The FASB's New Standard on Derivative Financial Instruments

By Jan R. Williams and Tim V. Eaton

The latest statement from the FASB in its financial instrument project focuses on derivatives. Derivative financial instruments have been blamed, sometimes incorrectly, for huge losses by all manner of entities. The Board concluded that increased disclosures about derivatives were required because they are not well understood by investors, creditors, and others.

Headlines in the popular business press indicate the significance of derivative financial instruments in today's capital markets and the urgent need for improved accounting and disclosure requirements for these instruments. The Oct. 31, 1994, Business Week included several articles that discussed the staggering risks associated with derivative financial instruments. Business Week reports that publicly announced derivative losses for 1994 tripled from 1993 to almost $6 billion. Substantial losses have been incurred by entities such as Barings P.L.C., Orange County CA, Proctor and Gamble, and Glaxo. In this risky environment, a few companies have navigated the waters successfully. Business Week lists Merck, Coca Cola, and McDonald's as among the best examples to follow.

To address this area, at least temporarily, the FASB issued SFAS No. 119, "Disclosure About Derivative Financial Instruments and Fair Value of Financial Instruments." SFAS No. 119 applies to both business and not-for-profit organizations.

What Are They and How Do They Work?

Companies face a variety of risks that arise from interest rate and exchange market fluctuations. Several tools have been developed to mitigate a company's exposure to these risks. Included in this set of tools is a wide range of financial instruments. In 1986, FASB began a long-term project to address accounting for these innovative financial products, some of which are complex in nature and relatively new in the marketplace. First addressed in SFAS No. 105 in 1990, and later in SFAS No. 107, financial instruments are defined as cash, evidence of an ownership interest in an entity, or a contract that both‹

1. imposes on one entity a contractual obligation a) to deliver cash or another financial instrument to a second entity or b) to exchange other financial instruments on potentially unfavorable terms with the second entity; and

2. conveys to the second entity a contractual right a) to receive cash or another financial instrument from the first entity or b) to exchange other financial instruments on potentially favorable terms with the first entity.

SFAS No. 119, however, addresses derivative financial statements. A derivative financial instrument is a product whose value is derived, at least in part, from the value and characteristics of one or more underlying assets. The most popular underlying assets are commodities and securities; however, they can include many other exotic items from the price of porkbellies to almost any item that can be imagined.

Typically, derivative financial instruments are used to provide a hedge against interest rate changes and other business risks, as well as to increase income over that which is available from more conventional investments or to lower borrowing costs. While many different types of derivative instruments exist, SFAS No. 119 specifically mentions‹

* interest rate swaps

* interest rate caps

* forward interest rate agreements

* option contracts

* interest rate collars

* interest rate floors

* futures contracts

* fixed rate loan commitments

* commitments to purchase stocks or bonds

These instruments can be grouped into two broad categories: 1) an option type and 2) a forward type.

Option Type

Option-type derivative financial instruments help protect the holder of the instrument from exposure to potential losses that can result from movements in the price of an underlying asset while still supplying the holder with potential benefits that can result from favorable price movements in the opposite direction. Option-type instruments can be differentiated from forward-type instruments in that the holder of an option-type instrument must pay a premium to acquire the instrument. Specific products in the option-type instrument classification include option contracts, interest rate caps, interest rate floors, fixed rate loan commitments, note issuance facilities, and letters of credit. Each of the above items is discussed individually below.

Option Contracts. The FASB's discussion memorandum on the recognition and measurement of financial instruments defines an option contract as a contract that both‹

1. imposes on one entity‹the option writer‹an obligation to exchange other financial instruments with a second entity‹the option holder‹on potentially unfavorable terms if an event within the control of the holder occurs; and

2. conveys to the option holder a right to exchange other financial instruments with the option writer on potentially favorable terms if an event within the control of the holder occurs.

Thus, an option contract provides an option to purchase (known as a call option) or sell (known as a put option) the underlying asset at a fixed price for a specified period of time. The holder of an option contract has no obligation to buy or sell an underlying asset. The option writer, however, has no rights in such a contract. Option contracts are very popular derivative instruments and are currently available on stocks, stock indices, foreign currencies, debt instruments, and commodities.

