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Financial statement disclosures.

Financial Statement Disclosures

The exposure draft on financial instruments concerns requires disclosures of these instruments and related transactions. Disclosure is made of both recognized and unrecognized instruments. The information is useful to stockholders, potential investors, creditors, suppliers, customers and management in their decision-making processes. The reader can evaluate the nature of the financial instruments and their effects upon the business.

A financial instrument is a contract whether recognized or unrecognized that is both a financial asset of one firm and a financial liability or equity instrument of another. It includes cash, receivables, payables, debt, equity securities, options, financial futures, forward contracts, financial guarantees, interest rate and currency swaps, collateralized mortgage obligations, etc. For example, equity securities include common stock, preferred stock, stock options, stock warrants, certificate of interest or participation and partnership agreement.

Disclosure regarding financial instruments is essential for investment and credit decision-making since it provides information regarding credit risks, interest rates, market prices, future cash receipts and cash payments and contingent obligations.

Credit Risks

Credit risk refers to the failure of a party to honor contractual terms. Disclosures are to be made either in the body of the financial statements or in the footnotes concerning each type of financial instrument having credit risk. The following credit risks may exist: maximum, reasonably possible and probable.

Maximum Credit Risk

Maximum credit risk is when there is a complete dishonor of the obligation and any collateral placed is worthless. The maximum credit risk is to be given for recognized financial assets which is typically the carrying value. If carrying value is used, no disclosure is needed. Recognized financial liabilities and unrecognized financial instruments should be identified and the maximum credit risk exposure shown by type. When an offset right exists, the maximum credit risk is the net asset after deducting the liability set-off. For instance, an asset of $200,000 and a related liability of $60,000 would be shown net at $140,000.

A measure of maximum credit risk for a financial guarantee is the discounted value of future payments that may not be made. The measure of maximum credit risk for a loan commitment is the amount of the loan under the commitment terms (e.g. letter of credit). The valuation of the maximum credit risk associated with an unrecognized interest rate swap or forward currency contract is the current market rates to replace the swap or forward contract if there is a default by the counter party. This amount constitutes the market value of the instrument.

Disclosure is made when the maximum credit risk of all financial instruments with a particular party is either (1) in excess of 20% or (2) exceeds 10% of total assets. Information disclosed includes data regarding the counterparty (e.g. industry, geographic location) and the particulars regarding the degree and amount of credit risk (e.g. reasonably possible credit loss).

Reasonably Possible Credit Loss

The reasonably possible credit loss is the one incurred by the firm because a counterparty dishonored his contractual payments. Disclosure should be made of the remaining credit loss that is at least reasonably possible including the upper and lower range of loss. If an estimate is not ascertainable, the maximum credit risk associated with the financial instrument should be specified along with descriptive data about it (e.g. collateral, counterparty).

Loans made to risky foreign countries should be disclosed including the amount, identification of foreign areas and the terms.

Probable Credit Loss

The probable credit loss is the loss likely to be incurred because of a counterparty's failure to carry out a contractual agreement. Accrual is made of the probable credit loss. In addition, the probable loss should be stated in the footnotes for each class of financial instruments.

Credit Risk Disclosures

Disclosure is required of credit risk for significant group concentrations of counterparties. A group concentration is when counterparties are involved in similar activities so they are susceptible to common conditions (e.g. economic factors). Information footnoted includes data about the shared geographic location and the amount of credit risk.

Industry or regional concentrations of credit risk have to be disclosed including a description of the nature of the businesses involved. For instance, a retail concern may provide information regarding the type of business, geographic location, credit policy and experiences with customers.

Recommended disclosures also exist for collateral and security supporting financial instruments having credit risk.

Disclosure is suggested when the source of repaying a loan is restricted by a nonrecourse arrangement for funds derived from the sale or use of collateral. A typical disclosure might be: On December 31, 19X2, X Company had security interests in machinery as collateral in support for its leases receivable.

Market Value

A financial asset is defined as cash, right to receive cash or other financial asset, right to exchange other financial instruments on favorable terms or another firm's equity instrument.

A financial liability is an obligation to pay cash or give an asset to another firm or to exchange financial instruments on potentially unfavorable terms with another business.

An equity instrument is an ownership interest in another entity. Financial assets and liabilities should be reported at market values by class in the body or footnotes to the financial statements. If the market value is not ascertainable, footnote disclosure should be made of that fact. Market value is based on quoted prices. When quoted market prices are not available, there should be an estimate made of the market value. The estimate may be tied into the market price of a similar financial asset or liability (e.g. similar terms, risk) or another measure indicative of current prices. For example, in the event a quoted market price does not exist for a loan, the market value is estimated based on the market prices of similar loans or financial assets with similar credit ratings, interest rates and maturities. When estimates are required, disclosure should be made of the method and assumptions used.

