The many faces of financial instruments.
Wondering where the FASB's financial instruments project stands? Here's an update from an insider.
The Financial Accounting Standards Board Financial Accounting Standards Board (FASB)
Board composed of independent members who create and interpret Generally Accepted Accounting Principles (GAAP). (FASB FASB
See: Financial Accounting Standards Board
See Financial Accounting Standards Board (FASB). ) has been working on its financial instruments project for more than five years now. The Board recently issued a number of important documents in connection with the project and is undertaking several new phases or subprojects this year. So what milestones has the Board met thus far, and what are the next steps?
The FASB's primary objective for the project is to develop broad standards for resolving the accounting issues raised by financial instruments, financial transactions, and the inconsistent accounting guidance and practice developed for financial instruments over the years. This objective has two parts: first, to create comprehensive guidance and, second, to eliminate existing inconsistent accounting guidance and practice. To be a success, the project must achieve both, and that demands considerable time and effort.
With that in mind, the Board initially divided the project into three parts: disclosures, liabilities and equity, and recognition and measurement. But, given the wide variety of existing financial instruments and the growth of new instruments, the Board needs more than simply a good articulation articulation
In phonetics, the shaping of the vocal tract (larynx, pharynx, and oral and nasal cavities) by positioning mobile organs (such as the tongue) relative to other parts that may be rigid (such as the hard palate) and thus modifying the airstream to produce speech of the issues to accomplish its task. It needs a tool to help understand the economics of financial instruments and transactions and the potential accounting consequences of different economic characteristics. That tool is the fundamental financial instruments (FFI FFI Fuel Freedom International
FFI Foreign Function Interface
FFI For Further Information
FFI Fatal Familial Insomnia
FFI Fauna and Flora International
FFI Forces Françaises de l'Intérieur (WWII, French Resistance Army) ), or the "building-block," approach.
First and foremost, the FFI approach is an analytical tool. Like the analytical methods of "financial engineering," widely accepted in the investment community today, it's built on the assumption that all financial instruments are made from a set of only a few different building blocks. Therefore, all financial instruments could be reduced to their simplest expression, and that breakdown may help establish proper accounting guidance for all instruments.
With the FFI approach, you can group recognition and measurement issues under three headings: those related to fundamental instruments (the building blocks); those related to compound instruments (instruments that are made up of more than one fundamental instrument); and relationships between fundamental instruments, compound instruments, or fundamental and compound instruments.
The Board has tentatively identified six fundamental financial instruments, each characterized by the obligations and the rights it entails:
* An uncondiitonal receivable and payable--an unqualified right or obligation to receive or deliver cash or a financial instrument (for example, a zero-coupon bond Zero-Coupon Bond
A debt security that doesn't pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value.
Also known as an accrual bond. );
* A conditional receivable and payable--a qualified right or obligation to receive or deliver cash or a financial instrument depending on whether an uncertain event occurs (for example, a potential obligation under a casualty insurance contract);
* A financial forward contract--an unconditional HEIR, UNCONDITIONAL. A term used in the civil law, adopted by the Civil Code of Louisiana. Unconditional heirs are those who inherit without any reservation, or without making an inventory, whether their acceptance be express or tacit. Civ. Code of Lo. art. 878.
UNCONDITIONAL. right or obligation to exchange financial instruments (for example, a foreign exchange contract);
* A financial option contract--a right or obligation to exchange financial instruments if an event within the control of the holder occurs (for example, a put option to sell stocks);
* A financial guarantee or other conditional exchange contract--a right or obligation to exchange financial instruments if an event outside the control of either party occurs (for example, an obligation under a loan guarantee); and
* An equity instrument--a contract that provides an ownership interest in an entity.
One example of using the FFI approach as an analytical tool for compound instruments is in the case of bonds that contain a call provision allowing the issuer to buy back the bonds at a specified early date. From the issuer's perspective, those bonds can be analyzed an·a·lyze
tr.v. an·a·lyzed, an·a·lyz·ing, an·a·lyz·es
1. To examine methodically by separating into parts and studying their interrelations.
2. Chemistry To make a chemical analysis of.
3. as a series of unconditional payables (for the principal and interest amounts, assuming fixed-rate bonds) and a financial option (a call option held to repurchase re·pur·chase
tr.v. re·pur·chased, re·pur·chas·ing, re·pur·chas·es
To buy (something) again.