Example: ABC Co. common stock is currently trading at $12 a share. An option contract that costs $10 is available to buy 100 shares of the stock for $14 a share. The option contract expires in three months. If the stock fails to exceed $14 a share, the holder will not exercise the option. But if the price rises above the option price, e.g., to $16 a share, the holder would choose to exercise the option and make a profit of $190 (100 X [16-14] - 10).

In addition to stock option contracts, other examples of underlying assets in option contracts can include bonds and loan commitments.

Interest Rate Caps. Another popular option-type derivative financial instrument is an interest rate cap. An interest rate cap is a contract that grants a company certain payments if the interest index exceeds the cap rate. Thus, the company has protection against higher interest rates. An interest rate cap provides a guarantee that the holder will pay the lower of the cap rate or the prevailing rate. If rates go down, however, the company receives nothing. Generally, interest rate caps are settled at some periodic date, e.g., quarterly or semi-annually.

Example: DEF Co. sold $1,000,000 of bonds at a variable interest rate equal to that of a specific index. Currently the underlying index has an interest rate of 12%. Previously DEF had purchased an interest rate cap of 10% on the $1,000,000 principal. The difference between the index rate and the cap rate or $20,000 ([12%-10%] X $1,000,000) is paid by the financial institution that sold the cap to DEF. DEF is limited to out-of-pocket interest charges of $100,000 (10% X $1,000,000). But if the underlying index fell to less than 10% then DEF would not receive any benefit from its purchase of the interest rate cap.

Interest Rate Floors. An interest rate floor closely resembles an interest rate cap but the former is more like a put option than a call option contract. The interest rate floor is of no value if the underlying index rate is above the floor interest rate. interest rate floors are designed to protect lenders from receiving less than a certain rate. The lender will receive payments if the underlying interest index falls below the floor rate. An interest rate floor provides a guarantee that a lender will receive the higher of the prevailing index rate or the floor rate. An interest rate floor can be thought of as a series of conditional receivables for the holder and as a series of conditional payables for the counter party.

Example: GHI Co. lends $1,000,000 at a variable interest rate equal to that of a specific index. Currently, the underlying index rate is equal to 8%. GHI had previously purchased an interest rate floor of 10% on the $1,000,000 principal. The 2% difference between the index rate and the floor rate would be paid by the financial institution that sold the floor to GHI. But if the underlying index rate was above 10%, GHI would not receive any value from its purchase of the interest rate floor.

Note Issuance Facilities. A note issuance facility is a financial tool used by a borrower to issue short-term securities in the Euromarkets. Note issuance facilities can be differentiated from other short-term financing measures, such as commercial paper, by the underwriting commitment component. Under a note issuance facility, if the borrower is unable to sell the securities they will be purchased by commercial banks. The commercial bank that provides the underwriting commitment is financially obligated to purchase the paper that does not sell. Despite this obligation, banks still like note issuance facilities because they diversify the risk that would normally be present under a loan among several institutions.

Letters of Credit. A letter of credit is a financial instrument that can be used to satisfy initial margin requirements in financial transactions between two parties. The letter of credit provides assurance the trader has adequate funds to trade. The bank is also guaranteeing it will make up any financial shortfall on behalf of the trader if necessary. Issuing a letter of credit provides the trading party a substantial benefit of keeping its cash. Thus, the letter of credit effectively reduces the trading party's interest costs.

Forward Type

A forward-type derivative financial instrument is a contract in which one party agrees to buy or sell a particular asset at a specific time in the future for a specified price. Unlike an option-type contract, a premium is not required to enter into a forward-type contract. It effectively costs the contracting parties nothing to enter into such a contract. But in a forward-type contract, the parties have an obligation to make an exchange at some fixed date in the future. Specific items included in the forward-type category of derivative financial instruments include forward interest rate agreements, futures contracts, interest rate swaps, interest rate collars, and commitments to purchase stock or bonds.

