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FAS 105: the future of disclosure standards for financial instruments.

Off-balance sheet disclosure of financing obligations is not a new topic for the accountant, but it does represent an issue yet to be completely resolved. The FASB first addressed the topic (FAS No. 13) when it was faced with some lease issues left unresolved by the APB. In a later standard (FAS No. 47), the FASB looked into the disclosure of off-balance sheet long term obligations, such as unconditional purchase obligations. In another standard (FAS No. 49), the FASB dealt with off-balance sheet product financing transactions in which a company sells inventory and agrees to repurchase it at a specified price. The FASB continues to be concerned with off-balance sheet financing because of innovations in financial instruments. In the past decade, because of the dynamic state of financial markets brought on by such things as deregulation, increased competition, inflation, internationalization and changes in the financial services industry, there has been an explosion in the number and variety of financial instruments offered in the marketplace. To understand the nature of these instruments, a short course in finance would be needed. There are hundreds of new financial instruments and the following list is meant to be illustrative of some of the unusual names: interest rate swaps, collateralized mortgages, put and call options, exchangeable debentures, liquid yield option notes, floating rate notes and strips.

The traditional historical cost transaction based accounting model has created an incentive to develop financial instruments that allow recognition of income earlier than traditional instruments, defer losses and avoid disclosures of risks and liability recognition. Accounting for many of these financial instruments is not yet specified under generally accepted accounting principles. To develop a standard for every instrument would mean tremendous duplication as many of the instruments could be broken down into understandable parts. Once these understandable parts are dissected, sorting them into similar categories would be necessary in order to develop a standard for recognition and measurement. Recognizing this problem, the FASB came up with three phases in the financial instruments projects:

a. Disclosure;

b. Recognition and measurement;

c. Distinguishing liabilities and equity.

FAS No. 105 addresses the first phase of the project by requiring new disclosure standards for financial instruments. It does not alter any current requirements for recognizing, measuring or classifying these instruments.

The difficult part of this Standard is in the understanding of what is a financial instrument and, as a result, the Board provides a definition of a financial instrument and gives examples of instruments included and excluded from the definition. The Statement defines a financial instrument as cash, evidence of an ownership interest in an entity or a contract that both:

a. Imposes on one entity a contractual obligation: (1) to deliver cash or another financial instrument to a second entity, or (2) to exchange financial instruments on potentially unfavorable terms with the second entity; or

b. Conveys to that second entity a contractual right: (1) to receive cash or another financial instrument from the first entity, or (2) to exchange other financial instruments on potentially favorable terms with the first entity.

The key to this definition is it requires a two-way flow of cash or financial instrument as well as the favorable and unfavorable nature of the outcome. Fundamentally, a financial instrument must ultimately result in the delivery of cash or an ownership interest in an entity. As a result, the definition excludes many assets that contain no obligation to deliver cash or right to receive cash. Some examples include: inventory, property, plant and equipment, leased assets, patents, trademarks, prepaid expenses and advances to suppliers. The definition also excludes contracts either requiring or permitting settlement by the delivery of commodities because the future economic benefit is the receipt or delivery of goods or services instead of a right to receive or deliver cash or an ownership interest. For example, bonds to be settled in ounces of gold or barrels of oil rather than cash are not financial instruments under the definition.

The Standard also defines a financial instrument with off-balance sheet risk of accounting loss if the risk of accounting loss to the entity exceeds the amount recognized as an asset or a liability. This risk includes credit risk and market risk. Credit risk is the possibility a loss may occur from the failure of another party to perform according to the terms of a contract. Market risk means the possibility of future changes in market prices may make a financial instrument less valuable. The related risk of accounting loss, for many of the financial instruments, cannot exceed the amount recognized in the financial statements. This is because the amount recognized as a financial instrument already reflects the risk of accounting loss to the entity. For example, a receivable that is recognized and measured at the present value of future cash flows can eventually become uncollectible.

The accounting loss that might arise cannot exceed the amount recognized as an asset in the balance sheet. Even in the case of complete default, the creditor cannot recognize a loss greater than the carrying value of the receivable. Since the receivable has no off-balance sheet risk, the disclosure requirements of this Standard would not apply. However, some financial instruments recognized as assets can expose the entity to a risk of accounting loss that may exceed the amount recognized in the balance sheet. For example, depending upon the future changes in interest rates, a party to an interest rate swap could be exposed to a risk of accounting loss exceeding the amounts recorded on the balance sheet. An example of a financial instrument recognized as a liability and exposes the entity to a risk of accounting loss possibly exceeding the amount recognized on the balance sheet would be a financial guarantee. In both of these examples, the financial instrument could subject their holders to off-balance sheet risk.

There are still other financial instruments not recognized either as assets or as liabilities, yet may expose an entity to a risk of accounting loss. For example, loan commitment agreements, financial guarantees and recourse obligations on receivables sold are financial instruments having off-balance sheet risk.


For financial instruments with off-balance sheet risk, an entity is required to disclose in the body of the financial statements or in the related notes by class of financial instrument:

a. The face or contract amount;

b. The nature and terms, including a discussion of: (1) the credit and market risks; (2) the cash requirements; and (3) the related accounting policy (pursuant to APB Opinion No. 22).

In addition to the disclosures above, for those financial instruments having off-balance credit risk there are two other disclosure requirements.

They are:

a. The amount of accounting loss the entity would incur if any party defaulted and the collateral for the amount due proved to be of no value to the entity; and

b. The entity's collateral policy to support financial instruments subject to credit risk, information about the entity's access to the collateral, and the nature and description of the collateral.

Besides the disclosures required for off-balance sheet risk given above, the Board also requires disclosure of all significant concentrations of credit risk arising from all financial instruments. This risk can be due to an individual or a group. Group concentrations can be based upon engaging in similar activities or having similar economic characteristics causing their ability to meet obligations to be similarly affected by changes in economic or other conditions. The following must be disclosed about each significant concentration of credit risk:

a. Information about the activity, region or economic characteristic that identifies the concentration; and

b. The same disclosure requirements needed with off-balance sheet credit risk.

The difficult part of this Statement does not come with the disclosure presentations but with the understanding of the nature of the financial instruments. Once the knowledge is gained as to the implications of the financial instruments, the battle is over. Unfortunately, understanding these innovative financial instruments may require a number of continuing professional education hours in the field of finance. Since the market is ever changing, the types of new financial instruments offered in the business environment will be steadily increasing which in turn will cause more of a demand on the accountant to gain the expertise in finance in order to properly disclose the risks.

David Lavin, PhD, CPA, is an associate professor of accounting at Florida International University. He has published in many journals addressing issues in financial accounting, ethics, accounting education and taxes. Providing continuing professional education has been a primary activity of Dr. Lavin's.
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Title Annotation:Financial Accounting Standard
Author:Lavin, David
Publication:The National Public Accountant
Date:Nov 1, 1992
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