The Financial Accounting Standards Board (FASB) issued a Discussion Memorandum (DM), Recognition and Measurement of Financial Instruments, in November 1991. The DM is a neutral document that raises the recognition and measurement issues created by financial instruments and examines alternative accounting treatments that could be used to resolve those issues. One fundamental idea proposed in the DM is that all financial instruments consist of one or more "fundamental financial instruments" (FFI) or "building blocks."

The hope is that using an FFI approach may help the FASB and others better understand the economics of financial instruments and lead to enduring and consistent accounting guidance for all financial instruments and transactions. This article relates the hypothetical journey of Company X through a maze of financial instruments, guided by the FFI approach. The accounting choices made by Company X throughout its journey do not represent preferred positions of the FASB Board or its staff but merely serve to illustrate the issues involved.

On the First Day

Company X was created on December 1, 1992. Its mission: To accumulate as many accounting problems related to fundamental financial instruments identified in the DM as possible and to unequivocally resolve every problem. The beneficent founder of Company X, a successful businessman with a keen interest in accounting standards, invested $1 in common stock on December 1, 1992.

A major research project was undertaken to find the definitions of the six fundamental financial instruments in the 252-page DM; the definitions appeared on pages four to seven. Our businessman cleverly summarized the differences between the six fundamental instruments by the different rights and obligations they entail. These are shown in Exhibit 1.

After a thorough review of the definitions, Company X entered into the transactions listed in Exhibit 2 on December 1, 1992.

Decisions! Decisions!

Our businessman could hardly wait to record those transactions in his books and decided to prepare a statement of financial position as of December 1, 1992. The first two transactions did not seem to cause any problems. An investment in common stock of $85,000 and a corresponding variable rate liability of $85,000 should appear on the balance sheet. Our businessman wondered for a moment if the $225 paid for the loan guarantee provided by Bank Y should be recognized as an asset on the balance sheet. After all, that payment assured him a lower rate on the variable-rate loan than if the loan were not guaranteed. Therefore, it should be allocated to the period in which the interest savings are made. Although quite proud of that idea, our businessman decided the amount was not material and the borrowing would be repaid at the end of the year. Consequently, the $225 was expensed immediately.

The interest-rate cap, the conditional receivable, was a more difficult transaction. What should be recorded on the balance sheet on day one? Our businessman, an eternal optimist, could not imagine LIBOR increasing by more than two percent in the next year. It would seem the interest- rate cap had no value as an asset. On the other hand, there must be a slight chance of LIBOR increasing by more than two percent, otherwise our businessman would not have even considered purchasing the cap, nor would it have cost so much. Since he paid $250 for the interest-rate cap, it seems that the amount could represent a fair assessment, by both Company X and the other party, of the value of the cap at inception. Our businessman decided to record an asset for $250. Because the amount was not material, he also decided it was not necessary to amortize it over the life of the contract.

Now, what to do about the $10,000 received from Company C for the call option written on Company A's common stock? A number of distinct possibilities came to mind including reflecting the $10,000 in income, recognizing the premium as a liability, or recognizing the premium as income and recording a liability for common stock to be transferred with an offsetting receivable of $85,000 as if the option were certain to be exercized. The way our businessman saw it, this is a "no accounting loss" situation. If the market price of the common TABULAR DATA OMITTED TABULAR DATA OMITTED TABULAR DATA OMITTED stock is below $85 at the end of the year, the option will not be exercised and the $10,000 is pure gain. If the market price is above $85, the option will be exercised and Company X will receive $85,000, still leaving it with an accounting gain of $10,000 (the premium received). Our businessman knew, however, the difference between an accounting gain and an economic gain. If the market price of the common stock goes above $95, it would have been better not to write the call option and sell the common stock to realize a gain higher than $10,000. Quickly dismissing that possibility, our businessman decided to recognize $10,000 as income on day one and not recognize any additional assets or liabilities.

The final item was the forward contract. Although the contract called for the TABULAR DATA OMITTED exchange to take place in one year, our businessman toyed with the idea of recording the asset (1,000 shares of common stock) and the liability ($85,000 unconditional payable) immediately since the contract was binding and unconditional. However, he realized quickly how easy it is just to ignore the contract until it is fully executed and opted for that approach.

All those accounting decisions led to the balance sheet shown in Exhibit 3 as of December 1, 1992.

A Look Into the Future

Totally absorbed by his accounting task, our businessman decided to look ahead at the balance sheet for the first reporting period, March 31, 1993. He decided to sketch two scenarios, optimistic and pessimistic, to examine the impact on the fundamental financial instruments of Company X. His notes are shown in Exhibit 4.

Historical Cost or Fair Value?

Our businessman knew that a number of measurement attributes are used in practice to measure assets and liabilities at the reporting date. Some assets are reported at market value, some at lower of cost or market value (LOCOM), and others at cost or amortized cost. Our businessman decided to be bold, ignoring existing generally accepted accounting principles (GAAP), and drawing two balance sheets as of March 31, 1993, under each scenario: one based on historical cost (HC), the other based on market or fair value (FV). These balance sheets are shown in Exhibit 5.

