ALTERNATIVES TO CURRENT ACCOUNTING FOR DERIVATIVE INSTRUMENTS

By Arlette C. Wilson and Sarah Stanwick

Current authoritative literature related to derivative instruments represents a somewhat piecemeal and often internally inconsistent set of rules. The FASB is attempting to develop a more comprehensive and consistent framework for accounting for all financial instruments. To date, FASB statements on derivatives have focused primarily on disclosure issues. The Board continues to spend a great deal of energy on exploring and debating the measurement issues.

Current Accounting

What accounting rules that do exist have developed over time in a somewhat piecemeal fashion as financial markets have designed new derivative financial instruments. The authoritative literature includes two standards that apply to derivative products:

* SFAS No. 52, Foreign Currency Translation, and

* SFAS No. 80, Accounting for Futures Contracts.

Consensus positions of the Emerging Issues Task Force (EITF) are an additional source of guidance.

Accounting for those derivative instruments not specifically covered by existing authoritative literature has developed largely through practice and by analogy to the existing standards. As a general rule, the accounting treatment depends mainly on the purpose and designation in a particular transaction. The resultant accounting for these instruments can generally be categorized as‹

* hedge accounting,

* synthetic alteration or settlement accounting, or

* speculative accounting.

Hedge Accounting. If specific criteria are met, hedge accounting can be used. As a general rule‹

* if hedging an asset or liability carried at historical cost, gains or losses are deferred and recognized at the same time earnings are recognized on the asset or liability;

* if hedging an asset or liability carried at market or lower of cost or market, gains or losses are incorporated into the carrying value of the asset or liability.

* if hedging a firm commitment or anticipated transaction, any gains or losses are deferred and recognized as an adjustment to purchase or sales price at time of transaction.

SFAS No. 52 provides the criteria for use of hedge accounting in foreign currency transactions, while SFAS No. 80 provides the criteria necessary for futures contracts. Until additional financial accounting guidance is provided, to determine whether hedge accounting is appropriate for derivative instruments other than those specifically covered by these two statements, generally, analogy to the hedge criteria included in them would be necessary.

Synthetic Alteration or Settlement Accounting. Derivative instruments used to change the nature of one financial instrument to that of another financial instrument (such as an interest-rate swap changing floating-rate debt to fixed-rate debt) are accounted for in a manner consistent with the underlying asset or liability to which they are designated. As with interest rate swaps, any receivable/payable settlement is recorded as an adjustment to interest. The swap is not marked to market unless the related underlying asset or liability is carried at market value. If an interest-rate swap is terminated, any gain or loss is deferred and recognized as an adjustment to interest over the shorter of the remaining contract life of the swap or remaining life of the asset or liability.

Speculative Accounting. A derivative is assumed to be held for speculative purposes if hedge criteria are not met and the derivative is not being used to synthetically alter another financial instrument. All derivatives classified as speculative are marked to market with any realized or unrealized gains or losses included in current earnings.

Problems with Current Accounting

There are many concerns with the current accounting for derivative instruments. These concerns include lack of visibility on the financial statements, authoritative literature not explicitly covering all types of derivatives, inconsistency in the standards that do exist, and defects in the current hedge accounting model.

Lack of Visibility. Many derivative instruments do not require an initial cash investment and are therefore "off-balance-sheet." Unrealized changes in value are not recognized, and even some realized gains and losses are allowed to be deferred until the hedged item is sold or settled.

Several Instruments Not Explicitly Covered. Financial markets are continually designing new products and accountants must rely on analogy to the two existing standards or guidance provided by EITF. Even the EITF, however, has difficulty providing timely guidance on the quickly emerging derivative products.

Inconsistencies Between SFAS No. 52 and SFAS No. 80. Differences between these two statements have made difficult efforts to use analogy to resolve hedge accounting issues for other instruments. These differences include the following:

* SFAS No. 52 assesses risk on a transaction basis while SFAS No. 80 requires the risk condition must be present on an enterprise perspective.

