Any individual or organization may send written comments to the attention of the director of research and technical activities at the address listed below. To be timely, comments should be postmarked by May 31, 2000. Comments also can be submitted by electronic mail to director@fasb.org. Respondents submitting comments by electronic mail should clearly identify themselves and the organization they represent.

Copies of all written submissions on the project will be available for inspection in the FASB’s Public Reference Room. Copies are available for a duplication fee.

The Financial Accounting Standards Board has not decided whether to hold a public hearing to discuss the issues addressed in this Preliminary Views.

The Board encourages individuals and organizations to comment on the need for and timing of a public hearing and on what they would recommend as the next step in this project.

Any individual or organization may obtain one copy of this Preliminary Views without charge until May 31, 2000 on written request only. Please ask for our Product Code No. ITC17. For information on applicable prices for additional copies and copies requested after May 31, 2000 contact:

Order Department

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401 Merritt 7

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This Preliminary Views also is available on the FASB web site at www.fasb.org until May 31, 2000.

Copyright © 1999 by Financial Accounting Standards Board. All rights reserved. Permission is granted to make copies of this work provided that such copies are for personal or intraorganizational use only and are not sold or disseminated and provided further that each copy bears the following credit line: "Copyright © 1999 by Financial Accounting Standards Board. All rights reserved. Used by permission."

The primary purpose of this Preliminary Views is to solicit comments on the Board’s views about issues involved in reporting financial instruments at fair value. The Board has reached preliminary decisions about the definition of a financial instrument, the definition of fair value, and general guidance for determining fair value, but it has not yet decided when, if ever, it will be feasible to report fair values of all financial instruments in the basic financial statements. Before making that decision, the Board needs more information about potential problems and solutions. The Board invites comments on all matters addressed in this Preliminary Views; however, respondents need not comment on all issues and are encouraged to comment on additional issues they believe the Board should consider.

The Board is especially interested in comments on the ultimate goal expressed in this Preliminary Views—to measure financial instruments and related assets and liabilities at fair value—and on the following specific issues. Those comments will help the Board in deciding how to proceed with its project on reporting fair values of financial instruments. To the extent that respondents choose to comment on the issues, it would be helpful if their comments responded to the issues as stated and include the reasons for the position taken.

Definition of a financial instrument. The definition of a financial instrument appears in paragraph 14, and paragraphs 15–36 describe how that definition applies to various contracts and other assets and liabilities. Is the definition clear and operational? Is the analysis of what constitutes a financial instrument reasonable? Should the scope of this Preliminary Views be based on something other than the definition of a financial instrument (for example, all contractual rights and obligations)? If so, please explain what the scope should be and why.

Financial instruments excluded from the scope. The scope of this Preliminary Views is based on the definition of a financial instrument with certain exceptions listed in paragraphs 37–42. Should some of the excluded financial instruments be included? Are there other financial instruments that should be excluded? If so, why?

Related assets and liabilities included in the scope. Paragraphs 43–46 list assets and liabilities other than financial instruments that are included in the scope of this Preliminary Views. Is it appropriate to include those items? Are there other related assets and liabilities that should be included? If so, why?

Definition of fair value. Paragraph 47 describes fair value as "an estimate of the price an entity would have realized if it had sold an asset or paid if it had been relieved of a liability on the reporting date in an arm’s-length exchange motivated by normal business considerations." Is the use of an exit price appropriate? If not, what should fair value be based on and why? Is the discussion following the definition clear and operational? If not, what additional explanations or details should be provided?

Measuring items not actively traded. Paragraphs 60–82 discuss the appropriate sources of information for estimating an exit price for items not actively traded on exchanges or in dealer markets. Is the guidance appropriate and is the discussion clear and operational? Are there circumstances not discussed in this Preliminary Views in which a choice must be made among alternative sources of price information? If so, what guidance should be provided?

Recognition of gains and losses immediately in earnings. Paragraph 85 states that if items within the scope of this Preliminary Views are reported at fair value in financial statements, the changes would be reported in earnings when they occur. Is that treatment appropriate? What additional issues would this requirement raise?

Income statement presentation. Although the Board has not yet discussed the appearance of the income statement, the traditional line items are likely to change significantly if changes in fair values of financial instruments are reported immediately in earnings. The Board would be interested in suggestions about how to disaggregate the gains and losses. For example, how should interest income and expense be computed and presented? How should gains and losses due to changes in creditworthiness be computed and presented, especially gains and losses on liabilities due to changes in an entity’s own creditworthiness?

Complexity, subjectivity, and auditability. Some previous comments about measuring financial assets and liabilities at fair value are that valuation models can be complex, the assumptions necessary to apply the models often are subjective, and thus auditors may have difficulty attesting to the reported information. Those issues are not unique to fair value measurement. Existing accounting standards require complex computations and subjective judgments, and the results may be difficult to audit. For example, allowances for uncollectible receivables often are complex, subjective, and difficult to audit. However, experience with the existing complexity, subjectivity, and auditability has permitted financial statement issuers and their auditors to develop ways to deal with them. In contrast, the potential issues involved with comprehensive fair value information may not be as well known and understood, and many entities and their auditors have little experience in dealing with them. Thus, the Board is interested in detailed comments about implementation issues that have not yet been addressed and possible solutions.

Measurement of specific instruments. Which specific types of instruments are likely to be difficult to measure and why? What could be done to facilitate measurement of those difficult instruments?

Credit card and demand deposit relationships. The Board has not reached a tentative decision about how to report certain financial instruments that are traded only as a part of an entire customer relationship. Paragraphs 96–132 explain the issue and describe two types of instruments that raise the issue. Is the description of the rights granted and obligations imposed by credit card and demand deposit agreements accurate and complete? Is a demand deposit agreement an implied contract? How should the conflict of objectives summarized in paragraph 132 be resolved?

Transactions involving credit card and demand deposit relationships. The conflict summarized in paragraph 132 is based on the assumption that prices of credit card and demand deposit portfolios are available. Is that assumption accurate? That is, how frequently do transactions occur, and can prices be determined by entities that did not participate in any transactions during a given reporting period? How are the transactions priced?

Valuation techniques. Is the concern (expressed in paragraphs 103 and 122) about estimating an exit price for the financial instruments valid? That is, are there valuation techniques that can be demonstrated to approximate a market price for only the financial instrument portions of the relationships?

Certain credit cards, insurance policies, and warranties. Paragraphs 133–144 describe an unresolved issue related to certain credit cards, insurance policies, and warranties that do not meet the definition of financial instruments. Should they be reported at fair value? If so, should other similar items (for example, service contracts and forward contracts and options to buy and sell nonfinancial items) be reported at fair value? If not, how could a requirement be constructed to include all credit cards, insurance policies, and warranties without including those similar items?

Appendix C lists issues that the Board has not yet discussed. Are there other issues that are not listed? What sources of information about those issues are available?

