As the FASB moves toward more market value measurement, Accounting Principles Board Opinion (APBO) 21, Interest on Receivables and Payables, which suggests a market comparison at the point of exchange is of particular interest.

APBO 21 states in its introduction that "It is not intended to create a new accounting principle." Its primary objective "is to refine the manner of applying existing accounting principles." The nature of the guidance is as follows:

* Typically, it is assumed that a transaction will produce a fair exchange value and if debt is a part of that exchange, it reflects the appropriate time value of money;

* The guidance applies "to receivables and payables which represent contractual rights to receive money or contractual obligations to pay money on fixed or determinable dates, whether or not there is any stated provision for interest" with specified exceptions;

* A hierarchical relationship exists as to choices for valuation, with use of the stated rate unless it is deemed unreasonable, then use of the implied rate of interest by using the fair value of items exchanged and the payment terms of the instrument, and only resorting to an imputed rate when fair values are not determinable as a basis for identifying the implicit rate; and

* The imputed rate will differ across circumstances, which include the credit standing of the issuer, restrictive covenants, the collateral, payment and other terms pertaining to the debt, and the tax consequences to the buyer and seller.

In the words of APB No. 21:

The objective is to approximate the rate which would have resulted if an independent borrower and an independent lender had negotiated a similar transaction under comparable terms and conditions with the option to pay the cash price upon purchase or to give a note for the amount of the purchase which bears the prevailing rate of interest to maturity.

This guidance points a direction for action when debt instruments bear no interest rate and zero coupon bonds and the like become increasingly prevalent in economic transactions. However, short of that situation, the likelihood of the statement being invoked is not clear. For example, how often is other than the stated rate used? In particular, how often is the last resort reached whereby other than a stated or implicit rate is entered onto the books of a company's accounts? What are the common circumstances in which the imputed rate is invoked? Are patterns discernible that might operate as further guidance? Are such patterns helpful in drawing analogies to conceptual underpinnings of accounting practice in other areas?

DATA SETS EXAMINED

National Accounting and Auditing Retrieval Service (NAARS) is a commonly used population of companies and key word searches can be performed with ease on all the footnotes of public companies on the data base. In a search of NAARS, 4000 companies were subjected to a key word search for each year from 1984 to 1989. A total of 34 reports contained the key word, but only 16 of these appeared to potentially relate to APB No. 21; these reports had eight unique company references. In addition, disclosure's data set of 12,000 companies for 1989 and 1990 was subjected to a word search defined similarly and produced 285 citations. Of these citations, 130 potentially relate to APB No. 21. The key word "imputation" was likewise checked and produced 10 companies, of which only two appeared to be related to APB 21 for the Disclosure data set; no additional sample items were identified through use of the word "imputation" for the NAARS data set. The industry mix of the total sample is comparable to that found in all NYSE and AMEX companies.

RESULTS

Over half of the NAARS companies imputing interest appear to be doing so from a non-interest bearing instrument. Therefore, only three seem to be adjusting a stated interest rate. One of the adjustments involves notes to predecessor stockholders of ESI Industries, Inc. When related parties are involved, including transactions with stockholders, the stated rate apparently undergoes greater scrutiny. Yet, the overall low frequency of citations of imputed interest on the NAARS data base suggests such adjustment is fairly rare among public companies. When it does occur, its likelihood is greater with a non-interest bearing security involved in a transaction.

Context for Imputation

The context in which interest is imputed for each of the Disclosure sample companies follows:

Discontinuation5.93%

Acquisitionrelated11.85%

Compensationrelated7.41%

Relatedparty12.59%

Non-competeorearn-out3.70%

Other58.52%

Nature of Transactions

Those transactions involving related parties would be expected to pose greater risks in deriving an objective interest rate for a particular security exchanged and appear to undergo greater scrutiny. Yet, keep in mind the very low incidence from a population of 12,000 companies: only about 1% are identified as having imputed interest.

