The many faces of financial instruments.

• Author: Blanchet, Jeannot
• Position: Includes related article - Corporate Reporting

Wondering where the FASB's financial instruments project stands? Here's an update from an insider.

The Financial Accounting Standards Board (FASB) has been working on its financial instruments project for more than five years now. The Board recently issued a number of important documents in connection with the project and is undertaking several new phases or subprojects this year. So what milestones has the Board met thus far, and what are the next steps?

The FASB's primary objective for the project is to develop broad standards for resolving the accounting issues raised by financial instruments, financial transactions, and the inconsistent accounting guidance and practice developed for financial instruments over the years. This objective has two parts: first, to create comprehensive guidance and, second, to eliminate existing inconsistent accounting guidance and practice. To be a success, the project must achieve both, and that demands considerable time and effort.

With that in mind, the Board initially divided the project into three parts: disclosures, liabilities and equity, and recognition and measurement. But, given the wide variety of existing financial instruments and the growth of new instruments, the Board needs more than simply a good articulation of the issues to accomplish its task. It needs a tool to help understand the economics of financial instruments and transactions and the potential accounting consequences of different economic characteristics. That tool is the fundamental financial instruments (FFI), or the "building-block," approach.

THE FUNDAMENTALS

First and foremost, the FFI approach is an analytical tool. Like the analytical methods of "financial engineering," widely accepted in the investment community today, it's built on the assumption that all financial instruments are made from a set of only a few different building blocks. Therefore, all financial instruments could be reduced to their simplest expression, and that breakdown may help establish proper accounting guidance for all instruments.

With the FFI approach, you can group recognition and measurement issues under three headings: those related to fundamental instruments (the building blocks); those related to compound instruments (instruments that are made up of more than one fundamental instrument); and relationships between fundamental instruments, compound instruments, or fundamental and compound instruments.

The Board has tentatively identified six fundamental financial instruments, each characterized by the obligations and the rights it entails:

* An uncondiitonal receivable and payable--an unqualified right or obligation to receive or deliver cash or a financial instrument (for example, a zero-coupon bond);

* A conditional receivable and payable--a qualified right or obligation to receive or deliver cash or a financial instrument depending on whether an uncertain event occurs (for example, a potential obligation under a casualty insurance contract);

* A financial forward contract--an unconditional right or obligation to exchange financial instruments (for example, a foreign exchange contract);

* A financial option contract--a right or obligation to exchange financial instruments if an event within the control of the holder occurs (for example, a put option to sell stocks);

* A financial guarantee or other conditional exchange contract--a right or obligation to exchange financial instruments if an event outside the control of either party occurs (for example, an obligation under a loan guarantee); and

* An equity instrument--a contract that provides an ownership interest in an entity.

One example of using the FFI approach as an analytical tool for compound instruments is in the case of bonds that contain a call provision allowing the issuer to buy back the bonds at a specified early date. From the issuer's perspective, those bonds can be analyzed as a series of unconditional payables (for the principal and interest amounts, assuming fixed-rate bonds) and a financial option (a call option held to repurchase the bonds). Another example is a traditional home mortgate loan analyzed from the borrower's perspective as a compound instrument...