A FASB Statement No. 107 report card. (Financial Accounting Standards Board) (Interview)by Ballou, Brian
The authors surveyed how credit unions responded to the requirements of SFAS No. 107, Disclosures about Fair Value of Financial Instruments. They found the costs of preparing the information was relatively low. However, the disclosures themselves were often literally all over the lot.
In December 1991, FASB issued Statement of Financial Accounting Standard No. 107, Disclosures about Fair Value of Financial Instruments. This statement was implemented by all companies with assets exceeding $150 million for fiscal years ending after December 15, 1992. In June 1993, over 125 credit unions which prepared FASB Statement No. 107 disclosures for their most recent financial statements responded to a survey on the cost, effort, and methods used to prepare the disclosure. Over 75 of the respondents also provided a copy of their audited financial statements, which included their fair value disclosures. Each Big Six and numerous regional and local accounting firms were represented in the annual reports received. Examination of the disclosures revealed a broad array of methods and formats used to present fair value information. As is the case with other new FASB standards, a few years of experience may be needed to develop fairly uniform disclosures within an industry.
Credit unions are excellent examples of smaller financial entities. Over 80% of the responding credit unions had assets between $150 and $750 million. While credit unions are member-owned organizations, given the increasing sophistication of their activities, many disclosure issues pertaining to them are also considerations for other smaller financial services institutions. Much can be learned by examining some of the methods and presentation formats used by credit unions that have already implemented FASB Statement No. 107.
Can the accounting systems of smaller financial institutions of the size reported in this survey generate fair value information internally? If so, can they produce these data at a reasonable cost? Answers to both questions appear to be "yes." The more difficult question is whether the fair values were gathered carefully and reported properly. We have tried to match the requirements and perceived expectations of FASB Statement No. 107 with the note disclosures in audited financial statements. Also, the respondents' answers to our survey questions helped us understand the costs incurred, effort expended, and methods used to support the fair value disclosures. Several key issues relating to the actual disclosures reviewed are also analyzed later.
The Costs and Effort of Reporting Fair Values
Many early objections to FASB Statement No. 107 centered on perceived costs and the degree of difficulty of obtaining fair values that could be audited. Fair value disclosure is relatively new information provided to the financial public; however, the same basic information is used internally by many financial institutions as part of their asset/liability management processes and in estimating possible credit losses. Present value calculations and analyses are integral parts of assessing and managing interest rate risk. Duration, interest rate elasticity, and interest rate shock analysis are tools used by financial planners in many large financial institutions. Even funds gap analysis, which is part of the regulatory review processes for credit unions, requires knowledge of future cash flows, maturities, and repricing characteristics. However, much of this information is part of financial forecasting models and systems and generally not in readily auditable form.
In our survey, most respondents spent relatively little to implement FASB Statement No. 107. In fact, 75% of the respondents who disclosed their costs spent less than $4,000 to gather and report fair value information. The average incremental compliance cost was just over $3,250. Based on survey responses, the majority of these costs was spent on credit union personnel who gathered the fair value data. Additional audit costs were not significant, with a median cost to each credit union of $1,000 for those reporting. Nearly two-thirds of those responding could trace no additional audit costs to fair value work. However, due to the fixed-fee structure of many audit engagements, the audit costs associated with implementing FASB Statement No. 107 may not appear until subsequent years' audits.
An interesting finding from the survey is that smaller credit unions ($150 to $500 million in assets) spent as much on fair value estimation as did larger credit unions (over $750 million in assets). Although larger credit unions typically have a wider variety of financial instruments that tend to be more complex and larger in volume, it appears they also have greater sophistication in asset/liability management, stronger accounting systems, and more experience with financial modeling. Having such resources in place most likely reduced implementation costs. Smaller credit unions, on the other hand, spent relatively more time developing fair value data, increasing their implementation costs.
