On the other hand, market values (a surrogate for current value) for most financial instruments are more easily determined. While the impact of their use may be modest for many manufacturers and retailers, the impact on financial institutions with heavy concentrations of financial instruments will be significant.

In December 1990, the FASB issued the exposure draft Disclosures about Market Value of Financial Instruments. The FASB takes aim at enterprises, particularly financial institutions, whose balance sheets are comprised mostly of financial instruments. The Board is proposing a requirement to disclose the market value of all financial instruments, for both assets and liabilities on and off the balance sheet, for which it is practicable to estimate market value.

The comments received to date indicate that many respondents question the value of market value disclosures for those instruments that actually are not traded in a market of some kind.

This ED is part of the larger financial instruments project begun by the FASB in 1986. The project has three separate, though related, phases: disclosure, recognition and measurement, and distinguishing between liabilities and equity.

The disclosure phase of the project began with the ED Disclosures about Financial Instruments issued in November 1987. This ED took a very broad approach; it would have required disclosure of credit risks, contractual future cash receipts and payments, interest rates, and current market values. After reviewing public comments, however, the Board decided to divide the disclosure phase into two parts. During 1989, a revised ED was issued; it later resulted in SFAS 105, "Disclosure of Information about Financial Instruments with Off-Balance- Sheet Risk and Financial Instruments with Concentrations of Credit Risk."

THE NEED FOR MARKET

VALUE INFORMATION

Much has been written in recent years concerning the potential usefulness of information about market values of financial instruments, particularly in assessing the solvency of financial institutions. Problems develop when historical cost accounting fails to set forth accurately the financial position of an enterprise. Assets can become overvalued due to changes in interest rates or credit risk, and to the unwary, significant built-in losses may occur and not be properly recognized. Marked value accounting, however, would establish a meaningful standard for determining solvency. In many cases, troubled institutions would become apparent much sooner. Regulators could step in, prior to insolvency, and minimize the cost to federal insurers; they would have sufficient time to correct any mismanagement of the institution, shut it down, or place it in more competent hands before further losses accumulate. If regulators are able to help prevent losses covered by federal insurance, then taxpayers are the beneficiaries.

Market value information also helps in assessing a financial institution's ability to manage its financial assets and liabilities. Management is often reluctant to sell assets with market values below book value, in order to delay loss recognition under historical cost accounting. Conversely, management is more likely to sell assets that report a gain. The net result is that management does not always make decisions that enhance the economic value of the enterprise. For example, many S&Ls have been reluctant to foreclose on loans because the repossessed real estate would have to be revalued at fair market value. The disclosure of market value information would remove some of the incentives to manipulate the balance sheet.

OTHER ATTEMPTS TO

DISCLOSE MARKET VALUES

Prior to 1938, banks were generally using market valuations for financial instruments. During this time, a bank examiner determined the "real" value of assets and liabilities in order to arrive at bank equity. If liabilities exceeded or even approximated the value of assets, capital was determined to be impaired. By 1938, the economy had weakened as a result of severe deflation and the withdrawal of deposits from the banking system. Many banks had to provide additional capital, merge with another bank, or close. The money supply fell by one-third, and prices declined by one-half--a contribution to the Great Depression.

An expansion of the money supply and income occurred from 1933 until 1936. The Federal Reserve, however, viewed this expansion as excessive and once again tightened credit, ended economic expansion, and allowed the economy to drift into a recession by late 1937. The consequence of these actions was that the procedures used to appraise bank assets were relaxed. Banks no longer had to recognize price depreciation when long- term bond yields increased. Thus, a turning away from market valuation occurred.

In June 1938, the Federal Reserve Board and the Federal Deposit Insurance Corporation decided to abandon market valuation in favor of historical cost for investment grade securities, which represented approximately 90% of the securities held by banks. The thinking was that no matter what happened to interim price behavior, most securities would return to their par value by maturity.