Paragraph

Numbers

Introduction 1–11

Overview of the Preliminary Views 12

Preliminary Views 13–94

Scope 13

What Would Be Reported at Fair Value? 14–46

Definition of a Financial Instrument 14

Cash and Ownership Interests in Entities 15–17

Contractual Obligations to Exchange Financial Instruments and

Rights to Require Exchange of Financial Instruments 24–28

Similar Contractual Rights and Obligations That Are Not

Financial Instruments 29–33

Other Similar Assets and Liabilities That Are Not Financial

Instruments 34–36

Financial Instruments Excluded from the Scope of This Preliminary

Views 37–42

Related Assets and Liabilities Included in the Scope of

This Preliminary Views 43–46

What Does Fair Value Mean? 47–83

Definition of Fair Value 47–59

Estimating Exit Prices When Price Information Other Than Quotes from

Active Markets Is Available 60–72

Prices of Identical and Similar Items 61–62

More Than One Market 63–66

Adjustments to Market Prices 67

Blockage Factors and Control Premiums 68–70

Exercise Prices of Options 71–72

Estimating Prices When Little or No Market Price Information

Is Available 73–82

Liabilities and Credit Risk 83

How Should Changes in Fair Value Be Reported? 84–94

Issues Considered but Not Resolved 95–145

Estimating Exit Prices for Financial Instruments That Are Traded

Only as a Part of a Customer Relationship 96–100

Credit Card Relationships 101–121

The Cardholder’s Option to Borrow 104–110

The Cardholder’s Obligation to Pay the Card Issuer 111–113

The Noncontractual Benefits of the Credit Card Relationship 114–120

Demand Deposit Relationships 121–132

The Demand Deposit Agreement 123–128

The Depository Institution’s Obligation to Pay the Depositor 129–130

Other Benefits of the Demand Deposit Relationship 131

Summary of the Issue 132

Certain Credit Cards, Insurance Policies, and Warranties 133–144

Single-Entity Credit Cards 134–137

Certain Insurance Policies and Warranties 138–140

Why Is This Issue Unresolved? 141–143

Summary of the Issue 144

Alternative View 145–149

Appendix A: Relevance of Fair Value Information for Financial Instruments 150

Appendix B: The Effect of This Preliminary Views on FASB Statements No. 5,

Accounting for Contingencies, and No. 60, Accounting and Reporting

by Insurance Enterprises 151–192

Appendix C: Decisions in the Next Phase of the Project 193–202

1. The Board added a broad project on financial instruments to its agenda in 1986. The project initially focused on disclosures and resulted in the issuance of FASB Statements No. 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, in March 1990, and No. 107, Disclosures about Fair Value of Financial Instruments, in December 1991.

2. An FASB Discussion Memorandum, Recognition and Measurement of Financial Instruments, was issued in November 1991 as a basis for considering the financial accounting and reporting issues of recognition and measurement raised by financial instruments. The recognition and measurement phase of the financial instruments project, which began with the issuance of that Discussion Memorandum, resulted in the issuance of FASB Statements No. 114, Accounting by Creditors for Impairment of a Loan, and No. 115, Accounting for Certain Investments in Debt and Equity Securities, in May 1993; FASB Statement No. 118, Accounting by Creditors for Impairment of a Loan—Income Recognition and Disclosures, in October 1994; FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, in June 1996; and FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, in June 1998.

3. The basis for conclusions of Statement 133 stated:

The major conceptual advantage of fair value as a measurement attribute is that because it is a market-based notion, it is unaffected by:

Thus, fair value represents an unbiased measure that is consistent from year to year within an entity and between entities with the same access to markets and the same credit standing. Appendix A discusses the reasons why fair value provides useful information about financial instruments and illustrates some of the major points.

4. Although measurement at fair value has conceptual advantages, not all issues have been resolved, and the Board has not yet decided when, if ever, it will be feasible to require essentially all financial instruments to be reported at fair value in the basic financial statements. The practical issue most frequently cited by constituents is that market prices are not readily available for all financial instruments. Thus, it often will be necessary to use valuation models, some of which will have to be developed internally. The application of some of those models is likely to be complex and will require internally developed information and assumptions, which are, by their nature, subjective.

5. Those issues are neither new nor unique to fair value information. It is not certain that, on balance, fair value information would be more complex and subjective and more difficult to audit than some of the information reported today (for example, warranty liabilities and valuation allowances for inventory obsolescence and sales returns). Reporting financial instruments at fair value can accomplish with less complexity much of what special accounting for fair value hedges accomplishes. In addition, some of today’s complex and subjective requirements would be eliminated. A few examples are determining allowances for loan losses, deferring and amortizing loan fees and costs, and recognizing certain contingent losses.

6. Constituents have suggested several means of providing information about fair values of financial instruments other than recognition and measurement in the basic financial statements. One alternative is to require presentation of a separate set of fair value financial statements. Another possibility is enhancement of the disclosures currently required in notes to the financial statements. If the Board decides to increase the number of financial instruments reported at fair value in the basic financial statements, an extended transition period may be necessary, perhaps involving enhanced disclosures or separate financial statements for a period of time before full implementation. However, the Board has not yet considered possible transition provisions in detail.

7. This Preliminary Views is the next step in resolving the issues mentioned above and other issues involved in fair value measurement. The Board has issued this Preliminary Views to (a) gain more information about the conceptual and practical issues involved in determining fair value and (b) provide an early opportunity for constituents to express their opinions and convey their concerns. The Board is especially interested in comments about the issues that were considered but not resolved in this phase of the project. (Refer to paragraphs 95–144.) Responses will be most useful if they include the underlying reasons and the supporting evidence for the views expressed. The deadline for comments is May 31, 2000.

8. This Preliminary Views includes the Board’s views on three core issues:

The issue of how to report changes in fair value may not arise if the Board decides that enhanced disclosure alone is sufficient. However, if the Board decides to require that fair values of all financial instruments be reported in financial statements, the way changes are reported will be important. Because the Board has not yet decided which form of reporting will be required, it might be premature to consider how gains and losses would be reported. However, a number of constituents advised the Board to include a tentative answer to that question in this Preliminary Views because they believe that respondents would have difficulty forming an opinion about measurement and scope issues without knowing how changes in fair value would be reported.

9. The Board has not resolved two issues that were considered prior to issuing this Preliminary Views. The first issue involves financial instruments that normally are traded only in combination with noncontractual benefits of the relationship created by the financial instruments. Two examples are credit card contracts and demand deposits. Those instruments create a conflict between the primary objectives of the project—(a) to measure financial instruments at fair value and (b) to base fair value on observed market prices whenever they are available. Focusing on the definition of a financial instrument would lead to recognizing only the financial instrument portion of the relationship, which would require fair value to be based on an internally developed valuation technique. Focusing on available market prices would lead to recognizing the entire customer relationship and basing fair value on the observed prices. That issue and the factors that the Board has considered are discussed in paragraphs 95–132.

10. The second unresolved issue is whether to include in the scope of the project certain credit card contracts, insurance policies, and warranties that do not meet the definition of financial instruments. That issue and the factors that the Board has considered are discussed in paragraphs 133–144.

11. This Preliminary Views does not include preliminary views on a number of other issues because the Board has not yet considered them in detail. Additional issues that the Board expects to consider before issuing an Exposure Draft if it decides to require a form of reporting other than enhanced disclosure are discussed in Appendix C. Most of those issues will not need to be considered if the Board decides to require only enhanced disclosure.

12. The following is a highly summarized version of the Board’s preliminary views. It provides an overview only and should be read in conjunction with the remainder of the document. The key decisions in the project are:

13. The proposed requirements would apply to all business enterprises and not-for-profit organizations that hold financial instruments or certain other assets or liabilities as described in paragraphs 43–46.

14. The scope of this Preliminary Views is based on the definition of a financial instrument, with certain exceptions. A financial instrument is one of the following:

The obligations and rights described in (c) and (d) above are those imposed and granted by commercial contracts. They often are unconditional, but obligations imposed and rights granted by some financial instruments are conditional. The use of the term financial instrument in (c) and (d) is recursive (because the term financial instrument is included in defining a financial instrument), but it is not circular. Identifying a financial instrument may require analyzing a chain of contractual obligations to determine whether it ends with the delivery of cash or an ownership interest in an entity. Any number of obligations to deliver financial instruments can be links in a chain that qualifies a particular contract as a financial instrument.

15. Cash, or currency, is the most basic financial instrument.

16. Common stock is one financial instrument is evidence of an ownership interest in an entity. Other evidences of ownership interests include preferred stock, partnership interests, certificates of interest or participation, and warrants or options to subscribe to or purchase stock. From the holder’s perspective, those items are assets and are within the scope of this Preliminary Views. However, from the issuer’s perspective, an ownership interest is equity rather than a liability and is not within the scope of this project. The rights and obligations that make up the types of financial instruments described in paragraphs 14(c) and 14(d) are created by contracts, whether oral, written, or implied.

17. Table 1 provides examples of the types of financial instruments described in paragraphs 14(c) and 14(d). It also illustrates some similar contractual rights and obligations and other similar assets and liabilities that are not financial instruments.

