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An overview of the FASB's financial instruments project: financial innovation has left financial reporting behind.


Financial innovation has left financial reporting behind.

The financial activities of business enterprises are being revolutionized by new financial instruments--and financial reporting is having trouble keeping pace. The Financial Accounting Standards Board is doing something about that.

Innovative financial instruments and transactions--such as interest rate swaps and caps, foreign currency options, interest-only strips, asset securitizations and many more--have become commonplace and are changing the role of traditional instruments such as loans, bonds and stocks. While the effects on financial services companies are more noticeable, nonfinancial businesses also have been profoundly affected by these developments.

The economic and business forces that caused these changes persist. Increased volatility in foreign exchange and interest rates and other market prices has greatly increased market, credit and liquidity risks. Efforts to manage those financial risks, government deregulation, competition in financial services and technological advances in computers and information services will inevitably continue to spur even more financial innovation.

To a large extent, however, financial innovation has left financial reporting behind. Innovative instruments and transactions have raised accounting questions CPAs have found difficult to resolve using existing financial reporting standards. Among the many issues are what critics describe as

* Off-balance-sheet financing.

* Unjustifiable deferral of losses.

* Premature recognition of gains.

* Inadequate disclosure about risks.

Moreover, innovative financial instruments, increased volatility in financial markets and changes in the financial services industry have raised fundamental questions about the adequacy of current accounting standards for traditional instruments.


Some of the accounting issues raised by new financial instruments have been dealt with by the FASB, its emerging issues task force, the American Institute of CPAs and others. As some indication of the scale of these problems, almost half of the over 200 items considered by the EITF since its formation in 1984 have focused on financial instruments, financial institutions or off-balance-sheet financing. But critics have pointed out apparent inconsistencies between some of those ad hoc resolutions and other decisions on similar issues, and many issues remain unresolved.

The FASB's constituents asked for action. For example, a letter from the chief accountant of the Securities and Exchange Commission "strongly encourage[d] a macro-level review of the accounting and disclosure issues [that] would entail a fundamental re-examination of the recognition and measurement issues involved in financial assets and transactions which cross over industry lines." Messages such as that prompted the FASB in 1986 to add to its agenda a new major project on financial instruments and off-balance-sheet financing.

The project is expected to develop broad standards providing a consistent conceptual basis for resolving financial instrument accounting issues--both those issues that already have been identified as well as future issues that are sure to arise as the financial innovation continues.


With the help of a task force (see exhibit 1 FASB's financial instruments task force), the FASB is working on the accounting issues of financial instruments in three separate, though related, phases:

* Disclosure.

* Recognition and measurement.

* Distinguishing between liabilities and equity.


Initially, the FASB focused on how to improve disclosure of information about financial instruments. In November 1987, it issued an exposure draft, Disclosures about Financial Instruments. This ED defined financial instruments broadly and would have required for all financial instruments disclosures about credit risks, contractual future cash receipts and payments, interest rates and current market values.

After considering the responses from its constituents, the FASB concluded it should focus first on off-balance-sheet risk and concentrations of credit risk. This past July the FASB issued a revised ED, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk. It would require disclosure of information about the extent, nature and terms of financial instruments with off-balance-sheet risk and related information about credit risk, as well as information about concentrations of credit risk for all financial instruments. The FASB plans to issue a final statement before the end of 1989. Some of the proposed requirements would be effective right away--for years ending after December 15, 1989.


This phase of the financial instruments project is intended to answer such questions as

* Should financial assets be considered sold if there's recourse or other continuing involvement with them? Should financial liabilities be considered settled when assets are dedicated to settle them? Under what other circumstances should related assets and liabilities be derecognized, not recognized or offset?

* What should the accounting be for financial instruments and transactions that seek to transfer market and credit risk--for example, futures contracts, interest rate swaps, options, forward commitments, nonrecourse arrangements and financial guarantees--and for the underlying assets or liabilities to which the risk-transferring items are related?

* How should financial instruments be measured--for example, at market value, at amortized original cost, or at the lower of cost or market?

The FASB began significant work on recognition and measurement only after having issued the first disclosure ED in November 1987. Since then, the FASB has been developing a fundamental financial instrument approach to resolve the recognition and measurement issues of financial instruments.

