Other Liabilities measurement issues During the past several years, some additional measurement issues relating to liabilities

have arisen. Among the most important of these are the disclosure of offbalance sheet financing arrangements and derivatives. The proportion of debt in a firms capital structure is perceived as an indicator of the level of risk associated with investing in that company. Some companies have utilized innovative financing arrangements that are structured in such a manner that they do not satisfy liability recognition criteria. These arrangements are termed offbalance sheet financing. Their principal goal is to keep debt off the balance sheet. For example, several oil companies may form a joint venture to drill for offshore oil and may agree to make payments to support the venture over time, or a company may engage in a lease agreement that does not require it to capitalize the cost of acquiring a productive asset. In such cases, neither their share of the assets nor their obligation to expend future resources will appear on the balance sheet. In essence, the companies have acquired the use of economic resources (assets) without recording the corresponding economic obligation (liabilities). The FASB has an offbalance sheet financing project on its agenda. The objective of this project is to develop broad standards of financial accounting and reporting about financial instruments and related transactions. Due to the complexity of these issues, the FASB has decided to give the widest possible exposure to proposed statements prior to their release. As an interim step, the Board determined that improved disclosure of certain information is necessary. Subsequently, the FASB completed two disclosure phases, which resulted in the issuance of SFAS No. 105, Disclosure of Information about Financial Instruments with OffBalance Sheet Risk and Financial Instruments with Concentrations of Credit Risk, in 1990, and the issuance of SFAS No. 107, Disclosures about Fair Value of Financial Instruments, in 1991. SFAS No. 105 was later superseded by SFAS No. 133 (discussed in the next section). SFAS No. 107 requires the disclosure of fair value of financial instruments for which an estimate of fair value is practicable. The methods and assumptions used to estimate fair value also must be disclosed. The fair value of a financial instrument is defined as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. A quoted market price is cited as the best evidence of fair value. These disclosure requirements apply to financial instruments regardless of whether they are assets or liabilities or whether or not they are reported in the balance sheet. The following are exempt from the SPAS No. 107 requirements. Many of them already have extensive disclosure requirements. 1. Deferred compensation arrangements such as pensions, postretirement benefits, and employee stock option and purchase plans 2. Debt extinguished and the related assets removed from the balance sheet in cases of insubstance defeasance (no longer applicable)

3. Insurance contracts, other than financial guarantees and investment contracts 4. Lease 5. Warranty obligations and rights 6. Unconditional purchase obligations 7. Investments accounted for under the equity method 8. Minority interest 9. Equity investments in consolidated subsidiaries 10. Equity instruments classified in stockholders equity In addition, fair value disclosure is not required for trade receivables whose carrying amount approximates fair value. SPAS No. 133 (discussed in the next section) amends SPAS No. 107 to include the footnote disclosure provisions relating to credit risk contained in SPAS No. 105. The issuance of SPAS No. 159 may be viewed as a first step toward requiring fair value accounting for financial instruments. Although it does not require fairness, it does allow companies the option to do so for financial assets and liabilities within its scope. Its requirements and financial effects are described in Chapter 10. Derivatives A derivative is a transaction, or contract, whose value depends on the value of an underlying asset or index. (That is, its value is derived from an underlying asset or index.) In such a transaction, a party with exposure to unwanted risk can pass some or all of that risk onto a second party. When derivatives are employed, the first party can (1) assume a different risk from the second party, (2) pay the second party to assume the risk, or (3) use some combination of 1 and 2. The rise in the use of derivatives can be traced to the abandonment of currencies fixed against the value of gold, whereby most currencies have been allowed to float to exchange levels determined by market forces. In addition, most governments now allow interest rates to fluctuate more freely than they did in the past, and exposure to exchange risk has increased due to the growth of international commerce. All derivative transactions stem from two types of transactionsforwards and options. A forward transaction obligates one party to buy and another to sell a specified item, such as 10,000 Euros, at a specified price on a specified future date. On the other hand, an option gives its holder the right, but not the obligation, to buy or sell the specific item, such as the 10,000 Euros, at a specified price on a specified date in the future. The major difference between the two types of transactions is that a forward requires performance, whereas an option will be exercised only if it is financially advantageous to do so. But in either case the future price is locked in advance. The participants in derivative transactions can be categorized as dealers and end-users. There are only a small number of dealers (less than 200) worldwide. Dealers are generally banks, although some are independent brokers. The number of end-users is