18. Paragraph 14(c) describes obligations to deliver financial instruments, which may be conditional or unconditional. Many of the most common financial instruments are unconditional promises to deliver cash (promises to pay), that is, a contractual IOU. An ordinary trade account payable is a promise (contractual obligation) to pay in return for no consideration other than release from the obligation. The corresponding account receivable represents the creditor’s contractual right to require payment. The description in paragraph 14(c) is intended to apply to trade accounts payable and receivable.

19. A trade account may result from a written promise to pay, but the promise may be oral and informal. If the transaction is between two parties with a history of previous transactions, payment might not even have been discussed, but a promise probably was implied because both parties could be assumed to agree to the same payment terms used in previous transactions. Whether written, oral, or implied, the promise to pay is a contractual obligation. Thus, this Preliminary Views applies equally to all contractual obligations, whether they arise from written, oral, or implied contracts.

20. Some other unconditional promises to pay and corresponding unconditional rights to require payment include:

21. An obligation to pay and corresponding right to require payment need not be unconditional to be a financial instrument. A number of financial instruments involve conditional obligations to pay and conditional rights to require payment. For example, insurance policies, reinsurance contracts, and warranties that require cash payments are financial instruments even though the payments are due only if specified events occur. If a specified event occurs, an unconditional obligation arises. (The conditional and unconditional obligations are discussed as separate instruments because the conditional obligation continues to exist as long as the contract creating the obligation remains in effect.)

22. Some other examples of conditional delivery obligations and rights that are financial instruments are:

23. Obligations to deliver and corresponding rights to require delivery of financial instruments other than cash also are financial instruments. For example, obligations to return borrowed securities and the rights to require their return are financial instruments. Obligations to deliver securities for which payment has been received and rights to require that delivery also are financial instruments. In addition, if two parties agree to settle debt by delivery of financial instruments other than cash, the obligations and rights are financial instruments.

24. Obligations to exchange financial instruments and the related rights (paragraph 14(d)) are financial instruments whether they are conditional or unconditional. Some examples are forward contracts to purchase and sell financial instruments, options to purchase or sell financial instruments, and similar contracts. That category includes derivatives that require exchanges of financial instruments. It also includes similar contractual rights and obligations that are not derivative instruments, as defined in Statement 133, because one or both of the financial instruments to be exchanged are not readily convertible to cash. (Refer to paragraph 9 of Statement 133.)

25. Some examples of financial instruments that are promises to exchange financial instruments include:

26. All the examples in paragraph 25 are financial instruments separate from any outstanding accounts or notes receivable and payable. For example, the option in a credit card contract is a financial instrument because during the contract period, the cardholder has the right to demand a draft on the card issuer in exchange for a promise to repay the card issuer. The cardholder signs a receipt when using the card to make a purchase. That receipt is both a draft on the card issuer and a promise to pay the card issuer. Those financial instruments are separate from the contractual option.

27. Promises to exchange financial instruments may be conditional, unconditional, or a combination of the two. For example, forward contracts convey unconditional rights to and impose unconditional obligations on both parties. In contrast, the right of an option holder often is unconditional. The holder can choose to exercise the option at any time; however, the obligation of the option writer to deliver or accept delivery is conditioned on exercise of the option. In addition, some contracts permit a choice of net settlement or delivery of a financial instrument other than cash.

28. The discussion in paragraphs 14–27 is intended only to explain the definition of a financial instrument, not to establish different categories of instruments to be treated differently. Because this Preliminary Views applies to all financial instruments, it is not necessary to analyze complex financial instruments to determine whether they should be reported at fair value. It is necessary only to recognize that they are financial instruments. The key factors in applying this Preliminary Views are identifying contractual rights and obligations that are financial instruments, regardless of how they are labeled, and determining how best to estimate a price, which depends primarily on the available price information.

29. Some contractual rights and obligations that are not financial instruments are similar to financial instruments in that one party is obliged to deliver either cash or some other type of financial instrument. One example is a forward contract for the purchase and sale of goods or services. Even before the goods or services are delivered, contractual rights and obligations exist. One party (the customer) has the right to require delivery of goods or services and a corresponding obligation to deliver cash or a promise to pay. The other party (the vendor) has the obligation to deliver goods or services and a corresponding right to require delivery of cash or a promise to pay.

30. The forward purchase and sale of goods or services is not itself a financial instrument, but it may lead to creation of a financial instrument. The forward purchase and sale contract is not cash or an ownership interest in an entity (paragraphs 14(a) and 14(b)). It is not an obligation to deliver and a right to require delivery of a financial instrument for no consideration other than release from the obligation (paragraph 14(c)). It is not an obligation to exchange and a right to require exchange of financial instruments (paragraph 14(d)). However, if the customer delivers a promise to pay in exchange for delivery of the goods or services, that promise is a financial instrument.

31. The definition of a financial instrument also excludes contracts that require delivery of commodities. For example, bonds to be settled in ounces of gold or barrels of oil rather than in cash are not financial instruments under the definition. Commodity forward contracts and options are not financial instruments if they require delivery of the commodity.

32. Deferred revenues and prepaid expenses, advances from customers and advances to customers, and most warranty obligations and rights represent contractual obligations and rights to deliver goods or services, which are not financial instruments. Employment contracts, consulting agreements, and construction contracts and other contracts for services also are not financial instruments. The only contracts for services included in the scope of this Preliminary Views are financial asset servicing rights. They are not financial instruments, but they are specifically included by paragraph 43.

33. It is important to be able to distinguish those contractual rights and obligations that are financial instruments from those that are not because, with the exceptions described in paragraphs 37–42, this Preliminary Views would not apply to items that are not financial instruments.

34. Some items that are reported as receivables and payables in a statement of financial position are not financial instruments because they are not contractual. A primary example is income taxes estimated to be payable or receivable. Although by law the taxpayer either is obligated to pay or is entitled to a refund, that obligation or right is not contractual. Other items that ultimately may require the payment of cash but do not as yet arise from contracts, such as contingent liabilities for tort judgments, are not financial instruments. However, when those obligations are contractually reduced to fixed payment schedules (that is, the obligor promises to make payments in a specified manner), the items would be financial instruments under the definition. (Refer to Appendix B for further discussion of loss contingencies accrued in accordance with FASB Statement No. 5, Accounting for Contingencies.)

35. Some state laws require insurance companies to accept new applicants or renew existing policies in order to continue doing business in the state. That imposes obligations on the insurance company and conveys rights to the policyholder or applicant that are very similar to a contractual option (which would be a financial instrument). However, those obligations and rights are not contractual. They are imposed by law, therefore, they do not represent financial instruments.

36. Physical assets such as inventory, plant and equipment, and leased assets including their unguaranteed residuals, as well as intangibles such as patents, trademarks, and goodwill, do not meet the definition of a financial instrument. Each of those assets could eventually lead to the receipt of cash, but the asset does not result from a current contractual right to receive a financial instrument.

37. Certain financial instruments are excluded from the scope of this Preliminary Views, including:

38. The stock certificates that represent investments in consolidated subsidiaries are financial instruments. However, because that investment conveys control of the entire entity, users need information that is different from the information they need about other financial instruments. The Board currently has on its agenda a separate project on consolidation policy, and this project on financial instruments will not address those investments.

39. Although some Board members believe that measurement at fair value is superior to the equity method of accounting for most, if not all, equity investments that do not convey control of an entity, reconsideration of issues related to the equity method of accounting is not a part of this project. That consideration will occur as a part of a separate project on investments currently accounted for under the equity method.

40. This Preliminary Views would not require that a minority interest in a consolidated subsidiary or an entity’s own equity instrument be reported at fair value because they are not assets or liabilities.

41. Employers’ and plans’ obligations for pension benefits, other postretirement benefits, and certain other employee benefits are excluded for practical reasons. Some of those obligations can be especially complex, and accounting literature already requires periodic remeasurement of those obligations (albeit not at fair value).

42. Special provisions would apply to leases. The fundamental bases for recognition and measurement of leases would not be reconsidered as a part of this project. Thus, the criteria for capitalization of leases and for measurement of recognized leased assets would not be affected. However, all accounts receivable and payable recognized under existing lease accounting rules would be remeasured to fair value at each reporting date.

