Valuation assumptions under SFAS No.

140:
Understanding balance-sheet effects.
Article from: Bank Accounting & Finance | December 22, 2001 | Cheng, Kang |Copyright
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On September 30, 2000, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (SFAS) No. 140, "Accounting for Transfer and Servicing of
Financial Assets and Extinguishments of Liabilities," replacing a previous statement, SFAS No.
125, of the same title. SFAS No. 140 superseded SFAS No. 125 in two aspects: detailed
implementation guidance for transfer and servicing of financial assets between qualifying special-
purpose entities (SPEs) and additional disclosure of information about accounting policies, key
assumptions, and financial assets' sensitivity to changes in key assumptions. Underneath the
more detailed implementation guidance, however, the accounting for financial asset transfer is
carried over from SFAS No. 125 without revision. That is, under SFAS No. 140, the so-called
financial components approach will still be applied in accounting for transfer and servicing of
financial assets.
The financial components approach can be traced as far back as SFAS No. 65, "Accounting for
Certain Mortgage Banking Activities," which was issued in 1982. In simpler language, the
financial components approach is nothing more than the accounting treatment of a sale (or any
other ways of disposition) of a joint product. It is just that the subject happens to be financial
assets. The accounting question has two elements: how to identify different components of the
financial assets and how to value each component. SFAS No. 140, again following SFAS No.
125, employs fair value as the benchmark in determining gains or losses in financial asset
transfer transactions. This fair-value-based accounting for financial assets doesn't come as a
surprise; actually, it would be surprising if fair value were not employed. Recent statements of
accounting standards (SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities"; SFAS No. 122, "Accounting for Mortgage Servicing Rights"; SFAS No. 125, "Accoun
ting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities"; SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities"; and SFAS No. 138,
"Accounting for Certain Derivative Instruments and Certain Hedging Activities") generally
established fair value as the basis for accounting for financial assets and derivatives. Fair value
as the basis for financial assets is not entirely consistent with the historical-cost basis for
accounting for nonfinancial tangible assets. Yet, as the FASB put it in its concept statements and
several recent statements, while accounting information "must be both relevant and reliable to be
useful, trade-offs between these characteristics may be necessary or beneficial." For financial
assets, relevance, which is best represented by fair value, outweighs reliability, which most of the
time is represented by historical cost. For banks, the above statement is particularly true, since
their values are mostly reflected in their financial assets , and financial assets are riskier and
more sensitive to interest-rate risk and other market situations.
This emphasis on financial components and their fair values corresponds with evolving focus on
economic value. Conventional financial reporting, for banks and other industries, emphasizes
accounting income, where gain or loss on a transaction is calculated as net realized proceeds
minus the carrying value of assets relinquished. In the calculation, however, any economic value
added (such as expected future net cash inflow) is not relevant; only realized gains or losses are
reported.The financial components approach tries to recognize the economic value added
through a transaction. Economic values such as rights, …