Of the credit unions responding to a question about how their fair values are determined, over 75% used some type of computer-based financial model. In the majority of cases, software used was adapted from other internal uses; however, about 15% used software provided by their CPA firms. A few reported purchasing software specifically for fair value calculations. This, plus the learning curve effect, make it seem reasonable to believe average preparation costs will decrease in the future. The clamor about high costs appears unfounded, at least for these credit unions.
The Fair Value Disclosures
Of concern to auditors, statement readers, and statement preparers are the following three issues:
* Uniformity of disclosures,
* Understandability, and
* Completeness and correctness.
Fair value information can help users of credit union financial statements better assess the riskiness of financial assets and liabilities that are of major concern to them. According to the AICPA's audit and accounting guide, Audits of Credit Unions, credit unions are exposed to three important risks: credit, interest rate, and liquidity. Credit risks exist in cases of improper credit extension procedures, changes in the national or local geographic economy, changes in an industry, undue loan concentrations, and deterioration in the credit worthiness of borrowers. Interest rate risk exists when assets have rate ceilings or fixed interest rates, especially when such assets are funded through interest-sensitive short-term liabilities. Finally, liquidity risk exists when credit unions invest funds needed for liquidity protection in long-term securities or securities with limited marketability. FASB Statement No. 107 clearly addresses the need for information relevant to assessing interest rate risk and to some extent credit risk.
Up front, a few examples of what we believe are quality disclosures can set the tone for our discussion. First is an example of a disclosure describing methods used to measure fair values. Virginia Credit Union, Inc. provided the note in Exhibit 1 about the valuation methods used for various instruments.
This note covers each major category of financial assets, describes the methods used in each area, and provides detailed explanations of the valuation approaches used for loans. Also, off-balance-sheet items are identified, regardless of whether the balances were material.
Disclosure of the fair value amounts themselves took on many formats. Exhibit 2 shows examples from several credit unions for each major section of fair values: assets, liabilities, and off-balance-sheet items.
In each case, multiple categories of financial contracts with book and fair values are presented in the format paralleling FASB Statement No. 107. These categories apparently reflect the major account classifications relevant for these credit unions. These are more extensive than the typical note disclosure in our survey.
Uniformity of Disclosures
FASB Statement No. 107 does not require any specific level of detail or format for the presentation of fair values; however, Appendix B of the Statement does provide an example of how the disclosure could be presented. As might be expected, the reviewed annual reports included various levels of detail for estimations of fair values.
Several strategies were employed by credit unions to disclose fair-value information. The two most popular methods were to--
* disclose the methods of determining fair value estimates in the significant accounting policies note and then include the fair values of assets, liabilities, and off-balance-sheet items within the appropriate individual notes; and
* disclose all fair value information within its own note, usually as one of the last notes.
Using either of these strategies is satisfactory; however, the wide array of formats used made it difficult to compare credit union information. Over two thirds of the reports did include most of their fair value information in one note, which included both tle narrative explanations and fair value amounts.
Using the first option above spreads the fair value information throughout the notes, often in at least five places. Because of the various methods of presenting loan, investment, member deposit, and off- balance-sheet contingency data in footnotes, integrating fair value data within those notes provides a large array of presentation possibilities. It is possible a number of credit unions used this technique to dilute the total impact from the fair value information by dividing the information as much as possible and making it difficult to combine fair value information, even within one financial report. The reader must make special effort to link together the fair value information, particularly when terms like market value and estimated market value are used as fair value terms for accounts like investments, while fair value is used for other accounts within the same financial statements.
We, therefore, suggest all fair value information be reported in a single note. Reasons why a single note might be preferable to other methods include the following:
* Easier assimilation of fair value information. Because of its complexity and newness, having fair value information in one location assists the reader in grasping the impact of fair values.
* Easier inspection of material differences. The user will quickly be able to see how many estimates of fair value approximate carrying value, which will help the user to perform risk assessments.
* Easier comparison among entities. Users will more easily be able to compare fair value methods and estimates across peer credit unions and other financial institutions.