Forward Interest Rate Agreement. A forward interest rate agreement is a derivative financial instrument designed to serve as a hedge against interest rate fluctuations. In a forward interest rate contract, two companies agree to a fixed interest rate in the future. If the actual rate is different than the fixed rate, one party will pay the other party the present value of the difference between the interest cash flows. Essentially the two companies are gambling on which way the interest rate of an index will change. These contracts are not traded on an established exchange but rather are private contracts between parties.

Example: JKL Co. sells MNO Co. a forward interest rate agreement at an interest rate of 10% that will apply to a $100,000 principal. The time period is one year with quarterly settlement dates. The reference rate is based upon the specific index, e.g., the LIBOR rate. At the first settlement date, the LIBOR rate is greater than 10%. Therefore, JKL will have to pay MNO a value equal to the present value of the difference between the cash flows of the LIBOR rate and the 10% rate.

Futures Contracts. A futures contract provides protection against changes in the market value of an item. In a futures contract, two parties agree to buy or sell a specific item in the future at a fixed price. Unlike forward interest rate agreements, futures contracts are traded on established exchanges, such as the Chicago Mercantile Exchange. The exchange generally standardizes certain aspects of the contract to facilitate trades between parties that do not know each other. Items often standardized include quantity, quality, and delivery terms. Of course, price is not standardized but rather is negotiated. Some of the most actively traded futures contracts in the U.S. are U.S. Treasury bonds, crude oil, Eurodollars, corn, and gold.

Example: On April 5, 1995 PQR Co. contracts to buy 200 ounces of gold at $400 per ounce for September 1995 delivery. The total contract price is $80,000. If on April 6 gold is trading at $405 per ounce, PQR has effectively made $1,000 (200 X [405 - 400]). But if the price had dropped to $390 per ounce, PQR would have lost $2,000 (200 X [400 - 390]).

Interest Rate Swaps. Interest rate swaps are essentially a series of forward contracts. An interest rate swap is an agreement where one party (company A) contracts to pay another party (company B) a predetermined fixed interest rate for a fixed period of time. Simultaneously, company B contracts to pay company A variable interest rate over the same fixed period of time. Thus, an interest rate swap allows two companies to exchange interest rates as a hedge against fluctuating interest rates. One bets rates will go up, while the other bets they are going down. Settlement occurs on each interest payment date. On this date, one company sends the difference in the two interest payments to the other company. Principal payments are not made by either party. The principal amount is just used as a basis for determining the subsequent interest payments.

Example: STU Co. agrees to make payments to VWX Co. at a fixed interest rate of 8% for the next two years. VWX agrees to make payments to STU at a variable rate of interest equal to a specific index + 1%. If the index rate goes up, VWX will make payments to STU. But if the index rate goes down, STU will make payments to VWX.

Interest Rate Collar. An interest rate collar is a combination of an interest rate cap and an interest rate floor. This type of contract functions as if the borrower is buying an interest rate cap and is selling an interest rate floor to the financial institution. The cap and the floor, however, effectively wash each other out. Unlike an interest rate cap or interest rate floor, interest rate collars do not require a premium payment.

Example: YZ Co. contracts an interest rate collar with a financial institution for $1,000,000. The cap rate on the collar is 10%. The floor rate is 8%. The term of the collar is three years. If the index rate rises above 10%, YZ benefits. But if the index rate falls below 8%, the financial institution benefits.

SFAS No. 119

Derivative financial instruments, for purposes of SFAS No. 119, exclude all on-balance-sheet receivables and payables including those that derive their values or contractually required cash flows from the price of some other security or index, such as mortgage-backed securities, interest-only and principal-only obligations, and indexed debt instruments. It also excludes optional features embedded within an on-balance-sheet receivable or payable, such as the conversion feature and call provisions embedded in convertible bonds.