43. Financial asset and lease servicing rights are closely related to financial assets and leases. In fact, the cash flows that are associated with the servicing rights were associated with a financial asset or lease until the servicing rights were separated. Existing reporting standards already require initial measurement at fair value, and some constituents recommended that the Board require remeasurement to fair value because it produces gains and losses in income similar to fair value hedge accounting without the effectiveness requirements in Statement 133. For those reasons, the Board decided that servicing rights related to all financial assets and leases should be included in the scope of this project and remeasured at fair value at each reporting date.

44. The Board decided to include contractual obligations that would be financial instruments except that they permit one party to choose to settle by delivering either a financial instrument or some other asset or liability. Some of those items are not financial instruments because they do not create an obligation to deliver or exchange financial instruments. For example, an account payable does not impose an obligation to deliver a financial instrument (or convey a right to require delivery of a financial instrument) if the debtor can choose to deliver a commodity instead. If contractual obligations with that option were not reported at fair value, the requirements described in this Preliminary Views might be avoided simply by inserting a nonsubstantive settlement option into a contract.

45. This Preliminary Views also would require fair value measurement at each reporting date for nonreciprocal promises to give financial instruments that are recognized as contributions receivable and payable under the requirements of FASB Statement No. 116, Accounting for Contributions Received and Contributions Made.

46. Finally, this Preliminary Views would prohibit capitalization of policy acquisition costs of insurance enterprises. (Paragraphs 28–31 of FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises, describe acquisition costs and the current capitalization requirements.) Refer to Appendix B for further discussion of the effect of this Preliminary Views on accounting by insurance enterprises.

47. Fair value is an estimate of the price an entity would have realized if it had sold an asset or paid if it had been relieved of a liability on the reporting date in an arm’s-length exchange motivated by normal business considerations. That is, it is an estimate of an exit price determined by market interactions.

48. An asset’s or a liability’s exit price—the price at which it could be sold or settled at present—represents the market’s estimate of the present value of its expected future cash flows. That price reflects the amounts, timing, and uncertainty of future cash flows of the enterprise that holds the asset or owes the liability. Thus, the exit price is directly related to the objectives of financial reporting as stated in paragraph 37 of FASB Concepts Statement No. 1, Objectives of Financial Reporting by Business Enterprises:

49. In contrast, an entry price reflects the cost an entity would incur to replace its assets or liabilities. In some instances, entry value may be useful in estimating an exit value, but exit value is the objective.

50. Fair value is described as an estimate because only at the moment a transaction occurs is the exit price known. If a particular instrument is traded actively, an estimate can be made with a high level of confidence that the estimate faithfully represents what an actual exit price would have been. However, even in that case, the amount is an estimate. Principal-to-principal or brokered trades, significant announcements, or other events may have caused the price to change after the close of the market.

51. In general, there are four kinds of markets in which financial instruments can be bought, sold, or originated:

52. Ideally, the estimated exit price should be based entirely on market information. However, that will not be possible in all cases. Available information about prices differs depending on the kind of market in which an item is traded.

53. The exit prices for items actively traded on an exchange where last trade prices are quoted regularly are based on the closing price on the last trading day of the period less any commissions. Some assumptions about expected commissions are necessary, but otherwise, that exit price is based entirely on market information. (In fact, even the commissions are based on commissions observed in market transactions.) For items actively traded in dealer markets, where bid and asked prices are quoted regularly by the dealers, exit prices are based on what would have been realized or paid on the reporting date. For most entities, that means the exit prices of assets are based on bid prices and the exit prices for liabilities are based on asked prices on the last trading day of the period adjusted for any direct exit costs, but it would be appropriate for dealers that normally receive the asked prices for assets and pay the bid prices for liabilities to use those prices. Again, the exit price is based almost entirely on market information.

54. Items that are not actively traded involve more estimation and assumptions. Principles for determining fair values of items less actively traded are described in paragraphs 60–82.

55. In all cases, assets or liabilities being measured should be measured "as is." Value enhancements, such as guarantees or securitizations, that an entity plans to obtain in the future should not be considered in determining the exit price. An observed price of a similar instrument in a transaction involving enhancements may be used as a basis for estimating an exit price only if the effect on the value of the enhancements can be

subtracted. For example, an observed price of securitized receivables can be used as a basis for estimating an exit price of unsecuritized receivables of the same type only if the entity can eliminate the price effect of the liquidity, security, and other benefits added by securitization. It is the effect of the securitization on the price of the securitized assets that must be removed, not the cost of the securitization.

56. For a few financial instruments, immediate realization of an asset or relief from a liability may not be possible. For example, in the United States, it is extremely difficult to obtain release from obligations under some types of insurance policies. In those cases, the best estimate of a hypothetical exit price may be the present value of the expected cash flows that would result from a future settlement under the same market conditions that exist at the reporting date. That present value should incorporate the effects of adjustments for risk, market imperfections, and similar factors if market-based information is available to estimate those adjustments. Paragraphs 73–83 provide further details.

57. Estimating exit prices of items for which current price quotes from active markets are available is a relatively simple matter that requires few estimates or assumptions. The following discussion applies to items for which prices are not regularly published or otherwise publicly available from an exchange or dealers in active markets.

58. Paragraphs 60–72 discuss the situation in which some information about the market price of the specific item or a very similar item is available. (Refer to paragraph 61 for an explanation of how to determine whether two items are similar.) In that situation, more assumptions and estimates will be required to adjust the available price information for such things as changes in market factors since the last observable transaction or for slight differences between the item being priced and similar items. A valuation model may be used, but the available price information would provide the most important inputs to those models.

59. Paragraphs 73–82 discuss the situation in which little or no price information is available and the only available market-related information is general information about interest rates and other economic factors. In that situation, the most important inputs to the valuation model are likely to come from internal estimates and assumptions about market factors.

60. The following are general guidelines for estimating exit prices when price information other than quotes from active markets is available:

61. Whenever possible, exit prices should be estimated based on market prices in observed transactions involving an item identical to the one being measured. Estimates should be based on market prices of similar items if no prices are available for the identical item. Similar items are those with similar patterns of cash flows that can be expected to respond similarly to changes in economic conditions. Paragraph 32 of the present value Exposure Draft describes how to determine whether two items have similar cash flow patterns. The process involves the following steps:

62. If it is available, the price of the identical instrument should be used as the basis for estimating exit price. However, if a similar instrument is traded in a more active market or more recently than the identical instrument, its price may be particularly useful in determining how to adjust the price of the identical instrument for changes in market factors since the date of the last transaction.

63. An entity may have access to more than one market for certain items, and prices in those markets may be different. One example is a portfolio of promissory notes. The exit price of the portfolio as a whole might be higher than the total of the exit prices of the individual notes. If so, fair value should be based on the market with the most advantageous price. Most advantageous means the optimum price obtainable in a market to which the entity has reasonable access. The most advantageous price would be a higher exit price for an asset and a lower exit price for a liability.

64. Most advantageous does not refer to an entity’s broader goals. For example, an entity might decide that its most advantageous course of action is to get out of a particular line of business quickly even if that means the entity will not realize the best price for its assets and liabilities. That may be the best course of action for the entity, but it is not the most advantageous price for the individual assets and liabilities. If the entity were to sell an asset for less than the most advantageous price or settle a liability for more than the most advantageous price, the entity would report a loss when the sale or settlement occurs.

65. The Board’s intention is to provide an operational decision rule that yields consistent results. A most-advantageous-price decision rule is reasonable based on the assumption that the ultimate goal of most entities is to maximize profits or net assets. Reporting an exit price less than the most advantageous price and recognizing a gain on realization of the most advantageous price could be misleading. It might imply that the entity has realized a gain over the market price because of some special ability or competitive advantage, while, in reality, realizing the most advantageous price involves only accessing the right market.

