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Financial instruments disclosure: the FASB's intentions.

In the March/April 1988 edition of Financial Executive, two of my FASB colleagues, Lynn C. Hynes and Halsey G. Bullen, wrote an article about a 1987 exposure draft, "Disclosures about Financial Instruments" ("FASB Moves to Improve Financial Instruments Disclosure") The exposure draft was the first document published since the Board added to its agenda a major project on financial instruments and off-balance-sheet financing.

The draft, intended to be an interim step to improve information about financial instruments in the financial statements, pending completion of the recognition and measurement part of the project, proposed a comprehensive set of disclosures about the credit, liquidity, market, and interest-rate risks of financial instruments, including both assets nd liabilities on and off balance sheet. The article concluded with: "The Board encourages commentators who disagree with provisions of the exposure draft to suggest alternative improved disclosures about financial instruments that would satisfy the objectives set forth in the exposure draft. Comment letters providing that kind of information will have a major influence in deliberations on the final statement, scheduled for issuance in the third quarter of 1988."

What happened to the 1987 exposure draft?

Many constituents took the opportunity to Comment on the disclosures proposal; over 450 comment letters were received. A majority of respondents voiced their concern at the comprehensiveness of the proposed disclosures, believing that too much was required at the same time. The Board considered these comments and eventually concluded that the disclosure part of the financial instruments project should be addressed in phases; the 1987 ED never became a final statement,

The Board then decided to proceed with the first phase of the project, dealing mainly with financial instruments with off-balance-sheet risk because of the greater lack of adequate information on these instruments. The FASB issued a revised exposure draft in 1989 and, in March 1990, FASB Statement 105, "Disclosure of Information about Financial Instruments with Off-balance-sheet Risk and Financial Instruments with Concentrations of Credit Risk," was issued to complete the first phase.

At the same time, the Board decided to commence a second disclosure phase, focusing on market value disclosures. The first milestone on this project was issuing the exposure draft "Disclosures about Market Value of Financial Instruments," on December 31, 1990.

What's different this time? Of the disclosures proposed in the 1987 ED, the requirement to disclose the market value of all financial instruments was the most controversial. Respondents gave a variety of reasons for their opposition (the fact th t too many disclosures were required at the same time was certainly a compounding factor), but the problems could be broadly summarized by two words: subjectivity and costs. Some critics said that the lack of guidance on how to estimate the market value of a financial instrument would lead companies to use a wide array of methods and assumptions, resulting in a lack of comparability of the market value information among financial statements of entities, and even within the financial statements of the same entity, from year to year. Others said the costs of developing the systems necessary to provide the information were excessive, although many respondents acknowledged that they could not clearly estimate those costs.

Those two arguments were carefully considered by the Board in developing the 1990 ED. However, some similarities between the new exposure draft and the 1987 ED remain:

* The general requirement is to disclose an estimate of the market value of all financial instruments, both assets and liabilities on and off balance sheet (with a few exceptions), when it is practicable to estimate that value.

* When it is not practicable to estimate market value, other information pertinent to the market value of a financial instrument should be provided such as carrying amount, interest rate, maturity).

* There is no prescribed way to disclose the information in the financial statements as long as it is included in the body of the financial statements or in the accompanying notes.

* The requirements apply to all types of entities, including nonfinancial, private, or smaller entities.

Yet, despite the current similarities between the two EDs, the FASB did make significant changes in the 1990 version in response to comments received in 1987. In general, these changes aim at reducing the costs of complying with the disclosure requirements set forth in the proposed statement.

The first change deals with practicability. The Board wanted to make sure that an entity would not have to incur excessive costs to comply with the disclosure requirements, at the same time acknowledging that preparers are in the best position to determine what is practicable, depending on the types of financial instruments they hold and the information systems at their disposal. For the same reason, the Board also chose to continue providing only limited guidance on how to estimate the market value of financial instruments, even though general guidance may result in disclosures that are less comparable from entity to entity. The Board believes that investors and creditors are better off having some timely information, based on current market prices, that is less costly to produce under general guidance, and risking the possibility that the information might be less than fully comparable. The Board also noted that it's unclear how the current accounting and disclosure practices followed for various financial instruments achieve a high level of comparability among financial statements of entities.

