

The transfer of a security between categories of investments should be accounte for at fair value. At the date of transfer, the security's unrealized holding gain or loss should be accounted for as follows:

* For a security transferred from the trading category, the unrealized holdin gain or loss at the date of the transfer will have already been recognized in earnings and should not be reversed.

* For a security transferred into the trading category, the unrealized holdin gain or loss at the date of the transfer should be recognized in earnings immediately.

* For a debt security transferred into the available-for-sale category from the held-to-maturity category, the unrealized holding gain or loss at the date of the transfer should be recognized in a separate component of stockholder's equity.

* For a debt security transferred into the held-to-maturity category from the available-for-sale category, the unrealized holding gain or loss at the date of the transfer should continue to be reported in a separate component of stockholders' equity but should be amortized over the remaining life of the security as an adjustment of yield in a manner consistent with the amortization of any premium or discount. The amortization of an unrealized holding gain or loss reported in equity will offset or mitigate the effect on interest income o the amortization of the premium or discount for that held-to-maturity security.

Transfers from the held-to-maturity category should be rare, except for transfers due to changes in circumstances identified above. In addition, transfers into or out of the trading category should be rare, given the nature of a trading security.

Debt and equity securities may experience an impairment of value. For securitie classified as either available-for-sale or held-to-maturity, an enterprise should determine whether a decline in fair value below the amortized cost basis is other than temporary. For example, if it is probable that an investor will b unable to collect all amounts due according to the contractual terms of a debt security not impaired at acquisition, an other-than-temporary impairment should be considered to have been incurred. If the decline in fair value is judged to be other than temporary, the cost basis of the individual security should be written down to fair value as a new cost basis and the amount of the write-down should be included in earnings. The new cost basis should not be changed for subsequent recoveries of fair value. Subsequent increases in the fair value of available-for-sale securities should be included in the separate component of equity; subsequent decreases in fair value, if not an other-than-temporary impairment, also should be included in the separate component of equity.

Financial Statement Presentation

An enterprise that presents a classified statement of position should report al trading securities as current assets and should report individual held-to-maturity securities and individual available-for-sale securities as either current or noncurrent, as appropriate, under the provisions of ARB No. 43, Chapter 3A, Working Capital--Current Assets and Current Liabilities. Cash flows from purchases, sales and maturities of available-for-sale securities and held-to-maturity securities should be classified as cash flows from investing activities and reported gross for each security classification in the statement of cash flows. Cash flows from purchases, sales and maturities of trading activities should be classified as cash flows from operating activities.

Disclosures

For securities classified as available-for-sale and separately for securities classified as held-to-maturity, all enterprises should disclose information about the contractual maturities of those securities as of the date of the most recent statement of financial position presented. Maturity information may be combined in appropriate groupings. Financial institutions should disclose the fair value and the amortized cost of debt securities based on at least four maturity groupings: within one year, after one year through five years, after five years through ten years, and after ten years. Securities not due at a single maturity date, such as mortgage-backed securities, may be disclosed separately rather than allocated over several maturity groupings; if allocated, the basis of allocation should be disclosed.

For each period for which the results of operations are presented, an enterpris should disclose:

* The proceeds from sales of available-for-sale securities and the gross realized gains and gross realized losses on those sales;

* The basis on which cost was determined in computing realized gain or loss (that is, specific identification, average cost or other method used);

* The gross gains and gross losses included in earnings from transfers of securities from the available-for-sale category into the trading category;

* The change in net unrealized holding gain or loss on available-for-sale securities that has been included in the separate component of stockholders' equity during the period; and

* The change in net unrealized holding gain or loss on trading securities tha has been include in earnings during the period.

For any sales of or transfers from securities classified as held-to-maturity, the amortized cost amount of the sold or transferred security, the related realized or unrealized gain or loss, and the circumstances leading to the decision to sell or transfer the security should be disclosed in the notes to the financial statements for each period for which the results of operations ar presented.

Effective Date and Transition

SFAS 115 is effective for fiscal years beginning after December 31, 1993. For fiscal years beginning prior to December 16, 1993, enterprises are permitted to initially apply this Statement as of the end of a fiscal year for which annual financial statements have not previously been issued. SFAS 115 may not, however be applied retroactively to the interim financial statements for that year. Otherwise, initial application of this Statement should be as of the beginning of an enterprise's fiscal year; at that date, investments in debt and equity securities owned should be classified based on the enterprise's current intent. Earlier application as of the beginning of a fiscal year is permitted only in financial statements for fiscal years beginning after issuance of this Statement. SFAS 115 may not be applied retroactively to prior years' financial statements.

The effect on retained earnings of initially applying SFAS 115 should be reported as the cumulative effect of a change in accounting principle as described in APB Opinion No. 20, Accounting Changes. The effect on retained earnings includes the reversal of any amounts previously included in earnings that would be excluded from earnings under this Statement. The unrealized holding gain or loss, net of tax effect, for securities classified as available-for-sale as of the date that this Statement is first applied should b recorded as an adjustment of the balance of the separate component of equity. The pro forma effects of retroactive application should not be disclosed.

Conclusion

In spite of several unresolved issues, the disparities among industries, the differences in recognizing unrealized gains and unrealized losses, and the lack of even-handedness of the LOCOM method are eliminated by SFAS 115. Thus, the Statement does represent an improvement in financial reporting.

This Statement also responds to criticisms regarding the relevance of financial statement data. Many users of financial statements are critical of amortized cost accounting, claiming that the data are not relevant. At the same time, others are critical of fair value accounting for debt and equity securities because fair values are not as relevant for debt securities that are held to maturity and the valuation of only some assets, without related liabilities, could result in inappropriate volatility of reported earnings. The latter two criticisms prompted the Board to retain the use of amortized cost accounting fo debt securities that are held to maturity and reporting the unrealized holding gains and losses on securities available for sale outside earnings.

James H. Thompson, CPA, PhD, is a professor at Oklahoma City University. He received his PhD in business administration from the University of Oklahoma.

TABLE 2: AMENDMENTS TO EXISTING PRONOUNCEMENTS

Paragraph 4 of Chapter 3A of ARB 43 Paragraph 19(I) of APB Opinion No. 18 Paragraphs 45, 46, 50, and 51 of SFAS 60 Paragraphs 4-9, 12, and 28-29 in SFAS 65 Paragraph 5 of SFAS 80 Paragraphs 3 and 27(a) of SFAS 91 Paragraph 28 of SFAS 97 Paragraphs 8-9 of SFAS 102 Paragraph 36(b) of SFAS 109 Paragraphs 4 and 5 of FASB Interpretation No. 40 Paragraphs 1 and 6 of FASB Technical Bulletin 79-19 Paragraph 3 of FASB Technical Bulletin No. 85-1