FASB issues new acccounting rules for debt and equity securities

Healthcare Financial Management, Oct, 1994 by Alan Reinstein, Mohamed Bayou

INVESTING

The Financial Accounting Standards Board (FASB) recently issued a new statement that requires all companies to change their methods of accounting for debt and equity and securities. Rather than allowing organizations to use a historical cost approach in accounting for such financial instruments, FASB Statement No. 115 requires organization to adopt a market value approach. The provisions of this statement will affect significantly organizations in the healthcare industry that have large investment portfolios.

Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, published recently by the Financial Accounting Standards Board (FASB), is important for organizations in the healthcare industry, especially for-profit institutions (such as nursing homes) that have large inventories of financial instruments in their investment portfolios. The statement not only requires such institutions to recognize losses on investments, as they have in the past, but it also requires them to recognize gains on investments, even if an organization has neither sold the financial instruments nor made plans to sell the instruments in the near future. Because the standard alters the method of reporting net income, assets, and retained earnings, it skews the comparability of financial ratios from one period to the next. This incomparability of financial ratios could cause organizations to be in violation of loan covenants.

The issuance of Statement No. 115 manifests the change in FASB's focus from the income statement to the balance sheet. The statement alters the method of reporting on financial instruments in both the income statement and the balance sheet, which results in different accounting for gains and losses in market values for certain securities and an increase in deferred income taxes.(a)

History of securities accounting

In 1953, FASB's Accounting Research Bulletin No. 43 required organizations to carry, at cost, temporary investments in marketable debt securities (for example, bonds and debentures), unless the market value of these investments fell significantly and permanently below cost. In such cases, the organization was required to report the reduction in the market value of the debt instrument and to recognize any resulting losses in the income statement for the year during which the decline in market value occurred.

In 1975, FASB issued Statement No. 12, Accounting for Certain Marketable Securities, which applied to marketable equity securities, including common stocks, nonredeemable preferred stocks, and the rights to acquire such stocks. In keeping with this statement, organizations had to separate their short- and long-term marketable equity securities in each period and valuate each group of securities separately on the basis of the lower of two amounts--the cost or the market value for each balance sheet date.

Organizations had to report unrealized losses in market value both in a valuation allowance account on the balance sheet and on the income statement for the current year; however, they reported only those gains that did not exceed previously reported losses. Organizations reported gains in the valuation account for their short-term investments as part of their periodic income; however, they reported accumulated gains in the valuation allowance for long-term equity securities as a separate part of equity--without first including such changes in the income statement. Organizations also reported realized losses for equity securities that changed in classification from current to non-current and vice versa.

Because of significant fluctuations in interest rates since 1975 and the consequent wide swings in values for both debt and equity securities, many regulators and financial analysts have questioned the appropriateness of using the amortized cost or other historical methods to account for these transactions--particularly in light of the development of sophisticated hedging techniques and hybrid financial instruments such as interest-only or principal-only strips.

In response to these developments, FASB issued Statement No. 115 to expand the use of fair value accounting for debt and equity securities. At the same time, FASB formulated the statement to the use of amortized cost methods of accounting for investments in debt securities as long as the reporting organization has the positive intent and ability to hold these securities to maturity.

Statement No. 115 represents the third phase of FASB's financial instrument project, the objective of which is to ensure disclosure of more information about the value of financial instruments and to improve the use of generally accepted accounting principles for these instruments. The first phase of this project was completed in 1990 when FASB issued Statement No. 105, Disclosure of Information about Financial Instruments with Off-Balance Sheet Risk and Financial Instruments with Concentrations of Credit Risk. This statement requires all organizations to disclose information about the risk of accounting for losses from financial instruments that exceed the amounts reported on the balance sheet. It also requires disclosure of the maximum amount of exposure that would occur if any party to the financial instrument failed to perform his or her duties.