The Financial Institutions Accounting Committee has written the Financial Accounting Standards Board with comments on FASB Discussion Memorandum 109 A on recognition and reporting of financial instruments. FIAC is made up of 16 senior bank and thrift executives and is affiliated with the Financial Managers Society. Following are excerpts from the letter. Additional excerpts will be carried in the Aug. 31 edition.


Primary Issue 1:

What financial assets or liabilities arise from contracts to exchange other financial instruments?

Assets and liabilities arise when the rights and obligations pursuant to a transaction are unconditionally transferred. Cash, or its equivalent, is the most fundamental element of determining both recognition and measurement. The most basic and fundamental element of any asset or liability is the eventual cash flow that it produces. Every asset and liability should include a fundamental probability of an eventual cash flow.

This concept, when applied to financial options, guarantees and forwards, to consistent with existing practice. When considering the economic substance of such transactions, it would not be appropriate to assume that a future exchange will or will not occur. The element of uncertainty can never be fully eliminated from financial statements; nevertheless, only transactions that are probable of occurrence should be recognized. While we do not support accounting recognition, the off-balance sheet disclosure required by SFAS No. 105 is the most meaningful way to disclose information to the reader about possible future exchange transactions.

Primary Issue 2:

When should financial assets and liabilities that arise from conditional or unexecuted contracts be recognized?

Assets and liabilities should be recognized at the inception of a contract or agreement. Consistent with our response to Primary Issue 1, an uncertain future exchange should be recognized only in the amount of a current or probable future cash flow. It would not be appropriate to recognize rights and obligations pursuant to a conditional contract until a future event results in the probability of an exchange.

Primary Issue 3:

How should a financial instrument be analyzed for accounting purposes if two or more rights or obligations having different characteristics are embedded in a single contract--for example, a callable bond?

There should be one governing characteristic identified in every financial instrument that determines its accounting treatment. Using as an example a convertible bond, the instrument should be recognized as a bond until such time that the instrument has been converted to another form. In instances of certain compound instruments, the separate characteristics of financial instrument must be individually analyzed to determine the most appropriate accounting treatment. The single characteristic of such a compound instrument with the highest determined economic value should determine the classification and accounting treatment.

Applying the theory of using the building block approach to the recognition and measurement of financial instruments is impracticable, subjective and significantly influenced by assumptions. However, such a concept can be a valuable analytical tool. Nevertheless, the marketplace may from time to time produce compound instruments for which determining the single highest economic value characteristic may be difficult. In those situations, based upon the specific facts and circumstances, we would support bifurcation for purposes of determining the most appropriate accounting treatment, particularly if the components are detachable. However, we believe that such situations will be rare and will be best served through the development of accounting guidance as exceptions by the Emerging Issues Task Force.

Primary Issue 4:

In what circumstances should separate financial assets and liabilities be offset?

We generally support the view that offsetting is required when the legal right of setoff exists and when management has the intent to offset. Management's historical practices should be consistent with this intent. Requiring offsetting when the setoff criteria have been met will result in more comparable financial statements for financial institutions.


Primary Issue 5:

Should initial measurement of financial instrument be based on what was received or paid in exchange for them, on the amount stated in the contract, on their market value when recognized or on expected net future cash flows?

Business transactions that are executed at arms length are generally executed at their fair value. As discussed in our response to Primary issue 1 and Issue 2, the consideration to be received or paid upon recognition of an asset or liability is stated in terms of cash, or its equivalent. Generally, fair value will be equal to the amount received or paid, the market value, and the expected net future cashflows at inception discounted at a market rate of return. Financial instrument contracts generally bear a rate of interest or reflect a stated value upon a future exchange that includes an imputed amount of interest over the term of the contract. An exception would be trade receivables and payables that are normally fully collected and fully repaid during the normal one year accounting cycle.

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