In another change, the Board decided to exclude certain types of financial instruments from the scope of the proposed statement because the Board is uncertain about how the overall benefits of providing market value information about these instruments compares with the costs involved. These instruments include various forms of deferred compensation arrangements (such as obligations for pension benefits and other postretirement benefits), insurance contracts other than financial guarantees and investment contracts, lease contracts, warranty obligations, and substantively extinguished debt.

The Board also made a significant change to the definition of market value used in the exposure draft. The market value of a financial instrument is defined in paragraph 5 of the 1990 ED as "the product of the number of trading units of the instrument times its market price - the amount at which a single trading unit of the instrument could be exchanged in a current transaction between a willing buyer and a willing seller, other than in a forced or liquidation sale."

The revised definition better conveys the Board's opinion that the size of an entity's holding of a type of financial instrument should not be taken into account when estimating market value (sometimes referred to as the "blockage" issue) and that market value as defined in the ED does not imply liquidation value. Also, by focusing on an exchange rather than on a sale for an asset or on a settlement for a liability, the definition accommodates either a concept of entry value or origination market (for example, the market value of a long-term loan could be based on the rate an entity's bank would charge today for a similar loan) or exit value or trading market (for example, the bid price for a debt security quoted on an exchange market). Once again, the FASB gives preparers more flexibility to exercise their judgment in determining the methods and assumptions or prices to use to estimate market value.

Perhaps as important as the changes made to the 1987 ED are the changes in the economic environment in the past few years. New markets for financial instruments have emerged (for example, a market for distressed U.S. corporate loans); the volume in other markets has increased dramatically (for example, the markets for LDC loans and mortgage-backed securities); on-line quotation systems are more widely used; and valuation models (for example, option pricing models) have been significantly refined and are used to value a greater variety of financial instruments.

At the same time, pressure is mounting for more market value information in financial statements, particularly for financial institutions:

* The office of Thrift Supervision (OTS) is now experimenting with an internally developed market value model that uses data provided by thrift institutions to measure their interest-rate exposure.

* In February 1991, the Department of the Treasury issued a report entitled "Modernizing the Financial System," in which it concludes that it would be premature to impose comprehensive market value accounting on banks and thrifts (at least until further study of the issue is undertaken), but at the same time the Department supports the idea of more disclosures about market value.

* Over the past few months, SEC Chairman Breeden made clear his preference for the use of market value accounting by financial institutions. For example, in a testimony before the Senate Banking Committee on September 10, 1990, he stated: "Steps currently being taken to clarify the accounting treatment for investment portfolios should be part of a broader move in the direction of mark-to-market accounting. The benefits of market-based accounting warrant consideration of a broader shift in this direction. The presumption that market-based information is the most relevant financial data attribute should be recognized. It may be appropriate to utilize historical cost only where specifically justified by the circumstances in the future."

(Following these comments, and at the request of the AICPA and the Big 6 accounting firms, the Board decided, at its November 14, 1990, meeting, to consider accelerating a portion of its financial instruments project concerning the subsequent measurement of some financial instruments, to include investment securities and perhaps certain other financial assets and liabilities. No decisions have been reached yet on this potential project.)

Why include nonfinancial entities?

Many respondents to the 1987 ED argued that financial institutions are the real target of the market value proposal and that nonfinancial entities should not be dragged into the scope of the ED. They further argued that market value disclosures for financial instruments only are not relevant because a significant portion of their balance sheets are represented by nonfinancial assets, unlike the balance sheets of financial institutions.

As mentioned earlier, the proposed market value disclosures would be required from all entities, including small nonpublic nonfinancial entities. However, again as a cost-reducing measure, the Board proposes to give smaller entities, those with less than $100 million in total assets, one additional year to comply with the provisions of the proposed statement.