66. Certainly, entities sometimes engage in transactions that do not maximize profits or fail to engage in transactions that would have maximized profits. For example, an entity in a regulated industry may be required by a regulator to sell a single note for regulatory reasons for a price that may be less than if it had been sold as a part of a portfolio. If so, the action required by the regulator has a cost—the difference between the optimum price and the actual realized price. The loss would be reported as a loss at the time of the sale. Recognizing that loss at the time it occurs is informative because it clearly indicates that the entity has disposed of the asset or settled the liability in less than the optimum manner.

67. An entity need not conduct an exhaustive search of all possible sources of prices, but it must consider any price that is readily available. A market exit price, regardless of its source, is presumed to be the best evidence of the fair value of an asset or liability. Only the following factors may be used to rebut that presumption (and only if the entity can demonstrate that better information about fair value is available from another source):

68. In some circumstances, an entity might expect the exit price in a single transaction involving a large block of a single type of instrument to be different from the exit price of the same type of instrument sold or settled individually or in small blocks. However, if exit prices are available only for individual instruments, paragraph 67 would not permit the available price to be adjusted for potential blockage factors regardless of the size of the entity’s holdings.

69. Control premiums raise a similar issue. The price of a large block of voting securities may be greater than the sum of the prices of the individual securities. However, if that additional value is not included in the market price, paragraph 67 would not permit an adjustment of that market price.

70. One of the fundamental objectives in this Preliminary Views is to base fair value on market prices if they are available. Adjusting observed prices for estimated control premiums or blockage factors would conflict with that objective.

71. In the situation described in paragraph 63, the notes also might be prepayable by the debtors for a specified price; however, the creditor would not base fair value on that prepayment price. The prepayment amount is the exercise price of a call option held by a debtor on its own outstanding debt. It is not necessarily indicative of the price that would be negotiated by the debtor and creditor under current market conditions.

72. In contrast, the debtor’s liability should not be reported at an amount greater than the prepayment value. If the market price of a note is greater than the exercise price of the prepayment option, the debtor’s most advantageous exit price would be the exercise price of the prepayment option. It would be informative to readers of financial statements to report a loss if the debtor chose to exit the liability in any way other than by exercising the prepayment option. To report a gain simply because of prepayment would imply that the entity was able to realize an exit price more favorable than the market price through its own talents and skill.

73. There may be no market prices on which to base fair value if:

In that situation, an exit price must be estimated based primarily on general market information (such as interest rates, exchange rates, and similar factors) and internally developed estimates and assumptions. A computation of the present value of future cash flows is likely to be necessary. If so, the approaches described in the present value Exposure Draft should be applied. If a valuation technique other than a present value computation is used, the guidance in paragraphs 74–83 generally still is appropriate, especially the discussion of contractual and noncontractual cash flows.

74. Paragraph 26 of the present value Exposure Draft describes the limitations of using internally estimated cash flows in determining fair value and explains why it is the last choice of a measurement technique:

75. All present value calculations start with a set of projected cash flows. The projected cash flows for a financial instrument include those that are directly related to the contractual rights and obligations that constitute the financial instrument. That is, projected cash flows should reflect all cash expected to be delivered or exchanged under the contract, including net cash flows expected to result from exercises of options whether or not they appear to be in the money to the holder. (Refer to paragraphs 107–109 for further discussion of cash flows from the exercises of options.)

76. If fulfilling obligations under the contract entails costs (for example, administration of demand deposits, credit card contracts, and insurance contracts), the market’s estimate of those costs (not the individual entity’s expected costs) should be included in projected cash flows. Cash flows that are related to the contractual relationship but that do not result from rights and obligations under the contract itself generally should not be included in the projected cash flows. (Refer to paragraphs 96–132 for discussion of situations in which noncontractual cash flows might be included in determining fair value.) Two common examples of those cash flows that should be excluded are net cash flows from expected incremental sales of other products or services to the counterparty and rentals of customer lists. Those benefits represent potential assets separate from the financial instrument.

77. Another example of noncontractual cash flows involves contracts with specified expiration dates and no contractual right or obligation to renew. If both parties are expected to renew or extend the contract when the current contract expires, transactions may be expected to occur after the contractual expiration date. If the contract is renewed and the expected transactions occur, they will be contractual. However, at the reporting date, there is no contract beyond the expiration date and no contractual means for either party to require an extension or renewal.

78. Once the projected cash flows are estimated, they are adjusted for the following:

79. In a traditional approach to present value, adjustments for those factors are embedded in the discount rate. The cash flows are the contractual cash flows or, if some or all of the cash flows are optional or conditional, a single "best estimate" of the likely cash flows. That approach is acceptable but may not be the best technique. A single best estimate of cash flows may be difficult to determine if cash flows are conditional or optional. There may be no single estimate of the amount and timing of cash flows that can be assigned a high probability. Thus, the best estimate may only be marginally better than any other available estimate. In addition, the interest rate in a traditional present value computation cannot reflect uncertainties in timing of cash flows.

80. The "expected cash flow" approach that is described in the present value Exposure Draft is more appropriate than the traditional approach if an instrument’s cash flows are conditional, optional, or otherwise particularly uncertain. Generally, in the expected cash flow approach, only the time value of money is included in the discount rate. The other risks and uncertainties are incorporated by adjustments to the expected cash flows.

81. However, the expected cash flow approach is not the only acceptable method of applying present value techniques. The general principles, as identified in paragraph 29 of the present value Exposure Draft, are as follows:

82. In estimating an exit price, an entity may use internally developed models only if there is no other technique that better represents market prices. Consequently, the information necessary to estimate the adjustments referred to in paragraphs 78(c) and 78(d) may not be available. In that circumstance, it will be necessary to estimate cash flows without adjustment for risk premiums, illiquidity, market imperfections, and anticipated profit margins.

83. The effect of an entity’s credit risk should always be included in estimating an exit price for that entity’s liabilities. The present value Exposure Draft describes the basis for that decision in paragraphs 62–66:

84. It is not a foregone conclusion that the outcome of this project will be to require measurement of all financial instruments at fair value in the basic financial statements. Other alternatives (including a requirement for enhanced disclosures or a separate set of fair value financial statements) will be considered in the next phase of the project. Therefore, a decision about how to report gains and losses due to changes in fair values of financial instruments might be considered premature in this Preliminary Views. However, a number of constituents advised the Board to discuss in this Preliminary Views how changes in fair values of financial instruments might be reported, and the Board decided to accept that advice.

85. If fair values of securities, other financial instruments, and other items within the scope of this Preliminary Views are reported in financial statements, changes in fair value would be reported in earnings when they occur whether or not they are realized. The held-to-maturity and available-for-sale categories of securities permitted by Statement 115 would be eliminated. Paragraphs 92–94 of Statement 115 explain why that Statement established those categories.

86. Thus, the main reason for permitting gains and losses on available-for-sale securities to be reported outside earnings was the "unrepresentative" or "artificial" volatility that would result from reporting financial assets but not related financial liabilities at fair value. That reason would no longer apply if financial instruments and other items within the scope of this project are reported at fair value with changes reported immediately in earnings.

87. Paragraph 92 of Statement 115 explains how reporting the effects of events in the periods in which they occur provides a more equitable reporting of results to different shareholder groups. That discussion was written in the context of securities designated as trading, but it applies to all financial instruments whether or not they are designated as trading. A similar argument applies to equitable reporting of management performance—reporting gains or losses when they occur attributes them to the management in place when they occur rather than to a possibly different management team that may realize them later.

88. This Preliminary Views does not propose to amend Statement 133. However, even without an amendment, the results of applying Statement 133 would change if all financial instruments were reported at fair value with changes reported immediately in earnings.

89. Paragraph 21(c) of Statement 133 states that an asset or liability is eligible for designation as a hedged item in a fair value hedge if:

90. Paragraph 29(d) of Statement 133 states that a forecasted transaction may be designated as a hedged transaction in a cash flow hedge if:

91. If changes in fair values of all financial instruments were reported in earnings, those two provisions would effectively preclude hedge accounting related to existing financial instruments, forecasted acquisitions of financial instruments, and variable interest payments on financial instruments.