The act of buying something that one previously sold or owned.
Noun 1. the bonds). Another example is a traditional home mortgate loan analyzed from the borrower's perspective as a compound instrument made of a series of unconditional payables and a call option held (the prepayment Prepayment
1. The payment of a debt obligation prior to its due date.
2. The excess payment over a scheduled debt repayment amount.
1. Examples include deferred expenses such as rent and early loan repayments.
The Board is still developing the FFI approach, and it may change the set of fundamental instruments if members decide some instruments aren't fundamental. Or the Board may add more fundamental instruments to the list. How much the approach will help resolve the accounting issues raised by financial instruments remains to be seen. So far, it's served its original purpose of helping the Board understand the economics of complex financial instruments and transactions and shaping the issues the FASB will address in the recognition and measurement part of the project.
WHAT HAPPENS NEXT?
The principal documents published so far under the three parts of the financial instruments project are all consistent with the "comprehensive guidance" aspect of the project. After completing the discussion memorandum on recognition and measurement, the Board decided to further subdivide TO SUBDIVIDE. To divide a part of a thing which has already been divided. For example, when a person dies leaving children, and grandchildren, the children of one of his own who is dead, his property is divided into as many shares as he had children, including the deceased, and the share that part of the project into more manageable pieces, while still aiming to provide comprehensive guidance for all types of financial instruments and transactions. The FASB can't address all these pieces at the same time because of constraints CONSTRAINTS - A language for solving constraints using value inference.
["CONSTRAINTS: A Language for Expressing Almost-Hierarchical Descriptions", G.J. Sussman et al, Artif Intell 14(1):1-39 (Aug 1980)]. on both staff resources and the Board's time, so the group identified these subprojects for immediate attention: hedgeing, derecognition, and compound instruments.
Hedging and hedge accounting--Hedging and hedge accounting Why is hedge accounting necessary?
Many financial institutions and corporate businesses (entities) use derivative financial instruments to hedge their exposure to different risks (eg interest rate risk, foreign exchange risk, commodity risk, etc). need early consideration since hedging abounds and comprehensive guidance in the accounting literature is scarce. You can find most of the authoritative guidance in FASB Statements FASB Statement
A standard set by the Financial Accounting Standards Board regarding a financial accounting and reporting method. Essentially, FASB statements determine the acceptable accounting practices that Certified Public Accountants use in reporting 52, Foreign Currency Translation, for hedges of foreign currency items, and Statement 80, Accounting for Futures Contracts Futures Contract
An exchange traded agreement to buy or sell a particular type and grade of commodity for delivery at an agreed upon place and time in the future. Futures contracts are transferable between parties. , for futures contracts used as hedging instruments.
Unfortunately, these pronouncements cover only a few of the financial instruments used nowadays for hedging various kinds of risk. Also, some conceptual conflicts on how to apply hedge accounting exist between them. Generally, Statement 52 restricts hedging to an individual-transaction basis and restricts hedge accounting to hedges of firm commitments, assessed at the individual-transaction level; Statement 80 allows hedge accounting for hedges of many kinds of anticipated transactions, with risk assessed at the transaction and the enterprise levels. (Statement 80 allows hedging of a position, which normally consists of more than one financial instrument.)
The hedging subproject will reconsider re·con·sid·er
v. re·con·sid·ered, re·con·sid·er·ing, re·con·sid·ers
1. To consider again, especially with intent to alter or modify a previous decision.
2. the conclusions reached in both statements, but it'll also address more fundamental issues, like which hedge accounting method should be used. Currently, the deferral deferral - Waiting for quiet on the Ethernet. method is used in practice: You recognize losses or gains on the hedging instrument at the same time you recognize gains or losses on the hedged item. (Typically, this means you defer de·fer 1
v. de·ferred, de·fer·ring, de·fers
1. To put off; postpone.
2. To postpone the induction of (one eligible for the military draft).
v.intr. those gains or losses until you dispose of the hedged item.) As a result, in some instances, realized gains Realized Gain
A gain resulting from selling an asset at a price higher than the original purchase price.