* Ability to see the whole picture. The users' ability to view the aggregate fair value of nearly the entire debit and credit sides of a credit union's balance sheet in one place is significantly easier than linking fair values to balance sheet pieces. An example of such disaggregation appeared in one credit union report that tacked on fair- value methods and values as one sentence at the end of each note without presenting any carrying values next to them for easy comparability.
As always, uniformity need not mean standardization. However, the ability to use the information as the FASB intended requires commonality of presentation. We suggest the one-note approach does this best. Accordingly, a strong fair value footnote would include the information provided in both Exhibits 1 and 2. Many credit union annual reports did present fair value information in such a format but with less detailed descriptions and account groupings.
One of the underlying problems with the ill-fated SEC and FASB requirements for replacement cost and price-level disclosures in the late 1970s and early 1980s was the lack of uniformity in definitions and presentation. Fair value disclosures will most likely persist whether or not disclosures are uniform; however, users are best served by being able to easily read and understand disclosures.
Understandability of Measurement Methods and Fair Values
To be useable, information must be understandable. Fair value disclosure is a new reporting requirement and has numerous calculation and definitional requirements. From our analysis of annual reports, we noted several areas of concern that may limit users' ability to understand and/or use fair value information effectively. Below, we provide suggestions to improve the understandability of measurement methods and fair values.
More Detailed Explanations of Fair Value Methods Used. Most credit unions used similar methods to determine fair values within financial instrument type; however, many provided minimal explanations of how the methods were applied. In the area of loans for example, many described the methods used for determining fair values simply by stating that amounts were estimated by discounting future cash flows using current rates at which similar loans would be made to members with similar credit ratings. No mention is made of assessment of credit risk, maturities, or pre-payment options. Users of financial statements might benefit from having more detailed information similar to Exhibit 1, particularly for loans since they are the largest component of total assets in most financial institutions.
Without adequate descriptions, users of financial statements might reach inappropriate conclusions as to how specific fair values were determined within groupings of financial instruments.
A More Detailed Breakout of Asset Liability, and Off-Balance-Sheet Financial Instrument Classifications. Most credit unions had significantly fewer classifications of fair value information than presented in Exhibit 2. The level of detail presented to the financial statement reader varied considerably. Summarizing many loan categories into one line hardly provides much data for analysis. The number of account items reported ranged from a low of three to a high of 18. For the 52 credit unions that reported all fair value numbers in one note, Exhibit 3 shows the distribution of responses for assets, liabilities, and off-balance-sheet items.
A typical presentation had four assets, two liabilities, and one or no off-balance sheet items. The typical asset presentation was cash and equivalents, investments, loans, and either another loan or investment account. The liabilities were a member deposit account plus a borrowing, an accrual, or a regular share/certificate member deposit breakdown. The off-balance-sheet items were typically commitments to extend credit.
A Better Representation of the Scope of FASB Statement No. 107. Users will more likely get a better understanding of the phase-in approach of fair values within financial statements if they see that such information is currently only being provided for some assets and liabilities, both recognized and unrecognized. Should the FASB increase the disclosure requirements of fair-value information in the future, changes in a pre-existing note will most likely allow for a better understanding by users of the financial statements. If fair values are sprinkled throughout note disclosures, such understanding might be more difficult.
Limitation Statements Need to be More Neutral. Many disclosures also included some type of limitation statement regarding how the fair value information should be interpreted. These statements appear to be motivated by the fact FASB Statement No. 107 does not require disclosures of fair values for all assets and liabilities nor uniform methods for determining fair values. As such, it appears limitation statements were made for liability protection. A typical limitation statement appeared as follows:
The fair value estimates are made at a discrete point in time based on relevant market and financial instrument information. Since a market may not exist for a portion of the Credit Union's financial instruments, these estimates are based on judgments regarding future expected loss experience, current economic conditions, credit risk characteristics, and other factors. These estimates are subjective in nature, involve uncertainties and matters of significant judgment, and cannot be determined with precision. Changes in assumptions could significantly affect the estimates. The fair value estimates are based on existing on- and off-balance-sheet financial instruments without attempting to estimate the value of anticipated future business and values of assets and liabilities not considered financial instruments. Certain of the instruments' fair values cannot be substantiated by comparison to independent markets or to other financial institutions and do not necessarily represent the underlying value of the Credit Union.