The approach is based on the premise that all financial instruments are made up of a few building blocks--fundamental financial instruments--and that resolving the accounting issues related to those fundamental instruments is the key to resolving the recognition and measurement issues presented by combinations of the building blocks--compound financial instruments--and by relationships between instruments.

The fundamental financial instrument approach would answer the central recognition and measurement questions and the many detailed issues that underlie them by

* Identifying and determining the recognition and measurement of fundamental financial instruments.

* Determining the recognition and measurement of compound instruments by analyzing them in terms of their fundamental components and then aggregating (and perhaps tailoring) the accounting answers that their fundamental components would suggest as appropriate.

* Considering whether contractual or other relationships between financial instruments--both fundamental and compound--should affect the accounting for one or more of the related financial instruments and, if so, what that effect should be.

With the assistance of its task force on financial instruments, the FASB has been preparing an initial discussion document on recognition and measurement of financial instruments that's scheduled to be issued in 1990. Current plans are for that document to present the fundamental financial instrument approach and the central recognition and measurement issues expressed in terms of fundamental instruments, compound instruments and relationships between financial instruments. The document also is expected to include the FASB's preliminary conclusions on some issues.


The third phase of the project concerns how issuers should account for financial instruments that have both liability and equity characteristics. That question necessarily involves distinguishing between liability and equity instruments.

Here, too, with the assistance of its task force the FASB is preparing a separate discussion document that's scheduled to be issued in 1990. This document will be a neutral discussion of the issues without preliminary views of the FASB. Its focus will be on the definitions of liabilities and equity provided in FASB Concepts Statement no. 6, Elements of Financial Statements, with a view to clarifying and elaborating on them or perhaps revising them in some respects. The document will discuss such questions as these:

* Does a financial instrument (such as a stock purchase warrant or an employee stock option) that obligates an enterprise to issue its own stock at a fixed price rather than to transfer its assets qualify as a liability on the balance sheet?

* Does a financial instrument (such as mandatorily redeemable preferred stock or a put option written on an enterprise's own common stock) that obligates an enterprise to redeem or repurchase its own equity instruments for a specified price or at a specified time in the future qualify as a liability for financial reporting purposes?

* How should a compound financial instrument (such as convertible debt) with both liability and equity fundamental components be accounted for? Should the entire instrument be accounted for in the aggregate as either a liability or equity or should the instrument be broken into its fundamental components for financial reporting purposes?

* Are there circumstances in which an enterprise might reap profits or incur losses (or perhaps recognize assets or liabilities from which profits or losses will eventually stem) on transactions in its own equity instruments?


The FASB plans to issue at least three documents on financial instruments in the next 12 months. Of most immediate interest to both users and preparers of financial statements is the planned final statement based on the revised ED, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk. As proposed, that statement would begin to affect annual reports for 1989. Of greater long-term significance, however, will be the two discussion documents: one on recognition and measurement of financial instruments, including a discussion of the fundamental financial instrument approach, and the other on distinguishing between liabilities and equity.


FASB's financial instruments task force

The financial instruments task force is made up of 20 experts representing large and small banks, other financial enterprises, commercial and industrial enterprises, accounting and law firms, academe and federal regulatory agencies. The task force was created in early 1989; its members were nominated by a wide range of industry, public accounting, financial analyst, government and other organizations with an interest in standard setting. The specific responsibilities of the task force are to assist the FASB in

1. Identifying problems and issues.

2. Suggesting alternative solutions.

3. Evaluating the benefits of, as well as the costs and other disadvantages of, those alternative solutions.

4. Preparing documents for public comment that will articulate the issues and, in some cases, include the FASB's preliminary views on some or all issues.

5. Disseminating information to and gathering views from their associates, clients and others affected by the project.

The task force advises the FASB on all phases of the financial instruments project: disclosure, recognition and measurement and distinguishing between liabilities and equity.

CLIFFORD C. WOODS III is a research analyst at the Financial Accounting Standards Board, Norwalk, Connecticut. HALSEY G. BULLEN is a FASB project manager.
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Author:Bullen, Halsey G.
Publication:Journal of Accountancy
Date:Nov 1, 1989
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