There may be tax consequences for a realized profit. and realized losses Realized Loss
A loss recognized when assets are sold for a price lower than the original purchase price.
A portion of the realized loss may be applied against a capital gain or realized profit to reduce taxes. might be deferred for a long time.
An alternative is mark-to-market hedge accounting, under which you measure both the hedging instrument and the hedged item at market value, recognizing the resulting net gains or losses in income each reporting period (no net gain or loss would be recognized if the hedge is perfect). The mark-to-market method might avoid some problems currently associated with the deferral method, such as the need to assess correlation on a periodic basis.
Another question the hedging subproject will tackle is whether hedge accounting should extend to anticipated transactions. The FASB's Emerging Issues Task Force (EITF EITF Emerging Issues Task Force
EITF Edinburgh International Television Festival
EITF Europe International Taekwon-Do Federation ) recently addressed the hedging of anticipated transactions other than firm commitments, such as a hedge of next year's planned sales denominated in a foreign currency. Hedging anticipated transactions poses special problems because the items to be hedged don't qualify for recognition as assets or liabilities at the reporting date and, in certain cases, the amount of risk to be hedged is uncertain.
Work on the hedging subproject started in late 1991, and the Board is currently deliberating some of the issues. The plan is to issue a preliminary views document containing the Board's tentative conclusions on the major issues before moving on to an exposure draft that would address all the issues.
Derecognition--Derecognition is the process of removing a financial asset or liability from the balance sheet. In most cases, the derecognition question is straightforward. Most sales or transfers of assets and settlement of liabilities are unequivocal and justify immediate derecognition of the financial instruments. In other cases, however, the answer isn't so clear. FASB Statement 76, Extinguishment The destruction or cancellation of a right, a power, a contract, or an estate.
Extinguishment is sometimes confused with merger, though there is a clear distinction between them. of Debt, and Statement 77, Reporting by Transferors for Transfers of Receivables with Recourse, address two of those cases.
Statement 76 allows the derecognition of a liability when you meet certain criteria, for example when you place assets in an irrevocable trust Irrevocable Trust
A trust that, once its setup, cannot be changed at all.
This is to prevent fraudulent activities.
See also: Exemption Trust, Trust, Unit Trust
A trust that is unable to be amended, altered, or revoked. to satisfy the cash flow requirements (principal and interest) of a specific debt (the procedure is referred to as an in-substance defeasance In-substance defeasance
Process through which debt is removed from the balance sheet but not canceled. of debt). Statement 77 allows the derecognition of receivables in certain cases when an entity retains some of the risks (recourse provisions against the transferor) associated with the transferred receivables. This is the accounting treatment followed for securitization Securitization
The process of creating a financial instrument by combining other financial assets and then marketing them to investors.
Mortgage backed securities are a perfect example of securitization.
May also be spelled as "securitisation. transactions.
As a result of the derecognition project, which is just starting, the Board will reconsider the conclusions reached in these two statements. Deliberations should take place in the next few months.
Compound instruments--Should the fundamental components of some compound instruments be accounted for and displayed separately in the balance sheet? That's the primary question in the FASB's third subproject. For example, should the conversion option in a convertible bond be shown as an equity instrument on the issuer's balance sheet, or should it be reported as part of the liability? Should separate display be used only if one component is equity, or should it be applied more broadly? If separate display is prescribed pre·scribe
v. pre·scribed, pre·scrib·ing, pre·scribes
1. To set down as a rule or guide; enjoin. See Synonyms at dictate.
2. To order the use of (a medicine or other treatment). for certain compound instruments, then how should the initial carrying amount be allocated between the separate components?
The Board wants to provide initial guidance on these and possible other related issues quickly. Work on the compound instruments subproject is scheduled to start as soon as staff resources are available.
Over the past two years, the Years, The
the seven decades of Eleanor Pargiter’s life. [Br. Lit.: Benét, 1109]
See : Time FASB added to its agenda more specific subprojects related to financial instruments to eliminate inconsistencies in the current accounting literature. Each subproject addresses part of one or more of the five categories of recognition and measurement issues (recognition, initial and subsequent measurements, derecognition, and display)--identified in the November 1991 discussion memorandum--for specific financial instruments. Although the conclusions the Board reaches will resolve inconsistencies in the literature and in practice, they won't necessarily dictate the Board's subsequent decisions on the broader subprojects, which will eventually provide accounting guidance for all types of financial instruments and transactions.
