CUNA Regulatory Comment Call
June 11, 2001
Accounting Proposal to Measure All Financial Assets
and Liabilities at Fair Value
EXECUTIVE SUMMARY
The Financial Accounting Standards Board (FASB) has issued a special report that recommends full fair value-based reporting for virtually all financial assets and liabilities entitled Recommendations on Accounting for Financial Instruments and Similar Items (Draft Standard). The report was prepared by the Financial Instruments Joint Working Group of standard setters (JWG), an informal panel made up of representatives from FASB and FASB's counterparts in other countries formed to develop a world-wide framework for reporting financial instruments at fair value.
For the past several years, FASB has been working on its own project on fair value-based reporting and in December 1999 set forth its Preliminary Views (Reporting Financial Instruments and Certain Related Assets and Liabilities at Fair Value) on the issue. In February 2001, the Board reaffirmed its ultimate goal of requiring essentially all assets and liabilities to be measured at fair value in financial statements. The FASB Board also decided to establish an intermediate objective in the progress toward that goal. The intermediate objective is the issuance of a Statement that would describe more specifically how to determine fair value for financial instruments and improve the form and content of disclosures required by FASB Statement No. 107 (Disclosures about Fair Value of Financial Instruments). Although the Draft Standard is not a formal part of the due process in the FASB project, the Board expects comments it receives on many of the issues will be useful as its project progresses.
In the Draft Standard, the JWG explained its reasons for advocating the move to full fair value-based accounting: “Advances in financial risk management and information technology, globali[z]ation of capital markets, and accelerated use of sophisticated derivatives and other complex financial instruments have combined to change fundamentally the business and investment environment. It has become apparent that traditional accounting concepts for the recognition and cost-based measurement of financial instruments need to be rethought.” The JWG, believing that fair value is the most relevant measurement attribute for all financial instruments, has come to the conclusion that sufficiently reliable estimates of the fair value of financial instruments are obtainable for financial reporting purposes.
The Draft Standard proposes the following far-reaching changes to accounting for financial instruments and similar items:
- The proposed standards would require all financial assets and liabilities to be valued according to their current market value instead of valued according to their historical cost as has been the accepted practice.
- The new standards would require recognition in financial institutions' income statements of virtually all gains and losses stemming from changes in the fair value of financial instruments. Such gains and losses would be recognized in the periods in which they occur. Credit unions that have failed to set aside enough bad loan reserves could face big write-offs of their capital as they begin marking their loans to market.
- In addition, the report advocates an end to advantageous hedge accounting. Under FASB 's current rules for fair value hedges, gains and losses in financial instruments - usually derivatives - used to counter changes in the value of some underlying hedged asset or liability are deferred from the profit and loss statement to the extent that the hedging derivative offsets the risk of loss or change it is intended to target. The proposed change would apply to credit union financial assets and liabilities from share draft accounts and loan portfolios to exotic derivatives and securitized pools of credit card receivables.
Comments on the Draft Standard are due by June 30, 2001. Please submit your comments to CUNA by June 25, 2001. Please feel free to fax your responses to CUNA at 202-371-8240; e-mail them to Associate General Counsel Mary Dunn at mdunn@cuna.com or to Senior Regulatory Counsel Catherine Orr at corr@cuna.com; or mail them to Mary or Catherine c/o CUNA's Regulatory Advocacy Department, 805 15th Street, NW, Suite 300, Washington, DC 20005. If you would like to submit your comments directly to FASB, the address is Financial Accounting Standards Board of the Financial Accounting Foundation, ATTN: RTA Director, 401 Merritt 7, P.O. Box 5116, Norwalk, Connecticut 06856-5116; to submit comments to FASB electronically, send e-mail to director@fasb.org. If you submit comments directly to FASB, please also forward a copy of your comments to CUNA. You may contact CUNA if you would like a copy of the proposed Statement or you may access it on FASB's Web site at the following address: http://accounting.rutgers.edu/raw/fasb/new/index.html; click on Special Report, Financial Instruments and Similar Items; then click on the link under #2 Special Report; Financial Instruments and Similar Items that says “Download.”
DESCRIPTION OF THE PROPOSED STANDARD
Please click here for a more detailed description of the fair value proposal.
Scope and Definitions
- The Draft Standard would apply to all entities, including credit unions.
- The definition of a financial instrument would differ somewhat from the present IASC (International Accounting Standards Committee) definition which states “Any contract that gives rise to both a financial asset of one enterprise and a financial liability or equity instrument of another enterprise.”
- Some question whether cash can be considered a contract under the IASC definition. The Draft Standard would amend the definition of financial instrument so it specifically includes cash.
- Under the IASC definition, a contract might include financial and non-financial components. In such circumstances, only the financial components constitute a financial instrument. In order to overcome this difficulty, the definition would be amended to specify that it is the contractual rights to require delivery or exchange of financial instruments and the contractual obligations to deliver or exchange financial instruments that comprise financial instruments.