92. In summary, if gains and losses on all financial instruments were reported in earnings, Statement 133 would permit an entity to designate derivative instruments as:

93. In addition, financial instruments other than derivative instruments would no longer qualify as hedging instruments under Statement 133. In specified situations, Statement 133 permits an entity to designate a nonderivative instrument as a hedge of foreign currency risk but only if that instrument may give rise to a foreign currency transaction gain or loss under FASB Statement No. 52, Foreign Currency Translation. Paragraph 162 of Statement 52 defines a foreign currency transaction gain or loss as follows:

94. Thus, nonderivative instruments reported at fair value with changes reported in net income cannot qualify as hedging instruments because an item measured at fair value in a foreign currency and then remeasured into the functional currency at the current exchange rate does not give rise to a transaction gain or loss. Rather, any transaction gain or loss is simply a part of the total change in fair value during a period.

95. Paragraphs 96–144 discuss two issues that the Board considered but did not resolve before issuing this Preliminary Views. Those issues are:

96. The first unresolved issue involves a conflict of objectives that would affect the scope of this Preliminary Views. The primary objectives underlying this Preliminary Views are (a) to measure financial instruments at fair value and (b) to base fair value on observed market prices whenever they are available. Financial instruments that are traded only in combination with closely related noncontractual benefits create a conflict between those two objectives. Paragraphs 97–131 describe the characteristics of two instruments that raised the issue and explains some of the factors the Board has considered.

97. Contracts that represent securities or other financial instruments traded in exchange, dealer, or brokered markets tend to establish very limited, impersonal relationships. For example, the only aspect of a bondholder’s relationship with the issuer that affects the price of the bond is the issuer’s obligation to make specified future payments on the bond and the bondholder’s right to demand those future payments. Thus, those types of instruments do not raise the issue of what to measure. The relationship has so little noncontractual value that it can be ignored. Available transaction prices relate almost entirely to the financial instrument.

98. However, contracts that originate from direct contact between a customer and a vendor sometimes create a different kind of relationship, especially if a contract is of long duration, open ended, or renewable and provides for a series of transactions. Two examples are credit card contracts and demand deposit liabilities. Credit card issuers and depository institutions trade credit card relationships and depositor relationships. The transaction prices reflect the fair values of the financial instruments and noncontractual benefits of the customer relationships. (Prices for specific portfolios of credit cards or demand deposits will rarely be available, but prices for portfolios that are sufficiently similar to be useful may be available. Refer to paragraph 61 for an explanation of how to determine if two instruments or portfolios are similar.)

99. By definition, the noncontractual value of a customer relationship is not part of the fair value of a financial instrument. However, some financial instruments are traded only with the noncontractual aspects of a customer relationship, and it may not be possible for an entity that is not a party to the transaction to identify the portion of the total price attributable to the financial instrument.

100. Thus, the two objectives are in conflict. The objective of basing fair value on market prices would lead to recognizing and measuring the entire customer relationship using the prices in observed transactions involving similar relationships. The objective of measuring only financial instruments would lead to recognizing and measuring only the financial instrument using a present value technique that requires numerous internal estimates and assumptions. The Board has not decided how to resolve that conflict.

101. The discussion in paragraphs 102–120, which applies to credit cards issued by a financial institution or a financial services enterprise, describes the three sources of value in a relationship created by a credit card contract. It explains the types of expected future cash flows that would be considered in a computation of present values.

102. Credit card relationships include three components of value:

103. Generally, credit card relationships are traded in portfolios. The cardholder’s option and the noncontractual benefits of the relationship are not traded separately but only as a part of a package that includes the card issuer’s account receivable from the cardholder. In contrast, portfolios of accounts receivable from cardholders are traded separately, that is, without the cardholder’s option to borrow or the noncontractual benefits of the relationship. Consequently, a price for the cardholder’s option and the noncontractual benefits of the relationship can be estimated by comparing the package price with the price of only the accounts receivable. However, market prices of credit card relationships cannot provide a basis for estimating a price for the cardholder’s option separate from the noncontractual benefits. The best available technique for estimating that separate price would be a present value computation that depends heavily on internal estimates and assumptions.

104. A contract between a credit card issuer and a cardholder grants the cardholder an option to borrow from the card issuer. The contract specifies the interest rate (or how it is to be determined), the payment terms, and the other terms under which the cardholder can borrow. The cardholder can exercise its option in either of two ways. It can get a cash advance from the card issuer, or it can use the card to purchase goods or services from a third-party vendor. The cash advance is an exchange of cash (a financial instrument) for a promise to pay (also a financial instrument). Thus, the cardholder’s right to a cash advance and the card issuer’s obligation to provide the advance clearly meet the definition of a financial instrument.

105. The right to use a credit card to purchase goods or services from third parties also is a financial instrument. The transaction between the cardholder and the card issuer involves no goods or services. At the point of purchase, two transactions occur simultaneously. In one transaction, between the cardholder and the merchant, the merchant accepts a draft on the card issuer in exchange for the goods or services purchased by the cardholder. That is a relatively simple sale. The only financial instrument involved is the draft on the card issuer (which is a promise by the card issuer to pay the merchant).

106. In the other transaction, between the card issuer and the cardholder, the card issuer implicitly or explicitly accepts a promise by the cardholder to pay later in exchange for the card issuer’s promise to pay the merchant (represented by the draft the cardholder just signed and gave to the merchant). (Acceptance is implicit in the cardholder’s possession of the card unless the card issuer has given notice that the card is not valid. It is explicit if the merchant confirms the acceptance with the card issuer or an agent at the time of the purchase.) The card issuer’s obligation to accept the promise to pay (a financial instrument) in exchange for the draft (also a financial instrument) and the cardholder’s right to require that exchange represent a financial instrument.

107. The cardholder’s option to borrow is different from many other options because it can be either an asset or a liability to the card issuer, which is the writer of the option. Many, more traditional written options are always liabilities to the writer because the holders are expected to exercise the options only when the exercise price is detrimental to the writers. However, a cardholder often is motivated to exercise (to borrow) by factors other than the exercise price (that is, the interest rate on the card). Credit card transactions are convenient, and they may be the only way to make purchases by telephone or on the Internet. In addition, they often are more secure than cash transactions. Another possibility is that the cardholder may be unaware that less expensive forms of borrowing are available and may not want to spend the time or effort to find out.

108. The specific reasons cardholders borrow are not particularly important because the evidence from history is clear. Many cardholders borrow whether or not the interest rate on the card is unfavorable to them relative to other unsecured borrowings with similar payment terms. That means that if the interest rate on the card is favorable to the card issuer, the issuer can expect incremental future net cash inflows (as compared to the current market rate of interest) and therefore has an asset. However, if the interest rate is unfavorable to the issuer because the borrower’s lack of creditworthiness justifies a higher interest rate, the card issuer will have a liability.

109. Of course, the interest rate is not the only determinant of the value to a card issuer of the cardholder’s option. For example, a merchant who accepts the card does not receive face value when it presents its draft for payment. That discount, which is sometimes referred to as an interchange fee, reduces the cash outflows of the card issuer. The card issuer also expects to incur costs in fulfilling its obligations, for example, servicing costs and promotional expenses (such as the cost of frequent flier miles granted to cardholders). Credit losses also reduce expected future net cash inflows. All of those would be factors in setting a price (and in determining fair value).

110. Under existing accounting principles, cardholder’s options are not recognized as assets or liabilities by the card issuer unless they are acquired by purchase from another issuer. However, they qualify as recognizable assets or liabilities of the card issuers under the criteria in FASB Concepts Statements No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, and No. 6, Elements of Financial Statements, as demonstrated by the card issuers’ ability to sell them.

111. When a cardholder exercises an option to borrow, it promises to repay the card issuer according to the terms specified in the credit card contract. The card issuer’s resulting account receivable from the cardholder is a financial instrument separate from the cardholder’s option to borrow. As discussed in paragraph 103, it should be possible to estimate an exit price for the account receivable and, by process of elimination, to estimate a combined price for the cardholder’s option and the noncontractual benefits of the relationship.