Five subprojects are either currently on the Board's agenda or were just completed:
Marketable securities--This subproject was added to the agenda in June 1991. It deals with two of the five categories of recognition and measurement issues: subsequent measurement and display. The basic question is whether marketable securities Marketable Securities
Very liquid securities that can be converted into cash quickly at a reasonable price.
Marketable securities are very liquid as they tend to have maturities less than one year, and the rate at which these securities can be bought or sold has , both debt and equity securities, should be measured at fair value at each reporting date. Among the other questions the Board will examine are these: First, should some liabilities also be required or allowed to be measured at fair value to counterbalance the fair value changes on marketable securities? If yes, what method should you use to select the appropriate liabilities? And, second, should the net unrealized changes in fair value be displayed in the income statement or directly as a separate component of stockholders' equity Stockholders' Equity
The portion of the balance sheet that includes capital received from investors in exchange for stock (paid-in capital), donated capital, and retained earnings. This is equal to total assets minus liabilities, preferred stock and intangible assets. ?
After several months of deliberations, the Board tentatively decided on the following approach to subsequent measurement of marketable securities:
* Securities held as investments (that is, only those securities acquired with the positive intent to be held until maturity) should be measured at their historical or amortized cost.
* Securities held for possible sale (that is, securities that might be sold when market conditions change, as part of an entity's asset and liability management strategy) should be measured at fair value, with changes in fair value recognized in stockholders' equity.
* Securities held for trading should be measured at fair value, with changes in fair value recognized in the income statement.
As you can see, the proposal doesn't cover liabilities, and the Board didn't totally eliminate the use of management's intent as a factor in determining the appropriate measurement basis for marketable securities, one early criticism by the SEC. However, the proposal would virtually eliminate the use of LOCOM LOCOM Lower of Cost or Market (inventory valuation method/rule)
LOCOM Lake Oswego Communications (Oregon emergency dispatch) (lower of cost or market lower of cost or market
A method for determining an asset's value such that either the original cost or the current replacement cost, whichever is lowest, is used for financial reporting purposes. value) accounting for marketable securities and would reduce the number and amount of debt securities that financial institutions and other entities can include in their investment category. At press time, the Board expected to issue an exposure draft in September 1992.
1. A reduction in a company's stated capital.
2. The total capital that is less than the par value of the company's capital stock.
1. This is usually reduced because of poorly estimated losses or gains.
2. of a loan -- This subproject was added to the agenda in February 1991 as a result of requests by AcSEC and the Federal Deposit Insurance Corporation Federal Deposit Insurance Corporation (FDIC), an independent U.S. federal executive agency designed to promote public confidence in banks and to provide insurance coverage for bank deposits up to $100,000. (FDIC FDIC
See: Federal Deposit Insurance Corporation
See Federal Deposit Insurance Corporation (FDIC). ) to resolve whether creditors should measure impairment of loans with collectibility concerns based on the present value of expected future cash flows Expected future cash flows
Projected future cash flows associated with an asset. related to the loans. Present practice for accounting for troubled loans is mixed, and the AICPA AICPA
See American Institute of Certified Public Accountants (AICPA). accounting guides, particularly for banks and savings and loan associations savings and loan association, type of financial institution that was originally created to accept savings from private investors and to provide home mortgage services for the public.
The first U.S. savings and loan association was founded in 1831. , aren't totally clear and consistent on the issue.
The subproject is mainly concerned with subsequent measurement issues, primarily how impairment should be measured once it's determined there is impairment. The Board issued an exposure draft, Accounting by Creditors for Impairment of a Loan, on June 30, 1992, in which it proposed that you measure impairment by discounting the expected future cash flows using the contractual effective or implicit rate of the loan. The proposed statement would also require that troubled debt restructurings troubled debt restructuring
See debt restructuring. , currently covered by FASB Statement 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, be accounted for at fair value by the creditor at the date of the restructuring restructuring - The transformation from one representation form to another at the same relative abstraction level, while preserving the subject system's external behaviour (functionality and semantics). .
