by Glenn Cheney

Baton Rouge, La. - The Financial Accounting Standards Board has just closed the comment period on a proposed Interpretation on the accounting and disclosure of guarantees of indebtedness of others. The Technical Issues Committee of the American Institute of CPAs, however, says that the proposal is technically - and fatally - flawed.

The proposed interpretation would require that, at the time a guarantor issues a guarantee, it must recognize a liability at fair value for its potential obligation. The committee complains that the proposed accounting principle not only recognizes a liability for a transaction that may never take place, but also fails to specify the debit side of the transaction that must be recognized to balance the new liability.

The TIC has no problem with the new disclosure requirements, but the recognition requirement raises several difficult issues.

"According to my discussions with FASB, accountants will have to figure out what type of transaction a given guarantee was," said TIC chair Candy Wright, who is also audit director of Postlethwaite & Netterville, A.P.A.C., of Baton Rouge. "Was it an equity-type transaction? Was it something that should hit interest expense since it’s more of a cost of the loan? They’re not going to tell us. This is going to be a problem for small practitioners who have no access to resources. We’re going to be lost."

A FASB representative said that the board purposefully left the debit side of the equation open because the facts and circumstances for guarantee transactions can vary so much. The board therefore simply established the principle and leaves it to companies to apply it to specific situations.

One problem with the recognition is its measurement. Wright said that when she asked FASB how to measure the value of a loan guarantee, they told her to "call the bank." She subsequently talked with three community bankers. They were unaware of the Interpretation and had no idea how loan guarantees would be valued as liabilities. The bankers’ immediate reaction, Wright said, was that they would no longer be able to accept unlimited guarantees.

The problem, then, is not just in the vagueness of the Interpretation but the new requirement’s impact on small businesses. Small companies often use unlimited guarantees for multiple loans. Recognition of those guarantees could have a detrimental effect on their balance sheets and their ability to borrow money.

Letters of credit would be recognized as liabilities. Nonprofit organizations would be affected, too, if they issue guarantees for their affiliates.

Personal financial statements that must be prepared under generally accepted accounting principles, as they typically are in the loan situations of small companies, apparently would require parents to recognize liabilities for guarantees of their children’s car and student loans.

"When a bank requests financial statements on a company and personal financial statements on the company’s owners, which they always do, that’s almost going to be double booking," Wright said. "If a banker isn’t very careful, he’s going to think the person has more liabilities than he really does. That could create a problem with credit."

Wright said that the vagueness of the proposal is indicative of problems with principles-based accounting standards. While principles-based standards afford a certain flexibility, they can also result in inconsistency.

Wright said that the committee agrees with the views of the two dissenting FASB members who did not agree with the recognition requirements. The dissenting members okayed the new disclosure requirements but felt that the recognition requirements include "insufficient guidance with respect to the initial and subsequent period accounting." They also questioned the cost-benefit of implementing the recognition requirements.

The dissenting opinion posed several questions left open by the Interpretation: "Is the debt an expense or should it be amortized similar to a premium? How should guarantees and indemnities that are not financial instruments and that are issued without identifiable premiums be measured? Should the liability be frozen until the guarantee period expires at which time a gain would be recognized, or should it be adjusted periodically?"

Given the many questions that the committee, its constituents and certain banks are asking, Wright feels that the 30-day comment period, which closed June 21, was too short. Of the few bankers she has spoken with, none knew of the ED, its implications for their loan transactions or the answer to the question about the debit side of the recognition. Few of the TIC’s constituents understand the implications of the Interpretation.

If adopted as proposed, the Interpretation would apply to fiscal years starting after Sept. 15, 2002.

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