During the mid-1970s, the SEC and AICPA attempted to value real estate investment trust debt at market value by requiring realistic loan loss reserves. FASB became involved when it considered whether restructured debt should be adjusted to reflect market values when interest payments are deferred or interest rates are reduced. The chairman of the Federal Reserve Board, the Comptroller of the Currency, the Chairman of the FDIC, and many bank presidents argued against such a change. The American Banking Association, which lobbied against this initiative, was concerned that market value accounting would eventually be broadened to include all bank assets. The end product, SFAS 15, Accounting for Troubled Debt Restructuring, was much less restrictive than the original proposal.

Market value accounting for financial instruments has also been proposed for the S&L industry. During the early 1980s, the Federal Home Loan Bank Board (FHLBB) commissioned a task force to evaluate market value accounting for the industry, which had a high proportion of assets in long-term instruments. When interest rates went up, the imbalance of the industry's loan portfolios caused a severe downturn in earnings. Yet the task force recommended against any broad use of market value accounting, despite the FHLBB chairman's belief that historical cost information failed to account for the true performance of financial institutions.

THE FEASIBILITY OF

DETERMINING MARKET

VALUES

Since 1987, the FASB has reconsidered the issues regarding market value disclosure in anticipation of a new standard. The original ED attracted 356 comment letters that addressed market value disclosure; 97% opposed at least some portion of the disclosure requirements. Some respondents commented that the valuation of non-traded instruments would be subjective, hard to verify, and not comparable among firms. Furthermore, many believed that the information would be costly to obtain and would have limited usefulness due to frequent changes in market values. In spite of opposing arguments, the FASB believes that market value information is useful, and that the benefit would outweigh the cost. A major concern of the Board has been the practicality of developing market values for financial instruments not traded on a public exchange. However, the Board concluded that it is feasible to arrive at reasonably accurate market value estimates for most financial instruments. In fact, many large financial institutions already have systems in place to report, for internal purposes, estimated market values for non-traded financial instruments. The Board believes that the incremental costs associated with the disclosure requirements of the proposed statement will be reduced by requiring market value disclosure only when practicable, by allowing flexibility and giving only general guidance on how to estimate market value, by excluding certain financial instruments from the scope of the proposed statement, and by delaying the effective date of the proposed statement for smaller entities that may need more time to develop systems necessary to comply.

The FASB, as part of its research, asked the Bank Administration Institute (BAI) to identify the sources that banks use to obtain market values for financial instruments. Information was received from 12 banks that have 26 of the assets held by U.S. bank holding companies. The results indicated that markets exist for many types of securities, including high quality commercial and industrial loans, loans to less developed countries, mortgage-backed securities, asset-backed securities, corporate bonds, and government securities. Most of the financial instruments were valued at dealer prices, some were traded on an exchange, and others required the use of mathematical models. Generally, models were used to supplement dealer prices that were fairly inactive and believed by the institution to be either underpriced or overpriced.

An Information Statement prepared by the Federal Home Loan Mortgage Corporation (Freddie Mac) dated March 1990 stated:

"Market value information is used internally by Freddie Mac for planning, asset and liability management, interest rate risk management, simulations, and in measuring the economic impact of transactions."

The Information Statement noted that there is one interest-rate sensitive class of assets (mortgages) and two interest-rate sensitive classes of liabilities (other notes and bonds, and subordinated borrowings). The Consolidated Market Value Balance Sheet included in the statement developed market values for each line-item by discounting projected cash flows at prevailing interest rates. The market values were listed side-by-side with GAAP values for comparative purposes. Stockholders' equity was also recalculated based on the market values for the assets and liabilities.

The BAI and Freddie Mac communicated to the FASB that it is indeed possible to develop market values for financial instruments. In fact, it is already being done for internal purposes. The FASB believes that this information should be available for external users as well.

DEFINITION AND SCOPE OF

THE PROPOSED STATEMENT

The proposed statement would require all entities to disclose information about market values of their financial instruments. For this purpose, market value is defined 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 sale. The quoted price for a single trading unit in the most active market (for some instruments, prices are available in several markets) provides useful information to investors, creditors, and others and is the basis for determining market value.

