: FASB's Statement 107 is Amended by　Statement 119 [Federal Reserve Bank of Cleveland]　By Jeffrey A. Lange, C.F.A., and Supervisory Examiner　　 　In December 1991, the Financial Accounting Standards Board ("FASB") issued Statement 107, entitled Disclosures about Fair Value of Financial Instruments, in an attempt to enhance the relevance of financial instruments reporting. In October 1994, Statement 107 was amended by Statement 119, entitled Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments. 　Statement 107 became applicable for financial statements issued for fiscal years ending after December 15, 1992, while Statement 119 became effective for financial statements issued for fiscal years ending after December 15, 1994. Both Statements temporarily exempted entities with less than $150 million in total assets. FASB allowed additional time, until fiscal years ending after December 15, 1995, to these institutions so that they could develop the systems necessary to comply with both Statements. The Requirements of Statement 107 　Statement 107 requires market value disclosures for all financial instruments, unless exempted, and includes those not reflected in the balance sheet. It defines financial instruments as cash, evidence of an ownership interest in an entity, or a contract that both: (1) imposes a contractual obligation on one entity to deliver cash or another financial instrument to a second entity and, (2) conveys to that second entity the right to receive cash or another financial instrument. 　Exceptions to Statement 107 disclosures include deferred compensation arrangements, such as pension and other post-retirement obligations, insurance and lease contracts, warranties, extinguished debt, unconditional purchase obligations, investments accounted for under the equity method, and minority investments in consolidated subsidiaries. Certain items are excluded from disclosure because they are addressed by other FASB Statements. 　Under Statement 107, entities are expected to use the most reliable market price quotes; in particular, those prices obtained from active markets. When quoted market prices are practically unavailable, a "best estimate" of the instrument's market price should be developed. Statement 119 further requires entities to discuss the methods and significant assumptions used to estimate the market value of financial instruments. For some instruments that are short-term in duration or that possess certain characteristics, such as frequent variable-rate adjustments, the carrying amount is likely to approximate current market value. 　Statement 107 requires that longer-term loan estimates be based on the market prices of similar loans or equivalent financial instruments consistent with such characteristics as credit ratings, coupon rates, and effective maturity. Where market value estimates of longer-term loans cannot be estimated in this manner, the present value of the realistic expected cash flows, discounted at the valuation date's market rates must be computed. The market rates used in the discounting process should be based on rates for instruments with equivalent credit risk characteristics and maturity as those of the loans being valued. 　For liabilities that do not have readily available market prices, discounted cash flow valuation is acceptable, with a discount rate based on the current incremental borrowing rate of the entity or the rate the entity could pay a third party to assume the obligation. With respect to core deposits, Statement 107 does not permit the inclusion of intangible value within the market values disclosed. 　Off-balance sheet instruments, such as interest rate swaps and other over-the-counter derivatives may require estimates of market value based on market quotes for similar type instruments with like characteristics, adjusted for any custom-tailored features intrinsic to the instrument. In addition, entities could confirm the reasonableness of market quotes with models, cash flow computations, or other means of independent valuation. Valuation of Financial Instruments 　Some Fourth District financial institutions may want to review how other banks have complied with market value reporting requirements. Exhibit A contains a listing of financial instruments and the predominant methods utilized to value each respective type of instrument. 　FASB's preferred method of valuation, quoted market prices, is generally used by financial institutions to derive values for their securities portfolios. When market prices are unavailable for specific securities, proxy quoted prices for comparable instruments are generally used to value the securities. 　The valuation of off-balance sheet instruments by Fourth District banks generally relies on a combination of methods, consistent with industry practices. Futures contracts trade on an exchange and quoted market prices determine the market value of existing contracts. Current settlement values, which incorporate changes in rates and indices, are used as indicated values for forward contracts. 　A combination of over-the-counter market quotes and pricing models and formulas are used to value over-the-counter off-balance sheet derivatives instruments such as interest rate swaps and options, or option-like instruments such as caps or floors. Finally, the disclosed values of more traditional off-balance sheet exposures, such as loan commitments and various forms of guarantees, are based upon the institution's current fees, adjusted for customer credit risk and remaining terms. 　