constantly increasing as business and government organizations become involved in international financial transactions. End-users include businesses, banks, securities firms, mutual and pension funds, governmental units, and even the World Bank. The goals of end-users vary. Some use derivatives so that the risk of financial operations can be controlled, whereas others attempt to manage foreign exchange rate fluctuation exposure. Speculators may seek profits from simultaneous price differentials in different foreign markets. Or others may attempt to hedge exposure to currency rate changes. Five types of derivatives that transfer elements of risk can be identified: forward contracts, futures, options, asset swaps, and hybrids. Each carries an associated risk; however, although the associated risk is not unique to derivatives, they are difficult to manage because derivative products are complex. Moreover, there is difficulty in measuring the actual risk associated with the various types of derivatives. These five types of derivatives are summarized in Table 11.1 on page 388.

Each of these derivatives carries risk that can be identified as market, credit, operational, legal, and systems. Market risk is the exposure to the possibility of financial loss resulting from an unfavorable movement in interest rates, exchange rates, stock prices, or commodity prices. Estimating the market value of a derivative at any point is difficult because it is influenced by a variety of factors such as exchange rates, interest rates, and

time until settlement. Credit risk is the exposure to the possibility of financial loss resulting from the other partys failure to meet its financial obligations. Operational risk is the exposure to the possibility of financial loss resulting from inadequate internal controls, fraud, or human error. Legal risk is the exposure to the possibility of financial losses resulting from an action by a court, regulatory agency, or legislative body that invalidates all or part of an existing derivative contract. Systems risk is the exposure to the possibility of financial losses resulting from the disruption at a firm, in a market segment. or to a settlement system, that in turn could cause difficulties at other firms, in other market systems, or in the financial system as a whole. The FASB first addressed the question of derivatives in SFAS No. 105 and defined these securities under the broad category of financial instruments. This category includes not only traditional assets and liabilities such as notes receivable and bonds payable, but also innovative financial instruments such as forward contracts, futures, options, and asset swaps discussed above. Disclosure of the fair value of these financial instruments (whether or not recognized) was subsequently required by SFAS No. 107 when it was practicable to estimate fair value. Finally, in SFAS No. 119, Disclosure about Derivative Financial Instruments and Fair Values of Financial Instruments, companies were required to disclose information about derivative financial instruments and change the methods of disclosure of such information. In 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities.39 This statement establishes accounting and reporting standards for derivative financial instruments and similar financial instruments. it requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position, measured at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or a firm commitment, (b) a hedge of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation. The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation. 1. For a derivative designated as a hedge of the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item. The effect of this accounting treatment is to adjust the basis of the hedged item by the amount of the gain or loss on the hedging derivative to the extent that the gain or loss offsets the loss or gain experienced on the hedged item. 2. For a derivative designated as a hedge of the exposure to variable cash flows of a forecasted transaction (referred to as a cash flow hedge), the gain or loss is reported as a component of other comprehensive income (outside of earnings) and recognized in earnings on the projected date of the forecasted transaction. 3. For a derivative designated as a hedge of the foreign currency exposure of a net investment in a foreign operation, the portion of the change in fair value equivalent to a foreign currency transaction gain or loss is reported in other comprehensive income