112. Card issuers often sell accounts receivable from cardholders in securitization and similar transactions. The portion of the total price of a credit card relationship attributable to the receivables can be inferred based on prices in observable transactions involving only the accounts receivable. However, securitization transactions often involve guarantees and other types of credit enhancement or forward purchase agreements and similar items. The estimate of an exit price for the receivables must take into account the effect of those factors. That is, to estimate a price for the receivables, the total amount received by the transferor must be adjusted for the value of any credit enhancements, forward contracts, and similar items (some of which also are financial instruments).

113. The prices of credit card receivables, after adjustments for credit enhancements and other factors, generally are not equal to their face values even though the cardholder has the right to pay off the balance at any time without penalty. The prices of the receivables depends on two factors: market participants’ expectations about the timing of repayments and the difference between the interest rate on the receivables and the rate on other types of unsecured borrowings with similar repayment terms and credit risks.

114. There are at least three sources of noncontractual benefits to the card issuer from a credit card relationship:

115. Cardholders’ options in credit card contracts generally have specified terms with automatic extensions unless either party gives notice of its intent not to extend the contract. Thus, the cardholder’s option to borrow extends only until the current term of the contract expires because neither party has a contractual right or obligation to extend.

116. History indicates that many cardholders will renew their contracts when they expire and will exercise their option to borrow during the renewal period. The expected net cash flows from future borrowings are a factor in determining a price for credit card relationships; however, they are not a part of the value of the existing financial instrument (the cardholder’s option to borrow). They are noncontractual even though borrowings during future renewal periods will be contractual if they occur. The reason is that neither party has a current contractual right or obligation to enter into transactions in future renewal periods because before they can occur, both parties must agree to extend the contract.

117. Expected fees from rental of the customer’s name and address as a part of a customer list are another noncontractual item that may contribute to the total price of a credit card relationship. Another is the expected incremental profit from transactions with the cardholder (other than borrowings under the credit card contract) that occur because of the relationship created by the contract. Those two sources of benefit are noncontractual even if they are expected to occur during the current contract period.

118. Those three may not be the only noncontractual sources of cash flows from credit card relationships. However, it will not be necessary to identify individual sources of noncontractual cash flows unless each source of noncontractual benefits from the credit card relationship is to be reported separately or if some are to be reported but others are not.

119. The asset represented by the expected noncontractual net cash flows from a credit card relationship is not recognized under existing generally accepted accounting principles unless an entity purchases a portfolio of credit card contracts. However, it is a recognizable asset of the card issuer under the criteria in Concepts Statements 5 and 6 as demonstrated by the card issuer’s ability to sell it.

120. It is unlikely that a noncontractual asset of the card issuer would be a liability of the cardholder. Some of the expected cash flows that contribute to the value of the noncontractual asset (for example, fees for customer list rentals) will come from entities other than the cardholder. Those that will come from the cardholder (for example, sales of other products or services to the cardholder and cardholder charges during future renewal periods) are discretionary. The cardholder has no obligation to provide them. The price that market participants are willing to pay for those future noncontractual cash flows is based solely on expectations.

121. Demand deposits raise issues similar to credit card contracts. Like credit card contracts, they are traded in portfolios along with items that are not financial instruments. The price at which demand deposit relationships are traded generally includes three things that are analogous but not identical to the three components of value of a credit card relationship. They are:

122. Generally, all three components are factors in the prices of demand deposit relationships. That is, the three are traded as a unit for a single price. Unlike the credit card relationship, none of the three are traded separately. (The card issuer’s accounts receivable from cardholders sometimes are traded separately from the contracts.) Consequently, in this case, the unresolved issue applies to all three of the components.

123. A demand deposit agreement between a depository institution and a depositor gives rise to an asset. The operation of the agreement makes it similar to a financial instrument. If the agreement obligated the depository institution to accept future deposits in return for a promise to repay the depositor, it would be a financial instrument.

124. However, the demand deposit agreements that the Board has reviewed give the financial institution the right to refuse deposits. The Board has been told that the right is enforced only in situations involving reasonable suspicion that the money came from illegal sources, coin deposits, and extremely large deposits. Most depositors are not even aware of that provision and probably have never considered the possibility that the bank would refuse deposits.

125. Even though the written contract does not obligate a depository institution to accept deposits, the agreement still would be a financial instrument if an implied contractual obligation exists. An implied obligation would be demonstrated if a court awarded compensation from the depository institution to a depositor harmed by that institution’s refusal to accept a deposit without reasonable cause. Courts have occasionally found financial institutions liable for damages caused by mishandling of a customer’s deposits even when no bank employee has formally "accepted" them, for example, loss of a deposit placed in a night depository. That might mean that the financial institution had an implied contractual obligation to accept the deposit, but the Board has not identified any cases in which the courts dealt directly with that issue.

126. Whether or not it is a financial instrument, the demand deposit agreement provides benefits to a depository institution in the form of incremental earnings on expected future deposits. Evidence from history indicates that customers are likely to make future deposits and that the institution will accept them. If that occurs, the institution will receive a benefit from the interest-free or low-interest use of that cash.

127. The interest rate on demand deposits is very low or zero because they are insured by government agencies and because the depositor can withdraw its money at any time. Because demand deposits are traded only as a part of a demand deposit relationship and are not priced separately, it is difficult to determine what rate market participants would use to represent the time value of money in a present value computation. However, even overnight borrowings by the depository institution would be expected to bear a higher interest rate than a demand deposit. Of course, the benefits are reduced by the cost to the depository institution of servicing the deposits.

128. Under existing accounting principles, demand deposit agreements are not recognized as assets by the depository institution unless they are required by purchase. The benefits of the demand deposit agreement qualify as a recognizable asset under the criteria in Concepts Statements 5 and 6 as demonstrated by the fact that those agreements and the associated benefits of the relationship with the depositor are bought and sold by depository institutions.

129. A demand deposit represents a promise by a depository institution to deliver the funds deposited by the depositor either directly to the depositor or to third parties designated by the depositor. It imposes contractual rights and obligations that clearly represent a financial instrument. Its term is indefinite. The depositor can demand settlement by writing a check or initiating an electronic transaction. The depository institution also generally has the right to settle at any time by returning the depositor’s money, even though that right is seldom exercised.

130. This financial instrument is analogous to a credit card issuer’s receivable from a cardholder although, of course, it is a liability. Like the card issuer’s receivable, the demand deposit is a financial instrument that results from actions pursuant to a separate underlying agreement. Also like the card issuer’s receivable, the value of the instrument depends on the market’s expectation of the timing of withdrawals and the level of interest rates on other borrowings with similar terms to maturity (until withdrawal). It is difficult to determine what rate market participants would use because trading in demand deposits occurs only in combination with the other parts of the demand deposit relationship.

131. The other sources of benefits from a demand deposit relationship are the rentals of the customer’s name and address as a part of a customer list and incremental net cash inflows from sales of products or services other than those described in the demand deposit agreement. There is no analogy to the other source of noncontractual benefit from expected renewals of a credit card relationship (in paragraph 114(a)) because a demand deposit agreement does not have an expiration date. As discussed in paragraphs 123–125, it is not clear whether or not the demand deposit agreement creates implied contractual rights and obligations that represent a financial instrument. If the demand deposit agreement is a financial instrument, all expected future deposits are contractual (and, therefore, are factors in estimating the value of a financial instrument), and if the demand deposit agreement is not a financial instrument, all expected future deposits are noncontractual.

132. This unresolved issue arose because of a conflict between two objectives. If the Board decides that the definition of a financial instrument is of paramount importance, entities would report fair value of a financial instrument based on a valuation model using internal estimates and assumptions about market factors. If the Board decides that it is more important to use market prices whenever they are available, entities would report fair value of a customer relationship that includes a financial instrument. The estimated exit price would be based on observable prices, but it would include noncontractual benefits that are not encompassed by the definition of a financial instrument.