Statement 119: To Trade or Not to Trade 　Statement 119 requires entities to present information concerning the amounts, nature, and terms of certain derivatives, differentiating between those instruments owned for trading purposes and those not used for trading purposes. All entities will need to distinguish between those instruments used for trading purposes and those used for purposes other than trading in the following ways: Trading Purposes: 　--Average fair value during the reporting period --End-of-period value 　--Whether value represents asset or liability 　--Net gains or losses by class of instrument, business activity, risk, or other meaningful distinction Purposes Other Than Trading: 　--Entity's objective for holding instruments, the underlying reason(s) for the objectives, and resulting strategies 　--How each class of instrument is reported in financial statements 　--Policies for recognizing or not recognizing gains or losses and for where those gains or losses are reported 　--Descriptions of hedges on anticipated transactions, the types of instruments used to hedge the anticipated transactions, the events that would lead to recognition of deferred losses or gains, and the amount of deferred gains or losses on these hedges Trading instruments include those measured at fair value with resulting gains and losses recognized in income. 　Statement 119 defines a derivative financial instrument as a futures, forward, swap, or option contract or other financial instrument with similar characteristics. Examples of other financial instruments with option-like characteristics include interest rate caps or floors and fixed-rate loan commitments. Examples of other financial instruments with forward-like characteristics include commitments to purchase stocks or bonds, forward rate agreements, and interest rate collars. FASB Statement 119 excludes from the definition instruments described as derivative securities, such as mortgage-backed securities, interest-only and principal-only securities, and indexed debt instruments. 　Amendments to Statement 119 also require these institutions to revisit Statement 105 which requires disaggregation of information about financial instruments with off-balance sheet risk of accounting loss by class, business activity, risk, or other category that is consistent with the entity's management of those instruments. 　Statement 119 requires that fair value (i.e., market value) information be presented without combining, aggregating, or netting the fair value of derivative financial instruments with the fair value of non-derivative financial instruments. This more detailed information must then be presented with the related carrying amounts in the body of the financial statements, in a footnote to the financial statements, or in a summary table, indicating whether the amounts represent assets or liabilities. 　Community bankers need to review the requirements of these three disclosure rules, Statements 105 and 107, as amended, and Statement 119 to comply with financial instrument disclosure rules for year-end 1995 financial statements. 　While Statement 119 does not require scenario forecasting of the effects of changes in key market interest rates, foreign currency, or other market variables on the entity's position, entities are "encouraged" to provide such disclosures. FASB suggests that hypothetical situations could quantify the effects upon future income, equity, and the possible durations or values of instruments with changes in key market rates or indices. 　With respect to amendments to Statement 107, FASB requires that entities not combine, net, or aggregate the fair value of derivative instruments with the fair values of non-derivative instruments, or net the fair values of different classes of derivative financial instruments, even if management believes the different classes of derivative instruments are somehow related. However, FASB does make an exception to this requirement in instances where FASB's Interpretation No. 39 applies. Interpretation 39, Offsetting of Amounts Related to Certain Contracts, allows the offsetting of carrying amounts in the balance sheet for those instruments operating under master netting contracts. 　Banks May Obtain Samples of Financial Instruments Disclosures From FASB 　FASB has recently published a special report, Illustrations of Financial Instrument Disclosures, which attempts to clarify disclosure requirements in Statement 119, and in the two prior standards that Statement 119 amended, Statement 105, and Statement 107. This report outlines four situations that may occur with respect to financial instrument disclosures: (1) an entity that uses derivatives sparingly and does not engage in trading of financial instruments; (2) a major corporation that uses derivatives for several purposes but does not engage in trading derivatives; (3) a domestic financial institution that engages in trading activities; and (4) an international institution that uses derivatives and other financial instruments for trading and end-user purposes. 　Copies of the special disclosure report may be obtained from the FASB Order Department, 401 Merritt 7, P.O. Box 5116, Norwalk, Connecticut 06856-5116. The telephone number is (203) 847-0700, extension 555, and the cost of the publication is $11 per copy. SAMPLE OF FOURTH DISTRICT LARGE BANKS' MARKET VALUE DISCLOSURE METHODS Predominant Financial Instrument Valuation Method 　Cash and due from banks Carrying amount 　Money market investments Carrying amount Bankers acceptances Carrying amount 　Money market and other savings accounts Carrying amount 　Resale agreements and repurchase agreements Carrying amount 　U.S. Treasury tax and loan demand notes Carrying amount Commercial paper Carrying amount 　Trading account securities Quoted market prices or dealer quotes(1) 　Securities available for sale Quoted market prices or dealer quotes(1) 　Investment securities Quoted market prices or dealer quotes(1) Performing variable rate loans 　that reprice frequently Carrying amount, adjusted for credit loss 　Performing fixed-rate loans Discounted cash flow analysis, using discount rates currently being offered for similar credit risk and maturity, adjusted for credit loss(2) 　Residential mortgage loans Discounted cash flow adjusted for prepayments and discounted using secondary market