- The Draft Standard would apply to all financial instruments except for certain financial instruments that have unique aspects, including: investments in subsidiaries and associates; employers’ assets and liabilities under employee benefit plans; retirement benefit obligations of defined benefit plans; most insurance contracts; and equity investments.
- Servicing assets and servicing liabilities are included in the scope of the Draft Standard.
Fair Value Measurement
- The Draft Standard sets out principles for estimating the fair value of financial instruments within a hierarchy:
- First, observable market exit prices for identical instruments are to be used if available.
- If such prices are not available, market exit prices for similar financial instruments should be used with appropriate adjustment for differences.
- Finally, if the fair value of a financial instrument cannot be based on observable market prices, it should be estimated using a valuation technique that is consistent with accepted economic pricing methodologies. The valuation technique should incorporate estimates and assumptions that are consistent with available information that market participants would use in setting an exit price for the instrument.
- The Draft Standard addresses circumstances requiring special consideration in using observed market prices to determine fair value. These include:
- Situations in which observable market prices may not be determined by normal market interactions (for example, where the observed market price would have been different if not for other transactions or contracts between the transacting parties);
- Where observable market transactions are only infrequently available;
- Where there are prices in more than one market for a financial instrument;
- Where an enterprise holds a large block of financial instrument and observable market exit prices are only available for small blocks; and
- Where the observable market price includes value that is not directly attributable to the financial instrument. A prominent example is demand deposit liabilities. Observable market exit prices for these liabilities include the value of benefits expected to result from future deposits and from other services that can be expected to arise from the customer relationship. These include the benefits of future interest free or low interest use of funds expected to be deposited in the future, rentals of customer lists and incremental cash flows from sales of products and services other than those set out in the deposit agreement. The Draft Standard would require that such value not be included in the fair value of deposit liabilities because the objective is to estimate the value of the existing financial instrument.
- Each entity should establish fair value measurement policy and procedures that are appropriate to its financial activities in order to ensure that fair value estimates and assumptions are made on a reliable and consistent basis.
Recognition and Derecognition
- All gains and losses resulting from measuring financial instruments at fair value should be recognized, after adjustment for receipts and payments, in the income statement in the reporting periods in which they arise (with the exception of exchange translation gains and losses relating to certain foreign operations).
- The historical cost “effective interest” method is not appropriate for the analysis of income determined on a fair value basis for interest-bearing financial instruments.
- An enterprise would be required to recognize a financial instrument when it has the contractual rights or obligations that result in an asset or liability and to derecognize a financial instrument or a component thereof when it no longer has the pertinent rights or obligations.
- The Draft Standard would require a components approach to transfers involving financial assets. The Draft Standard would require that a transferor generally continue to recognize a transferred financial asset, or part thereof, to the extent that the transferor has a conditional or unconditional obligation to repay the consideration received.
Financial Statement Presentation
- Interest revenue and interest expense calculated on a fair value basis, using the current yield to maturity basis, should be presented in the income statement or in the notes to the financial statements.
- Information about gains and losses should be presented by general classes of financial risk in the income statement or in the notes to the financial statements.
Disclosures
The JWG believes that financial statement presentation and disclosure should be sufficient to enable evaluation of risk positions and performance in respect of each of an enterprise’s significant financial risks. To accomplish this objective, the Draft Standard would require:
- A description of each of the financial risks that was significant to an enterprise in the reporting period and the enterprise’s objectives and policies for managing those risks;
- Information about the balance sheet risk positions and financial performance effects for each of those significant risks; and
- Information about the methods and key assumptions used to estimate the fair value of financial instruments.
Hedges
The Draft Standard does not permit special accounting treatment for financial instruments that are entered into as part of risk management activities. Financial instruments that are used for hedging purposes (for example, used as hedges of risks expected to arise from anticipated future transactions) are to be recognized and measure at fair value, with gains and losses recognized immediately in the income statement, just as for all other financial instruments.
Implementation and Transition
- The JWG recommends two years between issuance of a final standard and the effective date as sufficient time for all entities to implement the Draft Standard.
- When the Draft Standard is first applied, many financial instruments will be measured at fair value for the first time. A one- time adjustment would be necessary to restate the value of the financial instruments. Any gains or losses should be recognized as an adjustment of the balance of retained earnings at the beginning of the financial year in which the Draft Standard is initially applied.
- Entities that already record certain items at fair value may need to change their accounting policies to reflect the fair value measurement principles required by the Draft Standard. All such transitional valuation adjustments should be treated as an adjustment of the balance of retained earnings at the beginning of the financial year in which the Draft Standard is initially applied.
- An entity should not adjust the carrying amount of non-financial items to exclude gains and losses from hedging arrangements that were included in that carrying amount before the beginning of the fiscal year
QUESTIONS REGARDING THE
PROPOSED STANDARD
Scope and Definitions
- The Draft standard would apply to all entities, including credit unions. Do you agree?