Like SFAS No. 105 and SFAS No. 107, SFAS No. 119 is a "disclosure only" pronouncement. That is, it specifies additional disclosure requirements but does not require different recognition standards for derivative financial instruments. The FASB determined that more disclosure about derivative financial instruments is needed because they are increasingly important in business and finance, but are not well understood by investors, creditors, and others. Information is specifically needed about the purposes for which derivative financial instruments are held or issued.

Disclosure Requirements

Information about the amounts, nature, and terms of many derivative financial instruments is already required because they come under the scope of SFAS No. 105. Other derivative financial instruments are not included in the scope of SFAS No. 105 because they do not have off-balance-sheet risk of accounting loss. For options held and other derivative financial instruments not included in the scope of SFAS No. 105, the disclosures specified in the accompanying disclosure checklist are called for by in SFAS No. 119.

Certain disclosures are required for all financial instruments. The face or contract amount (or the notional principal amount if there is no face or contract amount) must be disclosed for all financial instruments by category. Also, the nature and terms of the instruments must be disclosed, including a discussion of the credit and market risk of the instruments, their cash requirements, and the related accounting policy.

As indicated by the major headings in the disclosure checklist, SFAS No. 119 requires separate disclosure of information about derivative financial instruments held for trading purposes and for purposes other than trading. In providing background material for SFAS No. 119, the FASB indicates that one factor that contributes to the confusion and concern about derivative financial instruments is that financial statements omit or inadequately explain why entities hold or issue various types of derivatives. The definition of "trading purposes" included in SFAS No. 119 includes dealing and other trading activities. They are measured at fair value with gains and losses recognized in earnings. All other activities are considered to be for purposes other than trading.

Categories. An important distinction in the disclosures required by SFAS No. 119 is information by category of financial instrument. Category of financial instruments refers to class of financial instrument, business activity, risk, or other category that is consistent with the management of those instruments. If disaggregation of financial instruments is other than by class, SFAS No. 119 requires the entity to describe for each category the classes of financial instruments included in that category.

Used for Hedging. SFAS No. 119 specifies additional disclosures for derivative financial instruments held or issued for the purposes of hedging anticipated transactions. These disclosures include a description of the anticipated transactions whose risks are hedged, including the period of time until the anticipated transactions are expected to occur, a description of the classes of derivative financial instruments used to hedge the anticipated transactions, the amount of hedging gains and losses explicitly deferred, and a description of the transactions or other events that result in the recognition of gain or loss deferred by hedge accounting.

Optional Disclosures. The final section of the accompanying disclosure checklist includes optional recommended disclosures. These optional disclosures include disclosing quantitative information about interest rate, foreign exchange, commodity price, or other risks, as well as information about the risks of other financial instruments or nonfinancial assets and liabilities to which the instruments are related by a disclosed risk management strategy. Appropriate ways of reporting this information are expected to differ among entities and will likely evolve over time. SFAS No. 119 suggests the following possibilities for disclosing this information:

* Disclosing more details about current positions and activities during the period.

* Disclosing hypothetical effects on equity, or on annual income, of several possible changes in market prices.

* Presenting a gap analysis of interest rate pricing or maturity dates.

* Disclosing the duration of the financial instruments.

* Disclosing the entity's value at risk from derivative financial instruments and from other positions at the end of the reporting period and the largest value at risk level during the year.

Effective Date and Transition

SFAS No. 119 is effective for financial statements issued for fiscal years ending after December 15, 1994, except for entities with less than $150 million in total assets in the current statement of financial condition. For those entities, the effective date is delayed one year.

Earlier application is encouraged. SFAS No. 119 is not required to be applied to complete interim financial statements in the initial year of application.

Required disclosures that have not been previously reported are not required to be included in financial statements presented for comparative purposes for fiscal years ending before the applicable effective date of the statement. For all subsequent fiscal years, the information required for derivative financial instruments held or issued for trading purposes shall be included for each year for which an income statement is presented for comparative purposes. All other information required by SFAS No. 119 would be required for each year for which a statement of financial position is presented for comparative purposes. *

Jan R. Williams, PhD, CPA, is the Ernst & Young Professor and Tim V. Eaton, CPA, is a doctoral student at the University of Tennessee‹Knoxville.

