Derivative financial instruments, puts, calls, futures, et al, are in the news and people are concerned. The FASB has issued an exposure draft that proposes additional disclosures for these financial instruments in financial statements for this year end.

Swaps, forwards, futures, puts, calls, swaptions, caps, floors, collars, captions--the rapid growth of these useful but complex and poorly understood financial instruments, known collectively as derivatives, has propelled them into the spotlight as one of today's hottest financial topics. Accountants--prepares, auditors, and standard-setters--are struggling to keep pace with this innovative and increasingly important market.

Definition

Derivative financial instruments are financial contracts whose values depend on--and are derived from--the value of an underlying asset, reference rate, or index. Derivatives exist as both exchange-traded contracts and privately negotiated contracts between a dealer and an end-user. The exchanges are located in Chicago, New York, London, Tokyo, and other financial centers. Most dealers are banks and securities firms, although a few insurance companies and industrial corporations also are dealers. End-users are commercial and industrial corporations, financial institutions, governmental entities, not-for-profit organizations, and institutional investors.

Types of Derivatives

So many derivatives have been created over the last 10 years that it is hard to categorize them. At a basic level, derivative financial instruments can be classified into two groups: forwards and options.

Forward Contracts. A forward contract obligates one party to buy and the other to sell a specific asset at a future date for a fixed price. Forward contracts provide benefits of favorable movements in the price of the underlying asset, rate, or index and exposure to losses from unfavorable price movements, generally with no payments at the inception of the contract.

For example, a U.S. company building a manufacturing facility in Japan with payment due one year from now may wish to protect itself from the risk of a rise in the price of the yen relative to the dollar. The company can do this by entering into a forward contract by agreeing to buy the necessary yen one year from now at a price negotiated today. The company will be pleased it entered into the forward contract if the price of the yen rises relative to the U.S. dollar, or displeased if the price of yen falls relative to the U.S. dollar. Either way, it will have effectively locked in the price of its new facility in dollar terms. That economic result can also be achieved with various other kinds of derivatives that resemble forward contracts, for example, futures and swap contracts.

Options. The other basic type of derivative financial instrument is known as an option. Option contracts generally require the holder to pay a premium to the issuer at the inception of the contract in exchange for the ability to benefit from favorable movements in the price of the underlying asset, rate, or index with no exposure to risk from unfavorable price movements other than the loss of the premium paid.

One example of an option contract is a call option on common stock. A call option entitles the holder to purchase the underlying stock from the issuer of the option at a specified price during a specified period of time in exchange for the payment of a premium. After the inception of the contract, the value of such an option will depend upon the price of the underlying asset. For example, if the terms of a call option specify the holder can purchase shares of General Motors stock for $50 per share (known as the strike price), the more the market price of General Motors stock exceeds $50, the greater the value of the option. On the other hand, if the market price of General Motors stock falls below $50, the option will end up worthless. That set of economic results can be achieved with various other derivatives that resemble options.

Use of Derivatives

One common use for derivative financial instruments is managing exposures arising from a financial institution's asset and liability mix. For instance, in the current environment many bank customers want to borrow at low variable rates and deposit at high fixed rates. As a result, as interest rates fall, the income a bank receives on its variable-rate assets falls faster than its expense on its fixed-rate liabilities to investors. The opposite occurs if interest rates rise. To alter this so called "asset sensitivity" and protect against a fall in interest rates, some banks enter into swap contracts under which they agree to receive a fixed interest rate and pay a floating rate.

A swap contract works like a series of forward contracts, each covering a specified period. At the end of each period, the parties to the swap contract settle up based on what has happened to interest rates during the period. For example, a bank uncomfortable with having variable-rate- loan assets and fixed-rate liabilities might enter into a swap in which it "pays" the floating rate and "receives" the fixed rate, applied quarterly to a "notional principal" amount. The bank makes or receives a net payment depending on which way interest rates went during the period. This counteracts the effects of the rate change on its interest income from variable rate loans.

Size and Complexity Attract Attention

The complex nature of derivative financial instruments and the sheer size of the derivatives market has attracted attention in almost every sector of the financial system. In terms of total "notional principal amounts," derivative financial instruments outstanding worldwide were recently estimated to be about $16 trillion. However, that huge number makes derivatives look more important--and much riskier--than they really are. In most derivatives, the "notional amount"--the principal- like amount used to calculate the swap, option, and forward contract payments--never changes hands.

