Late in 1991, the FASB issued two documents about this project: SFAS 107, Disclosures about Fair Value of Financial Instruments, and a Discussion Memorandum (DM) entitled, Recognition and Measurement of Financial Instruments. SFAS 107 completes the first phase of the financial instruments project-establishing disclosures applicable to financial instruments. The DM deals with the second and most difficult phase of the project-recognition and measurement of financial instruments in financial statements.

THE DISCLOSURE JOURNEY

The first stop along the way of disclosure was SFAS 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk.(1) It was effective for calendar year 1990 financial reports and required disclosure of financial instruments which lead to off-balance-sheet risk as well as those that constitute a concentration of credit risk. Outside financial institutions, the biggest impact of the statement relates to the disclosure of concentration of credit risk. SFAS 107 now completes the disclosure phase by requiring disclosure of financial instruments on the balance sheet.

Financial Instruments Defined

In SFAS 107, the FASB uses a definition that is essentially the same as that used in SFAS 105. Financial instruments are defined as cash, evidence of an ownership interest in an entity, or a contract that both:

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

* Conveys to that second entity a contractual right 1) to receive cash or other financial instruments from the first entity or 2) to exchange other financial instruments on potentially favorable terms with the first entity.

This definition of financial instruments is sufficiently broad that virtually all companies have financial instruments.

Further, since this is a disclosure document and does not establish measurement principles, all companies will need to examine the requirements carefully in determining the disclosures needed.

In SFAS 105, the FASB argued that the accounting risk associated with financial instruments has three components: 1) credit risk, 2) market risk, and 3) liquidity or control risk. It then went on to focus more on the first component of risk. SFAS 107 extends the requirements to include market risk factors as well.

Exclusions From the

Disclosure Requirement

Certain financial instruments are excluded from the disclosure requirements of SFAS 107 and are presented in Exhibit 1. SFAS 105 also had exclusions from its disclosure requirements. The SFAS 107 exclusions include all the SFAS 105 exclusions plus others that were added principally for purposes of clarification.

EXHIBIT 1

FINANCIAL INSTRUMENTS

THAT ARE EXCLUDED FROM THE

DISCLOSURE REQUIREMENTS OF SFAS 107

* Employer's and plans' obligations for pension benefits, other postretirement benefits including health care and life insurance benefits, employee stock option and stock purchase plans, and other forms of deferred compensation arrangements. Disclosures for these financial instruments are currently establish in SFAS 35, Accounting and Reporting by Defined Benefit Pension Plans, SFAS 87, Employers' Accounting for Pensions, SFAS 106, Employers' Accounting for Postretirement Benefits Other Than Pension, and SFAS 43, Accounting for Compensated Absences, and APBO 25, Accounting for Stock Issued to Employees and APBO 12, Omnibus Opinion - 1967.

* Substantively extinguished debt subject to the disclosure requirements of SFAS 76, Extinguishment of Debt, as well as the asset held in trust to meet the interest and principal payments on the debt which has been accounted for as extinguished through an in-substance defeasance.

* Insurance contracts, other than financial guarantees and investment contracts discussed in SFAS 60, accounting and Reporting by Insurance Enterprises, and SFAS 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of investments.

* Lease contracts as defined in SFAS 13, Accounting for Leases.

* Warranty obligations and rights.

* Unconditional purchase obligations as defined in SFAS 47, Discolosure of Long-Term Obligations.

* Investments accounted for by the equity method in accordance with the requirements of APBO 18, The Equity Method of Accounting for Investments in Common Stock. This exclusion extends to minority interests in consolidated subsidiaries, equity investments in consolidated subsidiaries, and equity instruments issued by the entity and classified in stockholders' equity in the balance sheet.

For all other financial instruments, the company is required to disclose market value unless it is not practicable to do so.

Market Value Disclosure

Requirements

The requirement to make disclosure of the market value extends to all financial instruments of the company - except those specifically excluded - whether the instruments are currently recorded on the balance sheet or not. Some of these instruments are financial assets - for example, the investment in stock of another company - whereas others are financial liabilities - for example, a mortgage payable. SFAS 107 requires disclosures for all financial instruments whether recorded or unrecorded, financial assets or financial liabilities.