* Correlation between the hedged position and changes in market value of the hedged item is an important criteria to be met to use hedge accounting according to SFAS No. 80 because cross-hedging is permitted. Correlation is generally not an issue when applying SFAS No. 52 since cross-hedging is only permitted when it is not practical or feasible to hedge in the identical currency.

* SFAS No. 80 allows for hedge accounting for both firm commitments and anticipated transactions if certain conditions are met. SFAS No. 52 allows only firm commitments to be hedged.

Defects of Hedge Accounting. In addition to hedging criteria being inconsistent, other concerns and criticisms exist regarding the current hedge accounting model. Gains and losses are often excluded from earnings even though they have been realized. And these deferred gains or losses that cannot be described as liabilities or assets are reported as such in the balance sheet.

For hedge accounting to be appropriate, risk assessment is required. That is, a company must demonstrate there was a net exposure to risk and acquiring a derivative would reduce that risk. There may be an inability for the company to objectively assess the enterprise risk reduction.

SFAS No. 80 requires a high correlation of the economic relationship between the item underlying the futures contract and the item being hedged. The statement does not define "high correlation" or provide guidance on how it should be measured. The correlation is supposed to be assessed regularly throughout the hedge period. But how the correlation is measured can result in significantly different outcomes. Should it be measured on a cumulative basis from date of acquisition or for each period individually?

Possible Alternative Accounting Methods

The increasing use of derivative instruments, coupled with significant losses recently suffered by a number of entities, has sparked concern from the SEC, banking regulators, and Congress. The FASB added the financial instruments project to its agenda in 1986 to develop broad standards for resolving accounting issues raised concerning financial instruments (including derivatives which the Board has been addressing since 1992). They have finished the phase on disclosures and are now focusing on the recognition and measurement phase of the project. The FASB has been considering various alternative approaches for the accounting for derivatives.

Pool Approach. All derivatives would be divided into two categories‹held for risk management (HRM) or trading. HRM derivatives would be further divided into those that are specifically designated to an identified exposure or combined into a pool based on risk involved such as interest rate, currency, or commodity risk.

All derivatives would be marked to market. Gains and losses on trading positions would be recognized in earnings. Realized and unrealized gains or losses on HRM derivatives specifically designated to an asset, liability, firm commitment, or anticipated transaction would be included in equity to the extent offsetting losses or gains exist in the identified item. Any excess gains or losses not offset would be recognized in earnings. The gains and losses included in equity would be removed when the identified item is disposed of. Unrealized gains or losses on pooled HRM derivatives would be recorded in equity. Realized gains and losses would be retained in equity, but only to the extent there are unrealized and unrecognized losses and gains on items in the same risk pool. This method could accommodate the hedger that manages its risk exposures in the aggregate as well as one that manages risk on a transaction-by-transaction basis.

Mark-to-Market Hedge Accounting. This approach would mark to market the hedged position as well as the derivative. For example, if long-term debt were being hedged by a swap, both the swap and the long-term debt would be written to fair value. This method would be applied only to designated hedged positions. This approach might result in two identical items (such as two long-term debts) being carried at different measurement bases because one item, but not the other, is being hedged.

Mark-to-Market Accounting. This is an approach the FASB tentatively adopted at one point. All freestanding derivatives would be classified as trading or other than trading. Changes in value for those instruments classified as trading would be recognized as assets or liabilities with the corresponding loss or gain recognized in earnings. Derivatives classified as other than trading would also be measured at fair value and recognized as assets or liabilities with the changes in value included as a component of stockholders' equity until realized. Realized gains and losses would be included in earnings. The hedge accounting model that required an accounting linkage between a derivative and an exposed risk would be eliminated. *

Arlette C. Wilson, PhD, CPA, is an associate professor and Sarah Stanwick, PhD, CPA, an assistant professor, both at Auburn University.

Editor:
Douglas R. Carmichael, PhD, CPA
Baruch College

DECEMBER 1995 / THE CPA JOURNAL