Assisting Financial Institutions Apply the New Accounting Standards for Security Instruments

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ASSISTING FINANCIAL INSTITUTIONS APPLY THE NEW ACCOUNTING STANDARDS FOR SECURITY INSTRUMENTS

The Financial Accounting Standards Board (FASB) recently issued Statement No. 115 (SFAS No. 115), Accounting for Certain Investments in Debt and Equity Securities, whose provisions became effective for fiscal years beginning after December 15, 1993. This Statement constitutes the third phase of the FASB's financial instrument project. The first phase was FASB's SFAS No. 105, Disclosure of Information about Financial Instruments with Off-Balance Sheet Risk and Financial instruments with Concentrations of Credit Risk, issued in 1990 which required all entities to disclose information about their off-balance sheet risk (i.e., the risk of accounting loss for financial instruments that exceeds the amounts reported on the balance sheet) and concentrations of credit risk (e.g., the maximum amount of exposure on such financial instruments should any party to the agreement fail to perform his or her duties). The second phase was accomplished in 1991 when the FASB issued SFAS No. 107, Disclosures About Fair Value of Financial Instruments. This Statement required all entities (except those who use specialized accounting principles for investments, such as securities brokers and dealers, investment companies, and defined benefit pension plans) to disclose the fair market values of their financial instruments that were not covered by the provisions of another FASB authoritative pronouncement, where it was "practicable" to estimate that value. Accordingly, organizations must now perform a comprehensive analysis of their debt securities to ascertain if they can retain an historical cost basis for such securities, as well as use a form of market value to measure their debt and equity securities.

The provisions of this new standard are particularly important to financial institutions and other entities with large portfolios of financial instruments in their investment portfolios. They may now need to recognize gains and losses on investments that they have not sold nor plan to soon sell. Furthermore, the changes in net income, assets and retained earnings that arise from adopting this Standard can skew the comparability of prior period financial ratios and could cause violations of certain loan covenants. In turn, accounting and financial personnel at such financial institutions must comprehend the new Standard in order to analyze the financial statements of their pesent and potential clients.

Ernst & Young's (1993, p. 59) nationwide survey of 216 chief financial and investment officers from banks and thrifts whose assets' size ranged from below $150 million to more than $10 billion found many respondents indicating that "they would restructure the debt securities portfolio by decreasing their holding of long-term, fixed-rate instruments and increasing short-term investments, likely lowering their securities portfolio yield."

The issuance of SFAS No. 115 manifests the FASB's changing focus from the income statement to the balance sheet. Accordingly, reporting on financial instruments in these two statements is changed, resulting in different accounting for gains and losses in market values of certain securities and the consequent increases in deferred income taxes. Therefore, understanding of the provisions of SFAS No. 109, Accounting for Income Taxes, also is necessary for adhering to SFAS No. 115's provisions.

FASB's Trend Toward Addressing More Types of Risks

This financial and accounting literature defines risk as the variability of outcomes. In a financial institution, such sources for this variability include:

(1) Credit risk: Possible failures of the other party to perform the terms or duties specified in the contract.

(2) Market risk: Fluctuations that could decrease the value of financial instruments.

(3) Liquidity risk: Potential cash shortages necessary to meet the terms of the contract. …