OCTOBER 1995 / THE CPA JOURNAL

SFAS NO. 119 CHECKLIST

Are The Following Disclosures About Derivative Financial Instruments Included In The Financial Statements?

For all financial instruments Yes No N/A

The face or contract amount (or notional principal

amount if there is no face or contract amount). * * *

The nature and terms, including at least a discussion

of 1) the credit and market risk of the instruments, 2)

the cash requirement of those instruments, and 3) the

related accounting policy. * * *

For derivative financial instruments held or issued

for trading purposes

The average and related end-of-period fair value,

distinguishing between assets and liabilities. * * *

The net gains or losses (i.e, net trading

revenues) arising from derivative financial instrument

trading activities, disaggregated by class, business

activity, risk, or other category. * * *

The location where the net gains and losses are

reported in the income statement. * * *

If the disaggregation is other than by class, for each

category the class of derivative financial instruments

and nonfinancial assets and liabilities from which net

trading gains and losses arose. * * *

For derivative financial instruments held or issued for

purposes other than trading

A description of the entity's objectives for holding

or issuing the derivative financial instruments. * * *

The context for understanding and strategy

for achieving the above objectives, including the class of financial

instruments used. * * *

A description of how the derivative financial instruments and related

gains and losses are reported in the financial statements, including

the policies for recognizing and measuring the derivative

financial instruments. * * *

The location where the derivative financial instruments and related

gains and losses are reported in the financial statements. * * *

For derivative financial instruments held or issued

for the purpose of hedging anticipated transactions

A description of the anticipated transactions whose

risks are hedged with derivative financial instruments

(including the period of time until the anticipated transactions

are expected to occur). * * *

A description of the classes of derivative financial instruments

used to hedge the anticipated transactions. * * *

The amount of the hedging gains and losses that are

explicitly deferred. * * *

A description of the transactions or other events that result in

the recognition in income of gains or losses deferred by hedge

accounting. * * *

Optional recommended disclosures

Quantitative information about interest rate, foreign exchange,

commodity price, or other market risks. * * *

Information about the risks of other financial instruments or

nonfinancial assets and liabilities to which the derivative financial

instruments are related by a management risk or other strategy. * * *

OCTOBER 1995 / THE CPA JOURNAL

EXAMPLES OF FOOTNOTE DISCLOSURE

Investment related derivatives: Sears, Roebuck and Co.

The Company generally enters into interest rate swap agreements for investment purposes to change the interest rate characteristics of existing assets to match the corresponding liabilities. Gross unrealized gains and losses on open swap positions were $2 and $15 million at Dec. 31, 1994 and $12 and $10 million at Dec. 31, 1993. For pay floating rate, receive fixed rate swaps, the Company paid a weighted average rate of 4.3% and received a weighted average rate of 5.9% in 1994. For pay fixed rate, receive floating rate swaps, the Company paid a weighted average rate of 7.0% and received a weighted average rate of 5.4% in 1994. At December 31, 1994, interest rate swap agreements with notional amounts of $35, $298 and $85 million had maturity dates within one year, from two to five years and greater than five years, respectively.

Foreign currency forward contracts:
The Goodyear Tire & Rubber Co.

In order to reduce the impact of changes in foreign exchange rates on consolidated results of operations and future foreign currency denominated cash flows, the Company was a party to various forward exchange contracts at December 31, 1994 and 1993. These contracts reduce exposure to currency movements affecting existing foreign currency denominated assets, liabilities, and firm commitments resulting primarily from trade receivables and payables, equipment acquisitions and intercompany loans. The contract durations match the duration of the currency positions. The future value of these contracts and the related currency positions are subject to offsetting market risk resulting from foreign currency exchange rate volatility. The carrying amounts of these contracts totaled $.8 million and $6.7 million at December 31, 1994 and 1993, respectively, and were recorded in both current and long-term Accounts and notes receivable on the Consolidated Balance Sheet. *

OCTOBER 1995 / THE CPA JOURNAL