FASB 119 & derivative financial instruments: disclosure & fair value

National Public Accountant, The, Jan, 1996 by Steven Woodward, Joel G. Siegel, Anique A. Qureshi

Answer: They all suffered significant financial losses caused by derivatives. In fact, "derivatives trading brought the bank down," declared a press report soon after the news of the fall of Barings PLC was revealed in February 1995.

Highly publicized and unfortunate events like these have caused Congress, SEC, business and other groups to become highly concerned about derivative products. These groups have called upon the Financial Accounting Standards Board (FASB) to improve its disclosure requirements regarding derivative financial products.

The Board agreed that more disclosure was necessary because of the escalating size of the derivatives market and their importance to the business community. They also felt that many investors and creditors do not fully understand these complex financial arrangements. With its new pronouncement the Board intended to help financial statement readers understand why the companies use and how the companies account for derivatives. FASB No. 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments, builds upon the disclosure requirements of FASB No. 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, and FASB No. 107, Disclosures about Fair Value of Financial Instruments.

Derivatives Defined

A derivative is typically defined as a financial contract whose value is designed to track the return on stocks, bonds, currencies or commodities. Derivatives may also be contracts derived from an indicator like interest rates or from a stock market or other index. The derivative instruments that result include swaps, forwards, futures, caps, puts and calls. For example, swaps are typically tied to interest rates or currencies. A company that issues floating interest rate debt might protect itself from increasing interest rates by swapping into a fixed rate. Inverse floaters is a type of derivative whose value changes inversely to the movement of interest rates, stock indexes and the like. Generally, derivatives fall into two broad categories: forward type contracts and option type contracts. They may be listed on exchanges or traded privately.

For the purpose of FASB No. 119, the Board considers a derivative financial instrument as a future, forward, swap or option contract or other financial instrument with similar characteristics of options. Other financial instruments with similar characteristics to option contracts include interest rate caps or floors and fixed-rate loan commitments. A cap is an option that protects the purchaser from a rise in a particular interest rate above a certain level. A floor is an option that protects the purchaser from a decline in a particular interest rate below a certain level.

The Board decided to include fixed-rate loan commitments in their definition because they believed that these commitments have characteristics similar to option contracts because they provide the holder with the advantages of favorable price movements of the underlying asset or index with minimal or no exposure to losses from unfavorable price movements. Similar to options, the issuer is the party who is faced with the market risk. Even variable rate loan commitments and variable rate financial instruments that are similar to options would be included.

The Board's definition of a financial instrument does not include contracts that permit settlements by exchanging a financial instrument for the actual item or commodity. The exchange or delivery has to be between financial instruments. The definition does include, however, those commodity-based contracts that must be settled in cash.

FASB No. 119's derivative financial instrument definition does not include on balance sheet items like mortgage-backed securities, interest only and principal only debt and instruments indexed to the price of gold, silver or equity securities. The definition also excludes optional features that are embedded in an on balance sheet receivable or payable, such as the conversion and call provisions of convertible bonds.

Risks of Using Derivatives

Derivatives can be dangerous because they are generally highly leveraged. This leverage greatly multiplies the returns and the losses of the parties. This risk is further compounded because of the overall size of the market. According to the United States General Accounting Office, $12.1 trillion in notional or principle amount of derivative contracts were outstanding at the end of 1992.(1) Besides the risk from leverage, other types of risks include:

* Valuation risk: The chance that the profit on a transaction will be misstated.

* Management (operational) risk: The risk that internal errors may result in avoidable losses.

* Legal risk: The possibility a court may declare the contract illegal.

* Market risk: The chance the market value of the underlying instrument may move in favor of the counterparty.

* Credit risk: The risk that the other party to a contract may financially fail, leaving the contract unfilled. An example of credit risk is hedge funds.