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The FASB's new ED on disclosure: disclosures about off-balance-sheet exposures and credit risk concentrations are the FASB's targets.


Disclosures about off-balance-sheet exposures and credit risk concentrations are the FASB's targets. Are companies adequately disclosing information about the new financial instruments with off-balance-sheet risk--interest rate swaps, options written, forward interest rate contracts and financial guarantees? Some critics claim current information disclosed in the notes to financial statements is incomplete and not comparable.

In July 1989, the Financial Accounting Standards Board issued for comment a revised exposure draft, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk. This ED is more narrowly focused than the 1987 ED it replaces. See EXHIBIT 1 Summaries of the major provisions of the 1987 and 1989 exposure drafts.


Two years ago the FASB issued Disclosures about Financial Instruments. The purposes of disclosure set forth in the 1987 ED and retained in the 1989 ED are to

* Describe both recognized and unrecognized items.

* Provide a useful measure of unrecognized items and other relevant measures of recognized items.

* Provide information to help users assess risks and potentials of both recognized and unrecognized items.

Although many respondents agreed with the purposes of disclosure set forth, many also argued that the proposed disclosure requirements in the first ED were too extensive and that the cost of implementing them would be excessive. The FASB viewed the proposals as evolutionary; constituents viewed them as revolutionary.

The due process steps that followed the issuance of the first ED revealed an abundance of hotly debated issues. Many constituents contended off-balance-sheet issues are a driving force behind many of the financial reporting problems facing companies and were an important reason the project was added to the FASB's agenda in 1986. However, they argued that off-balance-sheet issues weren't sufficiently emphasized in the first ED. They urged the FASB to concentrate first on off-balance-sheet issues.

In the fall of 1988 the FASB decided to address the disclosure issues in two phases. Phase one resulted in the issuance of the revised ED. As its title implies, the current ED focuses principally on off-balance-sheet issues but also includes concentrations of credit risk for all financial instruments. Phase two, which is expected to begin when a final statement is issued on phase one, will include all financial instruments and will consider the need for information beyond that proposed in the ED, including information about interest rates, future cash receipts and payments and market value.


The current ED focuses on the reporting issues in most immediate need of improvement. The set of proposed disclosure requirements draws on information used in managing off-balance-sheet risk. In developing the proposals, the FASB

* Reviewed annual reports of companies that provide additional disclosure of information about financial instruments with off-balance-sheet risk either voluntarily or because of regulatory requirements.

* Reviewed the various Securities and Exchange Commission and regulatory reporting requirements concerning off-balance-sheet items.

* Reviewed how other standard-setting bodies around the world are responding to these issues.

* Requested and reviewed specific comments on those issues from task force members and other interested parties and organizations.

The FASB discussed the proposed disclosure requirements at eight public meetings. In addition, a mini-exposure of an earlier draft of the document's proposals was made to certain task force members and other constituents actively involved in the financial instruments project. The FASB also met with the financial instruments task force in April to discuss the document's proposals.


The deadline for comments on the revised ED was September 19, 1989, and the final statement is expected in late November 1989. Most of the disclosure requirements in the ED would be effective for 1989 calendar year reporting. These include the extent, nature and terms of financial instruments with off-balance-sheet risk and maximum credit risk for instruments with off-balance-sheet credit risk. However, the ED's proposed requirements for disclosing information about collateral and concentrations of credit risk would be effective for financial statements issued for fiscal years ending after June 15, 1990.

The FASB chose the 1989 effective date for two reasons:

1. Many constituents, including users, preparers, auditors and regulators, advocated 1989 implementation of the disclosure requirements. Some suggested the disclosure project's first phase be completed and implemented as soon as practicable so the FASB can more effectively consider the remaining disclosure issues as well as the recognition and measurement issues.

2. The FASB concluded that companies should be able to describe the nature and terms of their financial instruments with off-balance-sheet risk and to quantify the related contract amounts with minimal difficulty. An entity would need that information to manage its off-balance-sheet risk. The FASB was concerned, however, that some companies may not have systems in place to accumulate information about collateral and concentrations of credit risk. Therefore, it proposed a delayed effective date for those requirements.


At this time, companies that haven't already done so should assess the implications of the revised ED for their particular situations. The ED applies to all entities, not just financial institutions. Readers should closely review the illustration in the current ED that identifies some of the more common financial instruments and indicates whether these have off-balance-sheet risk (see EXHIBIT 2 Which financial instrument have off-balance-sheet risk aand which don't). That review will help entities in determining to what extent they're involved in financial instruments with off-balance-sheet risk and to what extent they'll be affected by the final statement. (See EXHIBIT 3 A sample disclosure about financial instruments with off-balance-sheet risk for how to make the required disclosures.)

Readers also should keep in mind that, although the current ED focuses principally on financial instruments with off-balance-sheet risk, the concentration disclosure requirements cover all financial instruments.


The FASB knows that some would prefer a faster pace of evolution and others a more moderate pace. The FASB also knows that not all constituents will endorse all its proposals in the current ED. However, all who stated their views were heard and considered, and comments from constituents on the current ED also will be considered in deliberations leading to issuance of a final statement. After considering the comments on the 1987 ED, the FASB concluded the revised ED would represent a worthwhile improvement in financial reporting. The FASB believes financial reporting for financial instruments is in a transitional stage. Once again, paragraph 2 of FASB Concepts Statement no. 5, Recognition and Measurement in Financial Statements of Business Enterprises, applies: "[T]he Board intends future change [in practice] to occur in the gradual, evolutionary way that has characterized past change."