Our businessman was able to prepare the fair-value balance sheets with the help of a friend, who happened to be a computer fanatic with an interest in option-pricing models. Although she briefly explained the methodology used in valuing interest-rate caps, and call options written, and forward contracts, our businessman was not totally convinced at this stage the resulting estimates of fair value were reliable enough for "public consumption." Nevertheless, he wrote down the numbers she gave him, entered them on the balance sheets, and concluded that he would need to talk to his auditor.

Our businessman spent a fair amount of time studying those balance sheets. As he expected, the fair value balance sheets were more volatile and related more closely to the conditions (good or TABULAR DATA OMITTED bad) existing at the reporting date. Part of that volatility came from the inclusion of the fair value of the forward contract and the call option written, which were not included in the historical cost balance sheets. But it also came from the changes in fair value of the interest- rate cap and the common stock in A. Our businessman realized that under the pessimistic scenario, existing GAAP would require recording the investment in common stock at its lower fair value ($79,000) rather than leaving it at historical cost.

More Questions!

Our businessman identified questions for which he could not come up with clear answers:

1. Under the optimistic scenario (HC), should a provision against the carrying amount of the interest-rate cap be made? The question is probably whether the existing conditions will persist until the exercise date of the interest-rate cap, in which case the cap will be worthless. In other words, is the impairment permanent?

On the other hand, a prudent practice could be to record impairment as soon as it arises (similar to using LOCOM accounting). Considering the amount of the interest-rate cap ($250), our businessman decided not to provide against the carrying amount.

2. Under the optimistic scenario (HC), is it appropriate not to consider the call option written when, based on current market conditions, it is probable that the option will be exercised (because it is so much "in the money")? One possibility would be to record a receivable ($85,000) and a liability (common stock to be delivered) as if the option were to be exercised. Our businessman was uncomfortable about not acknowledging the existence of the call option written on the balance sheet, but he felt even more uncomfortable about accounting immediately for the transfer of the common stock based on current market conditions that might change significantly before the exercise date of the option.

3. Also under the optimistic scenario (FV), is it appropriate to disclose the value of the investment in common stock at $99,000 when, under the call option agreement, the investment must be sold at $85,000 if the holder decides to exercise its option? Would an appropriate alternative be to offset the fair value of the call option written against the fair value of the investment? Perhaps that would better reflect the relationship between the value of the call option written and the value of the investment.

4. Under the pessimistic scenario (HC and FV), should the relationship between the value of the interest-rate cap and the interest payable on the variable rate borrowing be reflected in some way in the balance sheet? As displayed, it appeared that Company X was paying ten percent interest on the borrowing while the interest-rate cap ensured a maximum nine percent interest rate. One alternative would be to record a receivable representing one percent interest (ten percent less nine percent) as if the interest-rate cap were already effective. Again, our businessman was uncertain about recording an amount that might never materialize, depending on future changes in LIBOR.

5. Under the fair value balance sheets, should the changes in fair value be disclosed in the income statement or directly in stockholder's equity? Our businessman knew that under current GAAP, some changes in fair value are taken to income while others (for example, changes in fair value of non-current equity securities accounted for at LOCOM) are taken to stockholder's equity.

Before completing his review of the balance sheets, our businessman could not help imagining Bank Y's reaction under the pessimistic scenario. After all, under fair value, Company X appeared to have negative equity. Would Bank Y provide a liability for the possible default by Company X under the variable rate borrowing? Would it even consider providing for the full payment and record a receivable (from Company X under the financial guarantee agreement) for the same amount?

Let's Look Further

Quickly dismissing those dark thoughts, our businessman decided to further pursue the accounting exercise by looking at the projected income for Company X through December 31, 1993, under the same scenarios as shown in Exhibit 5.

Our businessman noted the only net difference between the results of the two measurement methods came from the carrying amount of the investment in TABULAR DATA OMITTED common stock A: $85,000 versus $99,000 under the optimistic scenario, and $170,000 versus $158,000 under the pessimistic scenario (under the latter scenario, Company X not only retained the original investment in common stock A, but it also had to buy an additional 1,000 shares under the forward contract agreement). That was consistent with a principle our businessman remembered from his undergraduate days. Accounting is largely a question of timing, and over time, the cumulative results should be the same under any measurement model used to account for transactions. However, our businessman also knew from experience that periodic results were important to users of financial statements, and he was amazed at the variability of those results under the various scenarios.

More of the Same

After all those projections and accounting decisions, our businessman was exhausted and confused. He felt that even though his accounting choices were justifiable, some of the alternatives were just as justifiable and appropriate in certain circumstances. In other words, he had no clear, unequivocal answers. To relax, he grabbed his copy of the DM and skimmed through the pages. The more he read, the more he realized he had been struggling with the very issues addressed in the DM: recognition, initial and subsequent measurements, derecognition, and display. He also realized that some of the issues were even more troublesome when applied to compound financial instruments, that is, instruments made up of two or more of the fundamental instruments he had been dealing with in Company X. At least he did not buy a Company A bond convertible into common stock or borrow using callable debentures. He rapidly finished reading the document and concluded that although those questions were important and must be addressed by the FASB, he should not risk his own money and spend so much effort in search of an accounting ideal.

Jeannot Blanchet, CA, is a Project Manager at the FASB assigned to the financial instruments project. Expressions of individual views by members of the FASB and its staff are encouraged. The views expressed in this article are those of Mr. Blanchet. Official positions of the FASB are determined only after extensive due process and deliberation.