FAS 105: the future of disclosure standards for financial instruments

National Public Accountant, The, Nov, 1992 by David Lavin

Off-balance sheet disclosure of financing obligations is not a new topic for the accountant, but it does represent an issue yet to be completely resolved. The FASB first addressed the topic (FAS No. 13) when it was faced with some lease issues left unresolved by the APB. In a later standard (FAS No. 47), the FASB looked into the disclosure of off-balance sheet long term obligations, such as unconditional purchase obligations. In another standard (FAS No. 49), the FASB dealt with off-balance sheet product financing transactions in which a company sells inventory and agrees to repurchase it at a specified price. The FASB continues to be concerned with off-balance sheet financing because of innovations in financial instruments. In the past decade, because of the dynamic state of financial markets brought on by such things as deregulation, increased competition, inflation, internationalization and changes in the financial services industry, there has been an explosion in the number and variety of financial instruments offered in the marketplace. To understand the nature of these instruments, a short course in finance would be needed. There are hundreds of new financial instruments and the following list is meant to be illustrative of some of the unusual names: interest rate swaps, collateralized mortgages, put and call options, exchangeable debentures, liquid yield option notes, floating rate notes and strips.

The traditional historical cost transaction based accounting model has created an incentive to develop financial instruments that allow recognition of income earlier than traditional instruments, defer losses and avoid disclosures of risks and liability recognition. Accounting for many of these financial instruments is not yet specified under generally accepted accounting principles. To develop a standard for every instrument would mean tremendous duplication as many of the instruments could be broken down into understandable parts. Once these understandable parts are dissected, sorting them into similar categories would be necessary in order to develop a standard for recognition and measurement. Recognizing this problem, the FASB came up with three phases in the financial instruments projects:

a. Disclosure;

b. Recognition and measurement;

c. Distinguishing liabilities and equity.

FAS No. 105 addresses the first phase of the project by requiring new disclosure standards for financial instruments. It does not alter any current requirements for recognizing, measuring or classifying these instruments.

The difficult part of this Standard is in the understanding of what is a financial instrument and, as a result, the Board provides a definition of a financial instrument and gives examples of instruments included and excluded from the definition. The Statement defines a financial instrument as cash, evidence of an ownership interest in an entity or a contract that both:

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

b. Conveys to that second entity a contractual right: (1) to receive cash or another financial instrument from the first entity, or (2) to exchange other financial instruments on potentially favorable terms with the first entity.

The key to this definition is it requires a two-way flow of cash or financial instrument as well as the favorable and unfavorable nature of the outcome. Fundamentally, a financial instrument must ultimately result in the delivery of cash or an ownership interest in an entity. As a result, the definition excludes many assets that contain no obligation to deliver cash or right to receive cash. Some examples include: inventory, property, plant and equipment, leased assets, patents, trademarks, prepaid expenses and advances to suppliers. The definition also excludes contracts either requiring or permitting settlement by the delivery of commodities because the future economic benefit is the receipt or delivery of goods or services instead of a right to receive or deliver cash or an ownership interest. For example, bonds to be settled in ounces of gold or barrels of oil rather than cash are not financial instruments under the definition.

The Standard also defines a financial instrument with off-balance sheet risk of accounting loss if the risk of accounting loss to the entity exceeds the amount recognized as an asset or a liability. This risk includes credit risk and market risk. Credit risk is the possibility a loss may occur from the failure of another party to perform according to the terms of a contract. Market risk means the possibility of future changes in market prices may make a financial instrument less valuable. The related risk of accounting loss, for many of the financial instruments, cannot exceed the amount recognized in the financial statements. This is because the amount recognized as a financial instrument already reflects the risk of accounting loss to the entity. For example, a receivable that is recognized and measured at the present value of future cash flows can eventually become uncollectible.