Which financial instruments have off-balance-sheet risk and which don't

A financial instrument has off-balance-sheet risk if the risk of accounting loss to the entity exceeds the amount recognized, if any, in the statement of financial position.

The risk of accounting loss on a financial instrument includes

1. Credit risk. The possibility of loss, even if remote, from the failure of another party to perform according to the terms of a contract.

2. Market risk. The possibility that future changes in market prices may make a financial instrument less valuable or more undesirable.

3. Liquidity risk. The possibility that an entity may be obligated to pay cash that it may not have available.

4. The risk of theft or physical loss.

The FASB's revised ED addresses credit, market and liquidity risk only.

The following are examples of some financial instruments that have ("yes") and some that do not have ("no") off-balance-sheet risk; not all financial instruments included in the scope of the revised ED are illustrated.
 sheet risk
Financial instrument Holder(1) Issuer(2)

Traditional items:

Accounts and notes
 receivable or payable No No
 Bonds No No
 Cash No No
 Common stock No No
 Loans No No

Innovative items:
 Collateralized mortgage obligations No No
 Financial guarantees No Yes
 Interest rate caps and floors No Yes
 Loan commitments No Yes
 Letters of credit No Yes
 Options No Yes
 Swaps (interest rate and currency) Yes
 Forward contracts Yes
 Futures contracts Yes

(1)Holder includes buyer and investor. (2)Issuer includes seller, borrower and writer. (3)For swaps, forward contracts and futures contracts, risks are assessed in terms of the position held by the company; therefore, the holder and issuer categories do not apply.


A sample disclosure about financial instruments with off-balance-sheet risk

Here's an example of how S&C Bank might disclose information about its off-balance-sheet risk. S&C is a party in these financial instruments with off-balance-sheet risk:

* Commitments to extend credit.

* Standby letters of credit and financial guarantees.

* Interest rate swap agreements.

S&C Bank has no significant concentrations of credit risk with any individual or groups of counterparties. The information present is not comparative. This is permitted in the year of implementation; for all subsequent years, the information would be presented on a comparative basis.

S&C might disclose the following:

Note A: Summary of accounting policies Interest rate swap agreements S&C Bank is an intermediary in the interest rate swap market. As an intermediary, the bank maintains a portfolio of generally matched offsetting swap agreements. Those swaps are accounted for at market value, with changes in value reflected in noninterest income. At inception of a swap, the portion of the compensation related to credit risk and ongoing servicing is deferred and recognized as income over the term of the swap agreement.

Note B: Financial instruments with off-balance-sheet risk The bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees and interest rate swap agreements. Those instruments involve to varying degrees elements of credit, interest rate of liquidity risk in excess of the amount recognized in the statement of financial position. The contract or notional amounts of those instruments express the extent of involvement the bank has in particular classes of financial instruments.

S&C's exposure to credit loss from nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual amount of those instruments. The bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. For interest rate swap transactions, the exposure to credit loss is much less than the contract or notional amounts. S&C controls the credit risk of its interest rate swap agreements through credit approvals, limits and monitoring procedures.

Unless noted otherwise, the bank does not require collateral or other security to support financial instruments with off-balance-sheet credit risk.
 Contract or
 notional amount

Financial instruments whose contract

amounts represent credit risk:

Commitments to extend credit $XX

Standby letters of credit and financial

guarantees written XX

Financial instruments whose notional

amounts do not represent credit risk:

Interest rate swap agreements XX

Commitments to extend credit are legally binding agreements to lend to customers. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future liquidity requirements. The amount recognized as a liability in the statement of financial position at December 31, 19XX, for deferred fees on those commitments was $XX. The bank evaluates each customer's credit-worthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by S&C on extension of credit is based on management's credit assessment of the counterparty. Collateral held varies but may include accounts receivable; inventory; property, plant and equipment; and existing income-producing commercial properties.

Standby letters of credit and financial guarantees written are conditional commitments issued by the bank guaranteeing performance by a customer to a third party. Those guarantees are issued primarily to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. S&C holds marketable securities as collateral supporting those commitments. The extent of collateral held for those commitments varies from X% to XX%; the average amount collateralized is XX%. The amount recognized in the statement of financial position at December 31, 19XX, as a liability for credit loss and a liability for fees received for standby letters of credit and financial guarantees written approximated $XX.

Interest rate swap transactions generally involve exchanges of fixed and floating rate interest payment obligations without exchanges of the underlying principal amounts. S&C Bank enters into the interest rate swap market as an intermediary in arranging interest rate swap transactions for customers. The bank, as a principal in the exchange of interest payments between the parties, is exposed to loss if one of the parties defaults. The bank performs normal credit reviews on its swap customers and minimizes its exposure to the interest rate risk inherent in intermediated swaps by entering into offsetting swap positions so that the risks essentially counterbalance each other.

Entering into interest rate swap agreements involves not only the risk of dealing with counterparties and their ability to meet the terms of the contracts but also the interest rate risk associated with unmatched positions. Notional principal amounts often are used to express the volume of these transactions but do not represent the much smaller amounts potentially subject to credit risk. Amounts recognized in the statement of financial position as assets and liabilities for swap agreements entered into as an intermediary approximated $XX and $XX, respectively, which represent the market value of those instruments. [Tabular Data Omitted]

JOAN LORDI AMBLE, CPA, is the project manager at the Financial Accounting Standards Board, Norwalk, Connecticut, on the disclosure phase of the financial instruments project. She will be joining the General Electric Company, Fairfield, Connecticut, as manager--accounting projects. She is a member of the American Institute of CPAs.
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Author:Amble, Joan Lordi
Publication:Journal of Accountancy
Date:Nov 1, 1989
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