Magnitude of Interest Differentials

The question arises of whether the impetus for the 1% incidence of adjustments relates to the size of the discrepancy between stated rate and assessed imputed rate. For companies disclosing both the imputed and stated rate, those quantities were compared and their proportion of the imputed rate was computed. Naturally, zero stated rate companies required a virtual 100% imputed rate adjustment, but once these non- interest bearing instruments are set aside, it is still the case that 84.21% of the sample companies involve adjustments of better than 20% of the stated rate. Indeed, over 10% of these sample companies experience more than a 40% adjustment.

The reasonableness of the rate differentials, averaging 5.39% for the total Disclosure sample, was evaluated by tracking the range of stated rates in the note disclosures and comparing those ranges to the reported transaction's imputed rate. One interesting finding was the substantial range of rates observable within a single company, e.g., 3.5% to 16.5% (Allegheny International Inc.'s 1989 statement); 5.375% to 17.5% (Chiquita Brands International Inc's 1989 statement); 9% to 23.9% (Buffton Corp.'s 1989 statement); and 4.875% to 13% (Conagra Inc.'s 1990 statement). Within such "barn doors" of observed stated rates, the imputed rates were observed to lie. Therefore, the imputations appear reasonable, although this test is by definition crude, given the broad range of reported rates.

Direction of Adjustment and Type of Transaction

While it is theoretically possible for an imputed rate to fall below or to exceed the stated rate, 95.35% of the imputations observed resulted in higher imputed rates than the stated rate. This likely relates to the type of transaction involved: borrowing or lending. Note that the FASB has emphasized that conservatism cannot appropriately be used to justify biased reporting. Yet, consider that each transaction presumably has two parties to the exchange that may often be public companies and would be expected to be influenced by the discrepancy in stated and imputed rates determined by one party to the transaction. Nonetheless, a paucity of receivable-related adjustments are observed in the samples. Less than one percent of the imputations (.96%) involve receivables. The application of imputed interest is almost entirely in the liability valuation process. A similar pattern emerged for the NAARS sample, although some representation of installment sales is apparent on the receivable side of transactions. The table provides a few examples of footnote disclosures regarding the imputation of interest. It bears out the variety of contexts for imputation and the diverse interest differential found.

CONCEPTUAL CONSIDERATIONS

Analogies can be drawn between practice as it relates to APBO 21 and other areas. Unreasonable terms and risk considerations prompt attention to transactions and greater conservatism in approaching valuation. Therefore, a non-interest bearing security that is long-term in nature will be the most prone to adjustment to an imputed interest rate, if an implicit rate can not be identified from a simple present value calculation that compares what is being exchanged from both sides of the transaction.

Risks associated with significant events, such as discontinuation of business, acquisitions and mergers, and sweeteners offered in anticipation of future financing, will likewise trigger the imputed rate on occasion (though relatively rarely). Those risks attendant to related-party transactions also appear to play a role in prompting attention to a possible need to adjust the stated rate. The fact that the direction of adjustment tends to be on the liability side and upwards, an average of 44.7% of the imputed rate is consistent with the general notion of conservatism and the asymmetrical loss function faced by participants in the securities markets.

EXAMPLES OF IMPUTATION OF INTEREST DISCLOSURES IN FOOTNOTES

ALLEN GROUP INC. Installment note receivable for sale of certain businesses of the company: 6% subordinated note, term to 1999, imputed at 13%

AMERICAN BARRRICK RESOURCES CORP. Interest on the funds that would have been received had the options been exercised: imputed at 9%.

ARMCO, INC. Note payable apparently no interest to individual: imputed at 10%

BALFOUR MACLAINE CORP. Former Affiliated Co., apparently no interest: imputed at 11%; payable to former president, apparently no interest: imputed at 9%.

BEVERLY ENTERPRISES, INC. Company received full recourse, zero coupon note with interest imputed at 8% from president and chief executive officer to purchase stock.

BIRMINGHAM STEEL CORP. Note and mortgage imputed 7% to 16%.

BUREAU OF NATIONAL AFFAIRS, INC. 5-year non-compete agreement payable over 3 years: interest imputed at 11.25%.