SFAS 105 defines a financial instrument as cash, evidence of an ownership interest in an entity, or a contract that both:

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

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

In general, a financial instrument consists of cash, or a contractual obligation that ends with the delivery of cash or an ownership interest in an entity. Any number of obligations to deliver financial instruments can be links in a chain that qualifies a particular contract as a financial instrument.

The ED applies to all entities. The Board considered excluding the disclosure requirements for predominantly nonfinancial institutions. It concluded, however, that even though the effect would be greatest on financial institutions whose assets and liabilities are primarily financial, financial instruments also constitute a large portion of the assets and liabilities of some nonfinancial entities. Furthermore, as a result of deregulation, the distinction between financial and nonfinancial institutions is becoming more and more blurred.

The proposed statement would require disclosure about market values for all financial instruments, whether recognized in the statement of financial position or not, except for instruments specifically excluded. Those excluded are: employers' and plans' obligations for pension benefits, other postretirement benefits including healthcare and life insurance benefits, employee stock option and stock purchase plans, and certain other forms of deferred compensation arrangements; substantively extinguished debt and assets held in trust in connection with an in- substance defeasance of that debt; most insurance contracts; lease contracts; and warranty obligations. The Board believes that definitional and valuation difficulties are present to a certain extent in those contracts and that further consideration is required before deciding whether to require disclosure about market value for those financial instruments.

GAAP already require market value disclosure or recognition for many classes of financial instruments. Although the terminology, definitions, and methodology of estimating market value differ, the amounts computed to comply with previous pronouncements are acceptable in complying with this proposed statement. Exhibit 1 provides a list of FASB and AICPa disclosure requirements for market value or an acceptable surrogate thereof.

DISCLOSURES ABOUT

MARKET VALUES OF

FINANCIAL INSTRUMENTS

Market values are most reliable when a financial instrument is publicly traded and quoted market prices are available. If quoted market prices are not available, management's best estimate of a market price may be based on the quoted market price of a financial instrument with similar characteristics or on valuation techniques such as discounted cash flows, option pricing models, or matrix pricing models.

For some financial instruments, such as short-term trade receivables and payables, market value may approximate historical cost due to the relatively short maturity of the instrument. Similarly, adjustable loans that are repriced frequently at market rates are also likely to be carried at an amount that approximates market value. In these situations, the disclosure requirement is already satisfied.

Market Value for Bank Loans

According to Mengle, bank loans range from approximately 51% of bank assets for the smallest banks to 60% for large regional institutions. Two-thirds of the loans are already at market because they have either maturities of one year or less, or have floating-rates with repricing intervals of one year or less. For the remaining one-third of loans the estimate of market value should be based on the market for similar loans or other financial assets with similar credit ratings, interest rates, and maturity dates. Specifically, market value estimates can be determined by discounting the expected cash flows of an instrument based on current market rates for instruments with similar maturities and risks. The ED states that some financial instruments, such as interest rate swaps and foreign currency contracts, may be "custom-tailored," which would make a quoted market price unlikely. Market value in these situations may be estimated based on the quotations for a similar financial instrument, and adjusted as appropriate for the effects of tailoring.

Other financial instruments, such as foreign currency options, put and call options on stock, and options on interest rate contracts, are also commonly "custom tailored." A number of option pricing models, have been developed in recent years and may be used. >TABULAR DATA OMITTED>

Although the need for disclosure emphasizes asset values, market price volatility can affect financial liabilities as well. For example, rising interest rates will lead to a price decline for an entity's debentures. Market values for financial liabilities for which market prices are not publicly traded can generally be estimated using the techniques for estimating the value of financial assets. For example, a loan payable to a bank would be valued at the discounted amount of future cash flows using the entity's current incremental rate of borrowing for a similar liability. Alternatively, the discount rate could be the rate that an entity would have to pay to a credit-worthy third-party to assume its obligation or the rate that an entity would have to pay to acquire risk-free assets to extinguish the obligation.

The Board acknowledges that less attention has been focused on information about market value of liabilities than on information about market value of assets. It did, however, decide to require information about the market value of liabilities based on the belief that the information will complement the market value information provided for assets, particularly for financial institutions. The Board encourages comments on the benefits and costs of estimating the market value of liabilities and the difficulty of estimating the market value for specific types of liabilities.