In the case where market value of a financial instrument is not determinable or estimable, disclosure should be made of the reasons why market value may not be expressed and of interest rate, carrying amount, maturity and other characteristics relevant to the valuation of the financial instrument.

Prices for financial instruments may be quoted in several markets. Typically, the price in the most active market will be the most appropriate market value to use.

It is suggested that the company disclose that if it sold all of the financial instruments held, the amount received may be less than the recorded or disclosed amount because a significant sales volume would downwardly affect market price.

In the event that possible taxes and other expenses related to the sale or settlement of a financial instrument have not been taken into account, a disclosure of that fact should be made.

Future Cash Receipts and

Cash Payments

A company must disclose in the body or footnotes to the financial statements data about future contractual cash receipts and cash payments resulting from financial instruments. Disclosure should be made of the dates they are contractually to take place. The disclosure includes principal, interest, preferred dividends and other contractual information. However, this requirement does not apply to financial instruments to be settled prior to maturity for which market value is presented in the financial statements.

Information must be given as to the future dates and amounts of financial instruments according to the contract, or, if not fully stated in the agreement, disclosure should be given to that effect. If the future dates and amounts are contingent upon future occurrences, that fact should be specified. The timing of cash flows of financial instruments that may be impacted by certain events include demand deposits of banks and mortgages containing pre-payment options. In these cases, the contracted dates are the earliest ones for which the creditor can demand payment (for example, the next business day for the bank).

Disclosure should be made of the maturity date, carrying value and effective interest rate for each major category of financial instruments. The disclosed amounts for a financial asset or financial liability involving a right of exchange of financial instruments are the amounts to be exchanged as per the terms of the contract.

Disclosure is made of cash receipts and cash payments that are to take place within one year, between one year and five years and after five years.

It is suggested that subdivision of those intervals occur, particularly for intervals that include more than half of a company's future cash receipts and cash payments. Information may be included in narrative or tabular form.

Certain financial instruments do not have a mandatory redemption date so there is no required future cash payment for principal. An example is the par value of preferred stock. In this case, disclosure is needed, but the future periodic cash payments (e.g. dividends) should be specified.

There should be disclosure of foreign currency items whose future cash flows or have material effects on the firm's overall interest rates. Here, aggregate amounts can be presented for total financial assets, total financial liabilities and total equity.

Prepayment provisions for financial instruments should be disclosed. Where anticipated cash receipts and cash payments may differ materially in amount or timing from the contractual provisions due to option clauses, it is recommended that such information be disclosed.

Interest Rates

Disclosure of the effective interest rates, carrying values, maturity dates and contractual repricing associated with interest-bearing financial instruments should be made. However, this information need not be presented for instruments held for sale being reported at market value.

Data regarding interest rates may be disclosed for individual financial instruments or weighted averages for the total financial instruments by class. Disclosure of interest rates may be made in narrative form (e.g. recommended for a small business) or tabular form (e.g. a larger business).

When the anticipated repricing or maturity dates of financial instruments differs materially from contractual requirements due to possible contingencies and options, appropriate disclosure is required.

It is assumed that a financial instrument reported as current is noninterest bearing. If not, such must be stated in the footnotes.

Information should be presented regarding interest rates of financial instruments denominated in foreign currencies when there is a material impact on the company's overall average effective interest rates.

It is recommended that there be a subdivision of the intervals, particularly for intervals that comprise in excess of 50% of the firm's total financial assets and liabilities.

Contingent Obligations

A contingent obligation may exist when a borrower pays a fee to the guarantor of a loan and the guarantor commits to reimburse the lender in the event of borrower default. The guarantor recognizes a financial liability while the lender records a financial asset.

Pension Plans

Pension plan liabilities are financial obligations to pay cash to retired employees as per a contractual arrangement. Pension plan assets consist of cash, receivables, equity securities, bonds, financial instruments and nonfinancial assets (e.g. real estate). Hence, pension liabilities and almost all pension plan assets are financial instruments.

Conclusion

To provide meaningful information to financial readers about financial instruments, disclosure is needed of credit risks including maximum credit risk, reasonably possible credit loss and probable credit loss. Data on interest rates also provide clues as to a company's financing strategy. The market value of securities is also relevant as well as expected cash receipts and cash payments. Contingent obligations must be presented for appraising possible future obligations.

Joel G. Siegel, Phd, CPA, is an accounting consultant and professor of accounting at Queens College of the City University of New York.

Peter Chiu, JD, is a financial consultant and professor of accounting at Queens

College of the City University of New York
COPYRIGHT 1990 National Society of Public Accountants
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Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Author:Siegel, Joel G.; Chiu, Peter
Publication:The National Public Accountant
Date:Aug 1, 1990
Words:1950
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