Since SFAS 107 is a disclosure document only, it does not change requirements that currently exist for recognition, measurement, or classification of financial instruments in the financial statements. For many financial instruments, some market value information is already required. For example, companies are required to disclose market value of their investments in certain marketable equity securities in accordance with SFAS 12, Accounting for Certain Marketable Securities. Neither does it alter nor affect the many definitions and methods used to estimate fair value that exist in current financial accounting literature. Various terms are used such as market value, current value, or mark-to-market. Any of these existing methods is satisfactory for measuring market value for disclosure purposes required by SFAS 107.

Without altering the existing definitions and methods, in conceptual terms SFAS 107 defines fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Additionally, consistent with SFAS 12, the FASB indicated that when a quoted market price is available and used for estimating fair value of a trading unit of the financial instrument, the quoted price is multiplied by the number of trading units the company owns.

There may be circumstances where the company owns a significant number of trading units of a financial instrument. 9 Therefore, if it tried to sell all these instruments at once, the market price would be affected. The FASB instructs statement preparers to ignore this concern in determining the market value of a the financial instruments.

In mandating the disclosure of market value of financial instruments, SFAS 107 states in paragraph 10 that:

"An entity shall disclose, either in the body of the financial statements or in the accompanying notes, the fair value of the financial instruments for which it is practicable to estimate that value. An entity also shall disclose the method(s) and significant assumptions used to estimate the fair value of financial instruments."

When it is not practicable to estimate the fair value of a financial instrument or a class of financial instruments, the company is required to disclose the following:

* Information pertinent to estimating the fair value of that financial instrument or class of financial instruments, such as the carrying amount, effective interest rate, and maturity; and

* Reasons why it is not practicable to estimate fair value.

This requirement has been modified from the ED. In that document, the FASB had proposed that for financial instruments for which it is not practicable to determine market value, the company should disclose whether it believed the market value was either significantly above, significantly below, or approximately equal to the carrying amount of the financial instrument. Commentators on the ED pointed out that if it was not practicable to determine market value, similar difficulty would be encountered in reaching the conclusions about the relationship of market value to cost, i.e., slightly higher or lower. The more reasonable requirement of SFAS 107 is to explain why it is not practicable to determine fair value.

As used in SFAS 107, the term practicable means that an estimate of fair value can be made without incurring excessive costs. As a result, what is practicable for one company may not be practicable for another. Likewise, whether it is practicable to determine market value for a financial instrument might change from year to year.

Additionally, certain aggregations are allowed when it is not practicable to determine market value on an item-by-item basis. For example, the company may be able to determine market value for a group of similar investments or another portfolio, even though it is not practicable to determine fair value for each financial instrument.

Trade Receivables and Payables

Trade receivables and payables are financial instruments. The guidance given for disclosures of such items in SFAS 107 is quite simple: "For trade receivables and payables, no disclosure is required ... when the carrying amount approximates fair value." This is an important change from the ED, which had called for a positive statement that the carrying amounts approximated fair value.

In the event the carrying amount did not approximate fair value, the fair vitlue could be calculated by discounting the expected cash flows at a current discount rate appropriate for financing the receivables and payables.

Effective Date for Making the

Required Disclosures

Since the requirements of SFAS 107 are for disclosure purposes only, it is not surprising that the scheduled effective date comes soon. The provisions of SFAS 107 are effective for financial statements issued for fiscal years ending after December 15, 1992, i.e., calendar 1992. However, for a company that has less than $150 million in total assets as reported in their first fiscal balance sheet dated after December 15, 1992, the disclosures are not required until fiscal years ending after December 15, 1995. Companies that have not made these disclosures for earlier periods are not required to do so in comparative statements issued after the effective date.

Determining Market Value

Some financial instruments do not have readily available market value quotations. The FASB indicates in SFAS 107 that market value might be determined depending upon the type of market which the financial instruments can be bought and sold. The types of markets so identified are as follows:

* Exchange Market. An exchange or auction market provides high visibility and order to the trading of financial instruments. Usually, closing prices and volume levels are readily available in an exchange market.