Why is the FASB including nonfinancial entities within the scope of the proposed statement? The Board gives two main reasons:

First, in the market value disclosures project, the view is that the project is about financial instruments, not financial entities. In the Board's opinion, the benefits of providing market value information for financial instruments (for example, to help users assess the consequences of an entity's financing strategy) are relevant for any type of entity. Furthermore, the costs of providing the required information should be lower for those nonfinancial entities that do not hold many sophisticated financial instruments. Finally, this view is consistent with the Board's preference for a transaction approach, rather than an industry approach, in setting accounting standards.

Second, the distinction between financial and nonfinancial entities can be difficult to make in today's economic environment; for example, certain major manufacturing companies have financial subsidiaries that rank among the largest financial institutions in the country.

Acknowledging that there was some support for exempting certain types of entities from the disclosure requirements proposed in 1987, the Board specifically requested comments on the scope, as well as the criterion used to delay the application of the proposed statement for some entities, in the Notice for Recipients of the 1990 ED. Various scopes could be considered: for example, financial institutions only, larger entities only (however defined), publicly registered entities only, entities with significant holdings of financial instruments only. The Board will reexamine these alternatives and others in light of the comments it received.

Why include financial liabilities?

Another contentious issue raised in 1987 was the inclusion of financial liabilities within the scope of the ED. Very little has been written so far in the accounting literature on market value information for liabilities, and that idea raises a number of difficult issues, including:

* Should the market value of a liability be affected by changes in an entity's own credit risk? Suppose, for example, that an entity's credit rating was downgraded by rating agencies. The entity's corporate bonds quoted on an exchange would presumably lose value; if the entity decides to buy back some of those bonds on the market, it would in fact realize a gain on the transaction.

Similarly, one could argue that an unrealized gain potentially exists for the entity's obligations that are not traded on an exchange since it could not obtain the same interest rate for a similar obligation because of the decrease in its creditworthiness. The question is, does it make sense to disclose an unrealized gain because the entity's financial condition is deteriorating? On the other hand, nobody suggests that the quoted market price of a bond is not a good indicator of the market value of that bond, whether it is held as an asset or as a liability of an entity.

* What rate should be used to estimate the market value of a liability that is not quoted on an exchange? The possible answers to that question range from a risk-free settlement rate (that is, a rate that would essentially ignore credit risk considerations) to an incremental rate of borrowing (that is, the rate an entity could obtain today for a similar loan taking into account its current credit risk rating) and depend on the concept of market that is adopted (trading market or exit value for settlement rate and origination market or entry value for incremental borrowing rate).

Consistent with the general guidance approach adopted for estimating the market value of financial assets, the Board did not prescribe a single rate to be used for estimating the market value of liabilities. A project currently on the Board's agenda that examines questions about accounting measurements based on the present value of future economic benefits or sacrifices will possibly result in additional guidance in the future on the appropriate rate to use when valuing financial liabilities. (A discussion memorandum, "Present Value-based Measurement in Accounting," was issued on December 7, 1990, as part of that project.)

* Would the market value information be as useful if provided only for financial assets? That question is more relevant in the context of financial entities because they tend to manage their financial assets and liabilities in a coordinated way to limit potential net loss from changes in interest rates. The Board concluded that, at least for those entities, the market value information for assets would be enhanced by the market value information provided for liabilities. Therefore, that constituted an added reason for including liabilities within the scope of the proposed statement.

Once again, the Board specifically requested comments from respondents to the 1990 ED on the benefits and costs of estimating the market value of liabilities and will revisit the issue after the end of the comment period.

The first step to market value accounting?

Is the market value disclosures phase the first step to market value accounting? Constituents often raise this question. There is a general misconception that the Board has already set its long-term agenda on how to measure financial instruments (at market value) and that the disclosures phase is a preliminary step towards that goal. This is definitely not the case. Apart from the potential project on investment securities referred to earlier, the Board has not started considering the appropriate way to recognize and measure most financial instruments. There is no doubt that the market value disclosures required by the proposed statement would provide the Board with valuable information to consider in recognition and measurement issues, but the primary purpose of the 1990 ED is to improve the current information provided on various financial instruments.