Some credit unions made no such limiting statements. Other credit unions made stronger statements than those in the above disclosure. For example, some disclosures did not include the word "necessarily" in statements concerning the application of aggregate fair values to the underlying value of the credit union and instead said the aggregate fair values "do not" represent the underlying value of the credit union. While such stronger statements might be true in absolute terms, the aggregate fair values do represent the material portion of the underlying value of the entity.
The tone of limitation statements appears to qualify fair value information too heavily. Accordingly, users might disregard the integrity of the entire disclosure. Excessive use of words such as "judgments," "subjective," "precision," and "uncertainty" may actually be misleading. Elements not objectively measurable are present in many aspects of accounting measures and disclosures; yet, limitation statements do not appear in other parts of the financial statements.
The caution noted within limitation statements we analyzed could convey three types of messages: 1) do not assume fair values are market values, 2) do not compare fair values of this credit union with others, and 3) do not create an equity section from the incomplete asset and liability numbers. The first message is addressed in the Basis of Conclusions section of the statement itself. The Board decided to use the term fair value in response to feedback from an earlier Exposure Draft. Respondents felt the term market value used in the Exposure Draft was too restrictive. The second message has some credibility at this point in time, particularly given the varied disclosures discussed earlier. The third message might be somewhat misleading. It is true not all assets and liabilities are converted to fair values; however, over 95% of all assets and over 90% of liabilities are financial instruments on a typical credit union's balance sheet. The only remaining assets and liabilities are fixed assets and accruals. Thus, it is an easy step to find the market value of portfolio equity, which is the difference between the present value of all assets and the present value of all liabilities. This is an accepted approach to internal assessment of interest rate risk and is now part of the risk-based capital reporting requirements for commercial banks.
The note writer has a delicate task. To have no statement of limitation may appear to give the current state of fair value information more credibility than it has earned. Certainly, credit union managers say the credit union is not for sale, no stock price is involved, and they do not intend to sell most assets. Yet, building equity is currently a major financial objective of the National Credit Union Administration, the chief credit union regulatory body. Also, measuring the impacts of interest rate risk is an integral part of regulatory examinations. Such observations imply fair value reporting has significant value but with limits on its general use.
We suggest credit unions seriously reconsider their current use of limitations statements. Should credit unions, or other institutions for that matter, feel the need to use qualifying statements, we suggest a more neutral presentation. A positive contribution would include references to how fair values assist in assessing credit and interest rate risks and their impact on economic equity.
Completeness and Correctness. The completeness and correctness of disclosures is a concern. While the large majority of disclosures appear to meet the intent of the Statement, several problem areas appeared to impair the integrity of the disclosures.
Balance-Sheet Explanations and Disclosures. As shown in Exhibit 3, many credit unions did not mention anything about off-balance-sheet items. It is highly probable credit unions with assets of at least $150 million do have material loan commitments, lines of credit, or other off-balance- sheet items. Even if such instruments do not have material balances, some mention of their existence should be included in the note (see fixed-rate loan commitment reference in Exhibit 1). Disclosing amounts of off-balance-sheet items is one of the intents of FASB Statement No. 107, and implementation of the statement should include such disclosures.
Disclosure of All Material Items. FASB disclosures are applicable to all material financial assets, liabilities, and off-balance-sheet items. This is important because many credit unions disclosed no material differences existed between carrying and fair values of both on- and off-balance-sheet items but failed to disclose the actual carrying and fair values of the items themselves. Even though differences between the estimates might be immaterial, the specific values contain important information to financial statements Users. For instance, some credit unions have outstanding loan commitments in excess of 50 percent of outstanding loans receivable. As an isolated example, the following disclosure appeared for a credit union with assets exceeding $500 million:
Management believes that the carrying value of the financial assets and liabilities included in the financial statements, as well as unrecognized financial instruments, approximate fair value.