The comment period on the exposure draft ended on September 30, 1992.
Investments with prepayment risk Prepayment Risk
The uncertainty related to unscheduled prepayment in excess of scheduled principal repayment.
This risk is generally associated with mortgage securities. -- The FASB added this subproject to its agenda in January 1991 at the request of the EITF. The EITF wanted to eliminate existing inconsistencies in practice and in the accounting literature on the subsequent measurement of certain investments, such as mortage loans, whose cash flows vary because of prepayments Prepayments
Payments made in excess of scheduled mortgage principal repayments. .
Under present accounting rules, inconsistencies arise about when prepayments are required or allowed to be anticipated and which method is required or allowed to be used to recognize changes in cash flow estimates due to changes in prepayment estimates or in actual prepayment experience. To remedy these inconsistencies, the FASB issued an exposure draft, Accounting for Investments with Prepayment Risk, in September 1991, proposing prepayments be anticipated if prepayments are probable, the timing and amounts of prepayments cab be reasonably estiamted, and the effect on the effective yield of anticipating prepayments would be significant. (If the last condition isn't met, anticipation of prepayments would be optional.)
The exposure draft further proposed that companies use the retrospective method to account for the effects of changes in prepayment estimates or actual prepayment experience. Under the retrospective method, the effective yield is recalculated from inception to reflect actual payments to date and estimated future payments, with the cumulative adjustment recognized in the income statement.
The Board received 72 comment letters on the exposure draft and, in light of those comments, recently decided not to issue a final statement on the project. Board members concluded that, while the problems a prepayments standard would address are real, they're closely related to other issues in the broader project on present-value-based measurements and should be addressed in that project.
Pension plan accounting for GICs -- This subproject was added to the agenda in 1990 at the request of the EITF. FASB Statement 35, Accounting and Reporting by Defined Benefit Pension Plans, currently requires that all assets reported in the financial statements of a defined benefit pension plan be measured at fair value, except for insurance contracts, which may be reported at cost. Many have interpreted that exception to include GICs issued by insurance companies and similar contracts issued by non-insurance companies.
The subproject examines whether the exception should cover GICs and similar contracts. An exposure draft, issued in March 1992, proposes that GICs and similar contracts are investment contracts, not insurance contracts, and therefore should be reported at fair value in a defined benefit pension plan's balance sheet. Insurance contracts could still be reported at contract value. The FASB received 48 comment letters on the ED and issued a final statement in August 1992.
Offsetting of amounts related to certain contracts -- This subproject, added to the agenda in 1991, examined the applicability of current offsetting rules, contained in APB Opinion APB opinion
A determination by the former Accounting Principles Board regarding the way a certain financial transaction is to be treated for reporting purposes. 10, Omnibus omnibus: see bus. Opinion--1966, to swaps, forwards, options, and similar contracts.
The subproject was completed in March 1992 when the FASB issued Interpretation 39, Offsetting of Amounts Related to Certain Contracts. This interpretation reaffirms the applicability of Opinion 10's offsetting rules to those contracts--that is, that there is a legal right of settoff and that the intent to set off must exist to use offsetting in the balance sheet.
However, it also introduces an exception to the basic offsetting rules: It permits the offsetting of fair value amounts recognized for multiple forward, swap, option, and other contracts executed with the same counterparty Counterparty
The other participant, including intermediaries, in a swap or contract. under a master netting arrangement. (A master netting arrangement is an agreement between two parties that provides for the net settlement of all contracts through a single payment in the event of default on or termination of any one contract.) Amounts other than fair value amounts must meet the traditional conditions for offsetting.
Interpreation 39 is effective for calendar year 1994.
The FASB has already been working on financial instruments for several years now and has issued several significant documents: Statements 105 and 107, DMs on liabilities and equity and on recognition and measurement, and a research report on hedging. Much remains to be done, but those documents conclude an important phase of the overall project and constitute a solid base from which the Board can begin making decisions. Those decisions will probably mean substantial amendments to the existing pronouncements. But, with the help of constituents at the various stages of the Board's due process, the decisions will spell improvements in financial instruments accounting and reporting.
[Mr. Blanchet is project manager for the Financial Accounting Standards Board's financial instruments project.]