Furthermore, while market value information might be useful additional information for recognized financial instruments, it does not necessarily follow that it is the most relevant measurement attribute for all financial instruments. Disclosures about the market value of financial instruments are a step in the direction of better information about financial instruments, not an experimental introduction to market value accounting.

Expressions of individual views by the members of the FASB and its staff are encouraged. The views expressed in this article are those of Mr. Blanchet. Official positions of the FASB are determined only after extensive due process and deliberation.

Some questions for the FASB about its market value disclosure proposal

Loretta Allen Moseman Vice President Citicorp

All of us know that there is a strong movement supporting market value information, from SEC Chairman Breeden, from Chairman Dingell, and from others. if you focus on financial institutions, some believe that requiring market value information will prevent another crisis of the magnitude of the thrift industry debacle.

But I don't think disclosing market values is the answer. The FASB's market value disclosure statement will require all of us - financial institutions and corporations alike - to provide market value information about all financial instruments of our companies, whether on or off balance sheet. What kinds of items? Items like accounts receivable or debt outstanding. For a corporation, for instance, the biggest financial instrument is debt.

I have problems with the market value disclosures for several reasons. First, the FASB gives us no guidance on how to do what it's asking. Basically, the Board tells us, if market values are available, we should use them, no matter how illiquid the market. The Board says that, when we compute our market value, we should ignore the intangible assets that are built into the market value base - things like the core deposit for a financial institution.

The Board also says we can't say that assets have changing values, outside of the interest-rate sensitivity, because that's an intangible that's separable. I don't agree. if a company discloses information and estimates a market value, then that firm has to consider all the factors that go into the market value, including credit, the supply-and-demand climate, and the economic and political environment - not just interest-rate or foreign-exchange sensitivity. That narrower focus is misleading.

Another problem with the proposed statement is its strange wording about practicability. According to the FASB, a company should disclose market value information only if it's practicable to do so. The Board describes the process of determining practicability as a dynamic concept, dependent on company size and the costs you expect to incur in disclosure. It also suggests that in some years disclosure may be practicable while in others it won't be.

That concerns me. Is the cost/benefit analysis completed with reference to an individual company's profitability? As for company size, the proposal suggests that small enterprises may find the task impracticable, while larger firms may not. Shouldn't the rules be the same for everyone? I think this "dynamic concept" of practicability will result in a lot of management estimates that purport to be market values but, in reality, absolutely lack comparability from one company to the next.

Now, what if a company decides not to make the disclosures? The Board says, if disclosure isn't practicable, you have to provide information about the carrying amount and the interest-rate sensitivity and maturity, plus you need to explain why you believe disclosing the market value is not practicable in your case. I believe it will be rather awkward for "practicability" to vary from company to company and for any company to justify its individual decision.

The FASB also wants companies to describe whether the carrying amount approximates market value or is more or less than market value. Does that mean that, though I can't make a true market value estimate, I should tell the Board whether the carrying amount is more or less than the market value based on my best guess? I don't like that kind of disclosure.

If we want market value disclosures - or, more appropriately, if we want to disclose interest and foreign-exchange sensitivity information - let's describe the process as such. Get away from the notion that management somehow can come up with a purported market value. The market value means a price at which I can sell something. I understand why people would love to know market values, but it's silly to put us in the position of estimating non-comparable and unreal market values or buying appraisals to satisfy these requirements.

Ms. Moseman's comments were adapted from a speech she delivered to FEI's New York City Chapter.
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Title Annotation:includes related article; Financial Accounting Standards Board
Author:Blanchet, Jeannot
Publication:Financial Executive
Date:May 1, 1991
Previous Article:Marketing costs: back to basics.
Next Article:Get your financial organization close to the business.

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