The many faces of financial instruments.
The 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 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), 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);
* 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 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 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 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 option).
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 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 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 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 52, Foreign Currency Translation, for hedges of foreign currency items, and Statement 80, Accounting for Futures Contracts, 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 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 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 those gains or losses until you dispose of the hedged item.) As a result, in some instances, realized gains and realized losses 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) 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 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 to satisfy the cash flow requirements (principal and interest) of a specific debt (the procedure is referred to as an in-substance defeasance 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 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 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 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, 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?
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 (lower of cost or market 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.
Impairment 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 (FDIC) to resolve whether creditors should measure impairment of loans with collectibility concerns based on the present value of expected future cash flows related to the loans. Present practice for accounting for troubled loans is mixed, and the AICPA accounting guides, particularly for banks and savings and loan associations, 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, 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.
The comment period on the exposure draft ended on September 30, 1992.
Investments with prepayment risk -- 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.
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 10, Omnibus 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 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.]