(outside of earnings) as part of the cumulative translation adjustment; any remaining change in fair value is recognized in earnings. 4. For a derivative not designated as a hedge, the gain or loss is recognized in earnings in the period of change. At the date of initial application of SFAS No. 133, companies were required to measure all derivatives at fair value and recognize them in the statement of financial position as either assets or liabilities. They also recognized offsetting gains and losses on hedged assets, liabilities, and firm commitments by adjusting their carrying amounts at that date. The transition adjustments that resulted from adopting this statement were reported in net income or other comprehensive income, as appropriate, as the effect of a change in accounting principle and were presented in a manner similar to the cumulative effect of a change in accounting principle. Whether the transition adjustments were reported in net income or other comprehensive income was based on the hedging relationships, if any, that existed for the related derivatives and was the basis for accounting under GAAP prior to the date of initial application. Transition adjustments reported as a cumulative-effect-type adjustment of other comprehensive income are subsequently recognized in earnings on the date on which the forecasted transaction had been projected to occur. The FASB thus recognized the emergence of derivative securities and their complexity, and it responded with pronouncements designed to require published financial statements to present a more accurate disclosure of the risks borne by firms using derivative financial instruments. The provisions of SFAS No. 133 are examined in more detail in an article by Blankley and Schroeder, contained on the Web page for Chapter 11. In addition to the FASB, the SEC also addressed the issue of accounting for derivatives in new required disclosure rules in an amendment to Regulation S-X. This release requires the disclosure of qualitative and quantitative information about market risk by all companies registered with the SEC for annual periods ending after June 15, 1998, and is discussed in more depth in Chapter 17 under the topic Management Discussion and Analysis. Market risk is defined as the risk of loss arising from adverse changes in market rates and prices from such items as interest rates, currency exchange rates, commodity prices, and equity prices. The required disclosures are designed to provide investors with forward-looking information about a companys exposures to market risk, such as the risks associated with changes in interest rates, foreign currency exchange rates, commodity prices, and stock prices. It is anticipated that the information provided will indicate the market risk a company faces and how the companys management views and manages its market risk. Troubled Debt Restructurings Corporations occasionally experience difficulty repaying their long-term debt obligations. These difficulties frequently result in arrangements between debtor and creditor that allow the debtor to avoid bankruptcy. For example, in 1976, Continental Investment

Corporation satisfied $34 million of the $61 million debt owed to the First National Bank of Boston by transferring all its stock in Investors Mortgage Group, Inc. (a subsidiary) to the bank. Accountants and financial statement users became concerned over the lack of GAAP by which to account for these agreements. Consequently, the FASB began a study of agreements of this type, termed troubled debt restructurings. This study focused on three questions: (1) Do certain kinds of troubled debt restructurings require reductions in the carrying amounts of debt? (2) If they do, should the effect of the reduction be reported as current income, deferred to a future period, or reported as contributed capital? (3) Should contingently payable interest on the restructured debt be recognized before it becomes payable? The issues underlying each of these questions relate to the recognition of liabilities and holding gains. A liability should be recorded at the amount of the probable future sacrifice of economic benefits arising from present obligations, A holding gain occurs when the value of the liability decreases. The result of the review of these questions was the release of SFAS No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings According to SFAS No. 15, a troubled debt restructuring occurs when the creditor for economic or legal reasons related to the debtors financial difficulties grants a concession to the debtor that it would not otherwise consider.4 A troubled debt restructuring may include, but is not limited to, one or any combination of the following: 1. Modification of terms of a debt such as one or a combination of: a. Reduction of the stated interest rate for the remaining original life of the debt. b. Extension of the maturity date or dates at a stated interest rate lower than the current market rate for new debt with similar risk. c. Reduction of the face amount or maturity amount of the debt as stated in the instrument or other agreement. d. Reduction of accrued interest. 2. Issuance or other granting of an equity interest to the creditor by the debtor to satisfy fully or partially a debt unless the equity interest is granted pursuant to existing terms for converting the debt into an equity interest. 3. A transfer from the debtor to the creditor of receivables from third parties, real estate, or other assets to satisfy fully or partially a debt.