The annual report included no disclosures for the values of such unrecognized financial instruments.
The Not Practicable Option and Nondisclosures. Paragraphs 14 and 15 of FASB Statement No. 107 states in effect that entities do not have to provide fair values when it is not practicable (defined by the FASB as meaning an estimate of fair value cannot be made without incurring excessive costs). Very few credit unions used the not practicable option and then only for certain off-balance-sheet items and certain non- performing loans. Several credit unions in our survey reported neither methods for determining fair values nor the actual fair values. Two credit unions did use the not practicable option. One fair value footnote said the following:
The Credit Union has determined it is not economically practicable, because of the existence of numerous individual instruments, to estimate the precise fair value of the loan portfolio and member time deposits. However, the following data has been provided to assist in estimating the fair value of these financial instruments as of December 31, 1992.
The information alluded to above included maturity ranges, interest rate ranges, effective yields, and carrying amounts but no fair values. Based on the relatively inexpensive costs reported to implement FASB Statement No. 107, the use of the not practicable option for many financial instruments seems unreasonable.
Improper Reporting of Fair Values of Loans. Two minor discrepancies in reporting loans were noted on numerous reports. First, the allowance for loan losses was reported in both the carrying value and fair value columns. The credit risk factor should be an integral part for determining fair values. Accordingly, no allowance account amount should appear in the fair value column. Second, in a few other credit union disclosures, loans were reported gross with no mention of the allowance account. Carrying value for loans means net of the allowance, and fair value means incorporating existing credit risk. An example of the proper format is shown in Exhibit 2.
Implications for the Future
Fair-value information will continue to grow in importance. Furthermore, obtaining fair-value information continues to become easier and less costly. Accordingly, it is unlikely that the FASB, or any regulatory body, will go any direction other than to increase disclosure and recognition of fair values of financial assets, liabilities, and off- balance-sheet items. The most fundamental change in fair value reporting is to change the tone from one of limiting responsibility for using flawed fair values to one of assessing interest rate and credit risks.
Note Disclosure of Fair Value Methods from Virginia Credit Union Inc.
Cash and Cash Equivalents
The carrying value at reasonable estimate of fair value.
Investments Held for Sale and Other Investments
Fair values of investments held for sale and other investments are based on quoted market prices or dealer quotes. In the absence of quoted market prices or dealer quotes, fair value is estimated using quoted market prices for similar securities, adjusted for differences between the quoted securities and the securities being valued.
Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by loan type (such as mortgage, unsecured and secured lines of credit, credit card, automobile and other consumer), interest rate terms (such as fixed or adjustable), and estimated credit risk. The fair value estimate of loans that have adjustable rates, such as unsecured lines of credit and credit card loans, is based on the value of existing loans at December 31, 1992. For loans such as some residential mortgage loans held for sale, fair value is estimated using the quoted market prices.
The fair value of other types of performing loans is estimated by discounting the future cash flows through the estimated maturities using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. The estimate of maturity is based on historical experience, with repayments for each loan classification modified, as required, by an estimate of the effect of current economic and lending conditions. Fair value for performing loans is based on estimated cash flows that are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and discount rates are judgmentally determined using available market information and specific borrower information.
Regular Savings, Share Accounts and Savings Certificates
The fair value of club, share drafts, and regular and premium savings share accounts is the amount payable on demand at December 31, 1992. The fair value of fixed maturity savings certificates is estimated based on the discounted value of the contractual cash flows using the interest rates currently offered for certificates of similar remaining maturities.
Off-balance Sheet Financial Instruments
The fair value of commitments to extend credit is estimated using the fees currently charged to enter similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The carrying and fair value of fixed-rate loan commitments is immaterial at December 31, 1992.
Harold M. Sollenberger, DBA, CPA, is Professor of Accounting and Brian Ballou, CPA, a doctoral student, both at Michigan State University.
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