* Dealer Market. In a dealer market, dealers stand ready to trade for their own account thus providing liquidity to the market. Typically, current bid and ask prices are more readily available than information about closing prices and volume levels. Over-the-counter" markets are dealer markets.

* Brokered market. In a brokered market, brokers attempt to match buyers with sellers but do not stand ready to trade for their own account. The broker knows the prices bid and asked by the respective parties, but each party is typically unaware of another party's price requirements-, prices of completed transactions are sometimes available.

* Principal-to-Principal Market. Principal-to-principal transactions, both originations and resales, are negotiated independently with no intermediary, and little if any information is typically released publicly.

For financial instruments that trade in quoted markets, the company should use the price from the most active market as the measure of fair value of that financial instrument. For financial instruments that do not trade regularly, or which trade only in principal-to-principal markets, the company should provide its best estimate of fair value.

For short-term financial instruments, the carrying amount presented in the financial statements may approximate fair value because of the relatively short time between origination and maturity,, of the financial instrument. Additionally, for loans that reprice frequently at market rates, the carrying amount often will be acceptable for meeting the disclosure requirements.

In some cases, the financial instrument may be "custom-tailored" and not have a quoted market price. In that case, value might be estimated by determining the quoted market price of a similar instrument and adjusting its quoted market value for the effects of the tailoring. Another approach might be to estimate current replacement cost for the instrument.

An approach suggested for certain "custom-tailored" financial instruments is to use a well-established option pricing model, such s the Black-Scholes model or binomial models.

For other financial instruments, an estimate of discounted future cash flows may be appropriate. In this case, the company should consider the market prices of similar traded financial instruments, the market prices of the similar securities, current prices - or interest rates - on similar financial instruments, or valuations obtained from loan pricing services.

For financial institutions, the fair value of deposit liabilities with defined maturities such as certificates of deposit, could be estimated using the discounted future cash flows expected to be paid. In estimating the fair value of deposit liabilities, the company is not allowed to consider the value of its long-term relationship with depositors - commonly referred to as core deposit intangibles. Because core depositors represent a separate, intangible asset, this asset is not a financial instrument.

The FASB does not preclude companies from disclosing fair value of any nonfinancial intangible or tangible assets or its nonfinancial liabilities. Importantly, though from those made for financial instruments.

Companies may need to experiment with various types of measurement methods for financial instruments that do not have a current quoted price. As in SFAS 105, these disclosure requirements will tend to evolve as companies get accustomed to the requirement and are able to refine their estimation methods.

The Disclosure Journey Does Not

End Here

In some ways, both SFASs 105 and 107 can be viewed as short-lived documents. The FASB hopes ultimately to issue standards that address the recognition and measurement question. As FASB continues its deliberations on that topic, it will like consider additional disclosure requirements as well as measurement principles. Since FASB has defined financial instruments in such a broad fashion, it is important for practitioner to monitor FASB's progress on the recognition and measurement phase of the project.

THE DIFFICULT ROAD OF

RECOGNITION AND

MEASUREMENT

On November 18, 1991, the FASB issued their DM on the recognition and measurement phase of the project, which establishes the scope of that phase of the project.

Since this project is very broad, it is possible that existing accounting standards may be modified or superseded by its conclusions. The DM identifies key existing pronouncements that will be examined and the aspects that are likley to be modified. They are listed in Exhibit 2.

EXHIBIT 2

DOCUMENTS TO BE RE-EXAMINED

IN THE RECOGNITION AND MEASUREMENT PHASE

OF THE FINANCIAL INSTRUMENT PROJECT

In the Discussion Memorandum, the FASB identified the following existing standards as possibly being subject to either modification or supersession as it proceeds on the recognition and measurement phase of the project:

1. APBO 10, Omnibus Opinion - 1966: The effect of the right of setoff relationship. 2. APBO 21, Interest on Receivables and Payables: Accounting and scope restrictions. 3. SFAS 5, Accounting for Contingencies: Impairment of receivables for collectibility. 4. SFAS 12, Accounting for Certain Marketable Securities: Entire document. 5. SFAS 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings: Entire document. 6. SFAS 52, Foreign Currency Translation: Subsequent measurement of forward exchange contracts and hedge accounting provisions. 7. SFAS 60, Accounting and Reporting by Insurance Enterprises: Subsequent measurement of investment assets and possibly certain insurance liabilities. 8. SFAS 65, Accounting for Certain Mortgage Banking Activities: Subsequent measurement and de- recognition of mortgage loans, mortgage-backed securities, and sale of loans with servicing retained. 9. SFAS 76, Extinguishment of Debt. Entire document. 10. SFAS 77, Reporting by Transferors or Transfers of Receivables with Recourse: Entire document. 11. SFAS 80, Accounting for Future Contracts: Hedge accounting provisions. 12. SFAS 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases: Entire document. 13. FASB Technical Bulletin 84-4, In-Substances Defeasance of Debt: Entire document. 14. FASB Technical Bulletin 85-2, Accounting for Collateralized Mortgage Obligations (CMOs): Entire document. 15. FASB Technical Bulletin 88-2, Definition of a Right of Setoff. The effect of the right of setoff.

In addition to the documents listed in the exhibit, various AICPA Audit and Accounting Guides, particulalry those for banks, savings institutions, finance companies, investments companies, and brokers and dealers, Statements of Position, Practices Bulletins, and Emerging Issues Task Force consensus on financial instruments, financial institutions, and off-balance-sheet financing issues are being considered as certain specialized accounting principles are reexamined.

This phase of the financial instruments project is broad in scope and has far-reaching implications to current financial reporting practices. To help provide some focus to this project, the FASB has identified 10 primary issues in the DM. Additionally, they have identified several sub-issues. The 10 primary issues identified are as follows:

1. What financial assets or liabilities arise from contracts to exchange other financial instruments?

2. When should financial assets and liabilities that arise from conditional or unexecuted contracts be recognized?

3. How should a financial instrument be analyzed for accounting purposes if two different characteristics are embedded in a single - for example, callable bond?

4. In what circumstances should separate financial assets and liabilities be offset?

5. Should initial measurements of financial instruments be based on what was received or paid in exchange for them, on the amount stated in the contract, on their market value when recognized, or on expected net future cash flows?

6. Should subsequent measurement of financial assets and liabilities be based on historical prices or current prices? Or should the basis depend on the type of instrument or other circumstances?

7. Should subsequent measurement of financial assets and liabilities differ because of a hedging or other relationship between financial instruments?

8. When should a financial asset that still exists be de-recognized?

9. When should a financial liability that still exists be de-recognized?

10. How should a realized gain or loss be reported?

The DM indicates that the FASB is in the early phase of the deliberative process. It is likely that FASB will be considering some of these issues for several years. However, practitioners should note that these deliberations have the potential to result in fundamental changes to the financial reporting model currently in use.

THE JOURNEY WILL BE LONG

WITH STOPS ALONG THE WAY

In SFAS 107, the FASB has established market value as a basis for disclosures for financial instruments. As it debates recognition and measurements principles, it likely will examine whether market value is appropriate for measurement purposes as well. Many argue that some method of market value should be used in measuring financial instruments.

Finally, it is important to realize that while the project will take substantial time to complete, the FASB has to carve out "sub-projects" as well. For example, one issue being considered is that of marketable securities. This issue has been accelerated partially in response to requests from the SEC, AICPA, and others to undertake a limited-scope project about the question of market-value-based accounting for investments in debt securities held as assets. The project involves consideration of the feasibility of permitting companies the option of reporting certain liabilities at market value as well.

While the FASB has not yet determined which securities, if any, should be valued at market value (mark-to-market), at its meeting of November 27, 1991, the FASB agreed that unrealized gains and losses on securities that are mark-to-market should be reported as earnings.

The documents that FASB is likely to issue that address the broad question of recognition and measurement of financial instruments will no doubt cut across

industry and company-size lines. And, since financial instruments have been defined broadly, it is vitally important that CPAS remain informed of the FASB'S action on this important project.