rates or rates currently being used to make similar loans 　Credit card loans Estimated cash flows and maturities based on historical experience discounted with contractual or current market rates Demand deposits, savings deposits, 　and some money market deposits Carrying amounts, without any associated deposit premium intangibles 　Fixed-maturity deposits Discounted cash flow analysis using rates currently being offered for similar deposits Federal funds purchased and other short-term borrowings Carrying amount 　Long-term debt Discounted cash flow analysis using entity's incremental borrowing rate or market yields for same or similar debt instruments Loan commitments, guarantees, and 　standby letters of credit Discounted cash flow analysis of remaining contractual fees over the residual contract term using rate currently charged for similar credit risk and term 　Off-balance sheet instruments used for trading 　and interest rate risk management purposes Primarily on market dealer quotes(3) 　Nonperforming commercial real estate loans Estimate based on "as-is" appraised value of underlying real estate 　Other nonperforming loans Carrying value less credit risk loss adjustment 　(1) If a quoted market price is not available, market values are generally estimated by applying quoted market prices of securities with similar credit, maturity, and interest rate characteristics. 　(2) In some cases, fixed-rate short-term loans with little remaining maturity, such as less than 90 days, were stated at carrying value after adjusting for credit loss. 　(3) Off-balance sheet and over-the-counter instruments can be secondarily determined by a combination of cash flow analysis, formulae, and models to validate dealer quotes. EXHIBIT B* 　SELECTED SAMPLE OF FOURTH DISTRICT LARGE BANKS' 　STATEMENTS CONCERNING MARKET VALUE DISCLOSURES Methodology 　Fair values are based on estimates using present values and other valuation techniques in instances where quoted market prices are not available. These techniques are significantly affected by the assumptions used, including discount rates and estimates of future cash flows. As such, the derived value estimates cannot be substantiated by comparison to independent markets and, further, may not be realizable in an immediate settlement of the instruments. 　Fair value estimates are made at a point in time...[Statement 107] specifies that fair values should be calculated based on the value of one trading unit without regard to any premium or discount that may result from concentrations of ownership of a financial instrument, possible tax ramifications, estimated transaction costs that may result from bulk sales or the relationship between various financial instruments...Because no readily available market exists for a significant portion of the Corporation's financial instruments, fair value estimates are based...judgments regarding current economic conditions, currency and interest rates characteristics, loss experience...estimates involve uncertainties and matters of significant judgment and cannot be determined with precision...Changes in assumptions significantly affect the estimates. 　For financial instruments with a remaining average life to maturity of less than six months, carrying amounts were used as an approximation of fair values. 　Because of the wide range of valuation techniques and the numerous estimates which must be made, it may be difficult to make reasonable comparisons of the Corporation's fair value information to that of other financial institutions. It is important that the many uncertainties discussed above be considered when using the estimated fair value disclosures and to realize that because of these uncertainties, the aggregate fair value amount should in no way be construed as representative of the underlying value of the Corporation. Exceptions to Market Value Disclosure 　[Statement 107] excludes certain items from its disclosure requirements. These items include non-financial assets, intangibles and future business growth, as well as certain liabilities such as pension and other post-retirement benefits, deferred compensation arrangements and leases. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Corporation. 　Fair value estimates do not include anticipated future business or the value of assets, liabilities and customer relationships that are not considered financial instruments. For example, the Corporation's fee-generating businesses...are not incorporated into the fair value estimates. Accordingly, the estimated fair value amounts of financial instruments do not represent the entire value of the Corporation. 　[Statement 107 estimates] do not take account of the fair values of long-term relationships, which are integral parts of the related financial instruments. The disclosed estimated fair values of such instruments would increase significantly if the fair values of the long-term relationships were considered. 　Certain assets are excluded from the table including real and personal property, leases, loan customer relationships, deposit customer intangibles, retail branch networks, fee-based businesses, such as mortgage banking and asset management, trademarks, and brand names. Interpretations and Analysis by Users 　It is not management's intention to immediately dispose of a significant portion of its financial instruments and, thus, the unrealized gains or losses should not be interpreted as a forecast of future earnings and cash flows. 　Fair values for financial instruments were based on various assumptions and estimates as of a specific point in time, represent liquidation values and may vary significantly from amounts that will be realized in actual transactions. 　*Samples represented in this exhibit were taken from footnote statements of the following Fourth District companies: Banc One Corporation, Mellon Bank, PNC Bank, Integra Financial, National City Corporation, Keycorp, and Fifth Third Bancorp.