133. The second unresolved issue also involves the scope of the Preliminary Views. The definition of a financial instrument would include some but not all credit card contracts, insurance policies, and warranties. Some believe that there is little difference between contracts that would be included and those that would be excluded. The issue is whether to make an exception to include in the scope of the project, credit card contracts, insurance policies, and warranties that do not meet the definition of a financial instrument because they provide for future delivery or exchange of products or services instead of financial instruments. Paragraphs 134–143 explain why some contracts do not meet the definition and some of the possible implications of making an exception.

134. Some credit cards are not issued by banks and financial services entities, and the explanation in paragraphs 104–110 may not apply to those. Cards that are accepted only by the entity that issues them (single-entity credit cards) may not be financial instruments. An example is a store credit card issued by a retailer. That contract obligates the retailer to exchange its products or services (generally nonfinancial items) for a promise to pay from the cardholder (a financial instrument) and gives the cardholder the right to require that exchange. If the card issuer’s products and services do not include financial instruments, the cardholders’ options convey no right to require an exchange of financial instruments. In that case, the cardholders’ options are not financial instruments.

135. However, if the card issuer’s products or services include financial instruments and the credit card can be used to purchase them, cardholders’ options give them the right to require an exchange of financial instruments. Likewise, the card issuer is obligated to exchange financial instruments. Consequently, the cardholders’ options are financial instruments. Of course, the cardholder also has the right to use the card to purchase nonfinancial items, and the retailer has the obligation to accept the card for those purchases, but the additional right and obligation do not affect the credit card’s qualification as a financial instrument. The definition of a financial instrument refers to obligations and rights to deliver or exchange financial instruments, but it does not require that those be the only rights and obligations.

136. Issuance of a credit card by a subsidiary or other affiliate also makes the contractual rights and obligations financial instruments even if the retailer does not sell financial instruments. That is because the definition of a financial instrument is based on legal notions of contractual rights and obligations. A card-issuing subsidiary and its parent are considered part of the same entity for financial reporting purposes, but, legally, the subsidiary is a separate entity from the parent.

137. Therefore, if a parent entity that is a retailer establishes a subsidiary to issue credit cards to its customers and the parent agrees to accept the card for purchases of goods or services, the set of rights and obligations associated with that card is a financial instrument. The card-issuing subsidiary is in the same position as a bank or financial services entity that issues credit cards. The subsidiary has not agreed to sell the cardholder nonfinancial products or services. Instead, its obligation is to accept a promise to pay from the cardholder (a financial instrument) in exchange for delivering to the parent a promise to pay (a financial instrument). The sale of goods or services occurs between the parent and the cardholder.

138. Many insurance policies are financial instruments. If specified conditions are satisfied, the policy issuer is obligated to deliver cash, and the policyholder has the right to require the policy issuer to deliver cash. That is a conditional obligation to deliver cash and a corresponding conditional right to require delivery of cash, which is a financial instrument. However, if an insurance policy requires the policy issuer to provide goods or services (for example, replacement products, health care services, or prescriptions), the policy is not a financial instrument.

139. To make the issue more difficult, it may not always be clear whether or not a particular policy requires delivery of cash. If the policyholder receives cash directly from the policy issuer, the status is obvious. However, policy issuers often pay third parties that provide goods or services. In that case, it may not be apparent whether the policy issuer’s obligation was to provide cash or to provide goods or services. If the obligation was to provide cash, the payment was made to the third party on behalf of the policyholder. If the obligation was to provide goods or services, the policy issuer contracted with the third party to provide those services.

140. Warranty contracts are subject to the same distinction as insurance policies. If the issuer of a warranty is obligated to deliver cash and the holder of a warranty has the right to require delivery of cash, those obligations and rights represent a financial instrument. If the obligations and rights are for repair services or replacement products, they do not represent a financial instrument.

141. The Board has not decided how to deal with this issue because the potential solutions that have been identified create new issues of their own. Because of their apparent similarity to financial instruments, it is reasonable to consider including single-entity credit cards and nonfinancial insurance policies and warranties in the scope of this project. Unfortunately, it would be difficult to design a requirement that would be narrow enough to include credit card contracts, insurance policies, and warranties that are not financial instruments without also including many other types of nonfinancial contracts. If a narrow requirement could be developed and explained clearly, it would be difficult to justify conceptually, and it would create its own set of potential problems. The most obvious would be, Why is a single-entity credit card different from a supplier’s agreement to sell goods on credit to a commercial customer and many other similar arrangements? Except for the existence of a plastic card, there seems to be little difference.

142. If the Board does not make special exceptions, the definition of a financial instrument would determine whether a credit card contract, insurance policy, or warranty is included or excluded from the project. The apparent inconsistency between credit cards issued by parents and credit cards issued by subsidiaries could be eliminated by applying the definition of a financial instrument on a consolidated basis. In other words, a contract with a subsidiary would be treated the same as a contract with the parent; issuing a credit card through a subsidiary would not transform the card into a financial instrument. However, that would have no effect on nonfinancial insurance policies and warranties.

143. The scope of the project could be broadened to include contracts that require delivery or exchange of items other than financial instruments. However, that would include many items other than credit card contracts, insurance policies, and warranties. For example, including all contractual rights to purchase on credit and obligations to sell on credit (which is what single-entity credit cards are) could result in including supply agreements, purchase orders, and similar items. Including requirements to deliver services would include prepaid goods or services (for example, obligations of service providers who bill in advance such as attorneys’ obligations under monthly retainer arrangements).

144. This second unresolved issue arose because the definition of a financial instrument excludes rights and obligations under certain credit card contracts, insurance policies, and warranties. The results of exercising those rights and obligations appear to be very similar to the results of exercising other contractual rights and obligations that are financial instruments. However, the rights and obligations involve delivery or exchange of items that are not financial instruments. Therefore, the contracts also are very similar to many other contracts such as forward purchases and sales of products or services and options to purchase or sell products or services. Consequently, it would be difficult to include the described credit card contracts, insurance policies, and warranties without also including a large number of other contractual rights and obligations that are not generally considered financial in nature.

145. Two Board members, who support measuring all financial instruments at fair value and support the conclusions of this Preliminary Views, disagree with a portion of the analysis of an unresolved issue in paragraphs 107 and 108 and with one of the alternatives in paragraph 100 for resolving that issue.

146. This Preliminary Views concludes that in certain circumstances, an option can be an asset of the entity that has written that option. Two Board members believe that written options can only represent liabilities—they cannot be assets. Those Board members acknowledge that circumstances may occur or other factors may be present that will cause an option holder to exercise an option that would otherwise not be exercised, thereby having a positive impact on the writer of the option. However, even if one concludes there may be a benefit to the writer of the option, that benefit does not make the option an asset of the writer because exercise of the option and whatever positive impact that may entail are controlled solely by the holder of the option—the option writer does not control whether any benefit is received. Furthermore, it is clear that the option is not a liability of the option holder.

147. Those Board members acknowledge that in pricing credit card contracts and other financial instruments, it can be observed that the market considers the combination of the option together with other factors and circumstances. They believe, however, that it is only those other factors and circumstances that produce value to the contract and that those other factors and circumstances are external to and independent of the option itself. Those other factors may represent an intangible asset, but not a financial instrument, and they are distinct from the written option, which is a financial instrument.

148. To elaborate on their concern, those Board members believe that the value to the issuer of a credit card contract stems not from the written option in that contract, but from the elements that are associated with the customer relationship that arises from the contract. They note that the only element of the contract (apart from any existing receivable or payable) that is a financial instrument is a written option of the issuer. They believe it is the other aspects of the contract, such as convenience of use, that will cause the holder to exercise what might otherwise be considered a disadvantageous option and produce some benefit to the issuer. The potential to receive interchange fees from third parties and the right to solicit the holder for other business also provide value to the issuer. Consequently, those Board members believe that, despite there being a written option (a financial instrument) in the contract, the value as an asset of such contracts is entirely nonfinancial—little different from other customer relationships.

149. Those Board members do not object to the recognition of intangible assets that result from customer relationships if those intangibles meet the definition of assets, and the recognition criteria of the FASB conceptual framework. However, they believe that those intangible assets that result from customer relationships that meet the definition of assets should be recognized in all circumstances, not only when they are related to a financial instrument.