In estimating the market value of deposit liabilities, the proposed statement does not allow a financial entity to take into account the value of core deposit intangibles, which are separate intangible assets and not financial instruments. Core deposits constitute approximately 40% of liabilities for most banks and are valuable due to the low rate of interest required to generate these funds. A financial institution could, however, carry as an intangible asset the present value of the difference between the actual interest cost of core deposits and the market cost that normally would be required to attract such funds.

Market Value Not Available

The ED requires that entities disclose the methods and significant assumptions used to estimate the market value of financial instruments. If it is not practicable for an entity to estimate the market value, the following disclosures are proposed:

1. Information about the carrying amount, interest rate, and maturity and other characteristics pertinent to estimating market value of that financial instrument or class of financial instruments;

2. Reasons why it is not practicable to estimate market value; and

3. Whether the entity believes either: the carrying amount approximates market value, is significantly more than market value, or is significantly less than market value.

The Board encourages comment of the information that should be provided when it is not practicable to estimate market value. In the context of the proposed statement, "practicable" means that an estimate of market value can be made without incurring excessive costs. It is a dynamic concept. What is practicable for one entity might not be for another; what is not practicable in one year might be practicable in future years. For example, the market value of a class of financial instruments may not be available because the valuation model necessary to make the estimate has not yet been obtained and the cost of an independent appraisal appears excessive. Also, it may be practicable to estimate market value on a portfolio basis instead of individually, or it may be practicable to estimate market value for a subset of a class of financial instruments.

PLACEMENT OF MARKET

VALUE DISCLOSURES

The disclosures required by the proposed statement must be included in the body of financial statements or in accompanying footnotes; however, the Board encourages comments about how market value disclosres should be displayed. Some disclosures are already required to be shown parenthetically on the face of the statement of financial position, while others are shown in the notes to the financial statements. One alternative would be to display all the market value information required by this proposed statement and the information already required by existing pronouncements in a single note that would reproduce the main captions of the statement of financial position. Another alternative would be to provide a supplemental statement of financial position in which all items for which market values are available would be reported at those amounts.

EFFECTIVE DATES

The disclosure requirements in this proposed statement would be effective for financial statements issued for fiscal years ending after December 5, 1991, except for entities with less than $100 million in total assets. The Board proposes to delay the requirements for those smaller entities for one year, on the assumption that those entities will need more time than others to develop the necessary information.

COMMENTS ON THE ED

The FASB staff has reported informally that approximately 200 comment letters were received on the ED. The majority of the comments reflect the opinion that the scope of the proposed statement is too broad, with many respondents seeking an expansion of the exclusions. Examples of the comments include the following:

* Financial institutions like disclosures of market values of liabilities but do not care for disclosures of market values for commercial loan portfolios for which there is no market;

* Non-financial institutions, i.e., manufacturers and retailers, do not believe the disclosures are meaningful for them and seek to be excluded;

* Many applauded making impracticability a basis for omission of the market value disclosures;

* Some felt the guidance given on how to develop market values was not specific enough and that there would be a lack of comparability; and

* Some felt the disclosures should be unaudited and treated in a manner similar to that previously required by SFAS 33.

After the public hearings, the FASB will review the comments and decide what modifications make sense. The main issue will probably be the scope of the disclosures and whether additional items should be excluded.

RIGHTS FOR THE TIMES?

The disclosure of market values for financial instruments appears to be right for the times. The benefit for the thrift and banking industries is that market value information may provide some early warning signals of distress that may not be revealed by traditional, historical cost data. For nonfinancial entities, particularly those with heavy concentrations of financial instruments, the benefit may be similar. Disclosure is an important and natural first step in the financial instruments project.

James H. Thompson, Phd, CPA, is Professor of Accounting at Oklahoma City University. He is a frequent contributor to accounting and other professional journals.

Dan W. Swenson, CPA, is an instructor at the University of Mississippi.