Yes ________ No ________
If not, please specify why you believe credit unions should be excluded from the scope and the basis on which you would distinguish credit unions from those entities that should apply the Draft Standard.
- The definition of a financial instrument would differ somewhat from the present IASC
definition. Do you agree with the changes to the definition?
Yes ________ No ________
If not, what changes would you make, and why?
- The scope of the Draft Standard would include certain additional items, such as servicing
assets and servicing liabilities. Do you agree that these additional items should be included
in the scope?
Yes ________ No ________
If not, why not?
Recognition and Derecognition
- The basic recognition principle is that an enterprise should recognize a financial asset or
financial liability on its balance sheet when, and only when, it has contractual rights or
contractual obligations under a financial instrument that result in an asset or liability. Do you
agree?Scope and Definitions
Yes ________ No ________
If not, why not? How would you amend the principle?
Fair Value Measurement
- Some credit unions question the JWG’s conclusion that fair values are, generally, reliably
determinable, at reasonable cost, for all financial instruments except certain investments in private
equity instruments. Those credit unions predict that volatility in financial statements, or wide
swings in gains and losses, will result from a fair value-based system and that such volatility will
not reflect reality. Do you believe that most financial instruments are capable of reliable fair
valuation?
Yes ________ No ________
If you believe that other financial instruments are not capable of reliable fair valuation, what are they, what factors cause their fair values not to be reliably determinable, and how should these items be measured?
- The Draft Standard would require an enterprise to measure all financial instruments at fair
value when recognized initially and to re-measure them at fair value at each subsequent
measurement date (with the exception of certain private equity investments). Do you agree?
Yes ________ No ________
If not, what other approach would you suggest and why?
- The Draft Standard sets out principles for estimating fair value of financial instruments
within a hierarchy. Do you agree with this hierarchy?
Yes ________ No ________
If not, how would you amend the proposal, and why?
- The Draft Standard provides that value that is not directly attributable to a financial instrument should not enter into the
determination of the fair value of a financial instrument. This includes expected cash flows from future
transactions with the customer that are expected to occur because of a relationship established by the existence
of the financial instrument. Is this conclusion appropriate and operational, in particular as it applies to
demand deposit and credit card relationships?
Yes ________ No ________
If not, why not?
- The Draft Standard would require the reported value of an entity’s financial liabilities to
reflect the entity’s own creditworthiness and changes in it. Do you agree?
Yes ________ No ________
If not, why not?
- The Draft Standard would require enterprises to establish appropriate policies and procedures
for estimating fair value of financial instruments. Do you agree with this proposal?
Yes ________ No ________
If not, how would you change it in a manner that provides reasonable assurance of reliable and consistent fair value estimates?
Financial Statement Presentation
- The Draft Standard would require credit unions to recognize all changes in the fair value of
financial instruments, after adjustment for receipts and payments, in the income statement in
the reporting periods in which they arise. Do you agree?
Yes ________ No ________
If not, how should such gains and losses be treated, and why?
- Do you believe that gains and losses arising on fair value measurement of financial assets
and liabilities should be separately presented in the income statement or notes thereto?
Yes ________ No ________
If yes, which gains and losses, and why do you believe that they should be shown separately? On what basis would such gains and losses be distinguished?
Hedges
- The Draft Standard would not permit any special accounting for financial instruments entered
into as part of risk management activities. Do you agree?
Yes ________ No ________
If not, why not?
Disclosures
- The Draft Standard would require disclosure of a credit union’s significant financial risks and
of the enterprise’s financial risk management objectives and policies. Do you agree that this
information is necessary to provide the context for understanding and evaluating information
about the enterprise’s actual financial risks and performance of its financial instruments.
Yes ________ No ________
If not, how would you change these disclosures?
Implementation and Transition
- The Draft Standard recommends about two years is a suitable period of time between
issuance of a final standard and the effective date to balance preparation time with the need
for standards. Is that sufficient time to prepare for implementation?
Yes ________ No ________
If not, what would be an appropriate length of time?
- Some commentators suggest that a comprehensive fair value model for financial statements
should be first introduced in supplemental financial statements, presented in parallel with
financial statements prepared in accordance with existing practices. Only after a period of
time would such financial statements replace financial statements prepared in accordance
with existing practices. Do you believe that supplemental financial statements should be
introduced before replacing financial statements prepared in accordance with existing
practices?
Why or why not?
- Other comments?
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Eric Richard • General Counsel • (202) 508-6742 • erichard@cuna.com Mary Mitchell Dunn • SVP & Associate General Counsel • (202) 508-6736 • mdunn@cuna.com Jeffrey Bloch • Assistant General Counsel • (202) 508-6732 • jbloch@cuna.com Catherine Orr • Senior Regulatory Counsel • (202) 508-6743 • corr@cuna.com |