Market participants generally view derivatives as useful products that have allowed businesses to become more competitive, investors to achieve superior returns, and governments to cut financing costs by managing financial risks in ways they previously could not. But others worry that derivative financial instruments could cause sudden losses that could trigger a financial crisis.

In recent months, the U.S. Congress, the Office of the Comptroller of the Currency, the Group of Thirty, the Commodity Futures Trading Commission, and several other groups have completed studies on derivative financial instruments. In addition, the Association for Investment Management and Research, the AICPA's Special Committee on Financial Reporting, the Federal Reserve Board, the Wall Street Journal, Business Week, Fortune, Newsweek, and Time, as well as others, have published reports or articles commenting on derivative financial instruments. Whether they viewed derivatives as useful risk management tools or potentially dangerous financial products, many of those studies, reports, and articles called for improved reporting of information about derivative activities. When the FASB asked in November 1993 whether it should take any action to improve disclosures about derivatives, some doubted the need for FASB action, but the SEC, the General Accounting Office, J.P. Morgan, and Arthur Andersen & Co. were among many who urged the FASB to improve disclosure standards.

FASB Project

After considering those calls for action, on December 8, 1993, the FASB agreed to undertake a limited-scope project on disclosures about derivative financial instruments. The project is an offshoot of a broad project on accounting and disclosure standards for financial instruments that was added to the Board's agenda in 1986. Following the decision to address reporting about derivative activities, the Board held an open meeting with interested parties to hear constituents' ideas on what disclosures needed to be improved and how those improvements might be accomplished.

The Board established general objectives for the proposed standard, which are the same as the objectives used in earlier projects on disclosures about financial instruments. Those objectives are to describe items recognized or not recognized in the financial statements, to provide appropriate measures of financial assets and financial liabilities, and to help users assess the risks and potentials that are present and the effects on the entity of different possible outcomes. The Board also established more specific objectives for this proposed standard:

* Enhance disclosure about derivative financial instruments;

* Make technical improvements to the disclosures about fair value of financial instruments; and

* Accomplish those things in time to improve 1994 year-end financial reporting.

The Exposure Draft

The exposure draft, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments, pursues those objectives with some new disclosures about derivative financial instruments and some amendments to FASB Statement No. 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, and No. 107, Disclosures about Fair Value of Financial Instruments.

The Board is limiting the exposure draft scope to derivative financial instruments--futures, forward, swap, or option contracts, or other financial instruments with similar characteristics. This scope builds on the definition of a financial instrument in Statements No. 105 and No. 107. That definition excludes contracts that either require the exchange of a financial instrument for a nonfinancial commodity or permit settlement of an obligation by the delivery of a nonfinancial commodity because those contracts involve the required or optional future exchange of an item that is not a financial instrument. The definition, however, includes some commodity-based contracts, for example, most oil swaps, because they must be settled in cash.

Information about the amounts, nature, and terms of derivative financial instruments with off-balance-sheet risk of accounting loss is already required to be disclosed under Statement No. 105. However, similar information about derivative financial instruments not subject to off- balance sheet risk of accounting loss, such as options held, is not required. This sometimes leaves the financial statement user with an incomplete picture of an enterprise's derivative position. This proposed standard would complete the picture by requiring information about the amounts, nature, and terms of derivative financial instruments not subject to Statement No. 105.

Several interested parties commented that what is important about derivatives varies depending on the purposes for which they are used. This proposed standard would require that disclosures distinguish between 1) derivative financial instruments held or issued for trading purposes (including dealing or other activities reported in a trading account and measured at fair value) and 2) derivative financial instruments held or issued for purposes other than trading.

Trading Derivatives

For derivative financial instruments held or issued for the purpose of trading, the average, maximum, and minimum aggregate fair values of each class of derivative financial instrument assets and liabilities would be disclosed. Disclosure of fair value of derivative financial instruments at the end of the reporting period is already required under Statement No. 107, however, because trading positions typically fluctuate and the ending balance may not be representative of the balances and related risks assumed during the period. Therefore, average, maximum, and minimum balances should provide investors and creditors with more complete information.

Net gains or losses arising from derivative financial instrument trading activities during the reporting period also would be disclosed, along with how those net trading gains or losses are reported in the income statement. For example, a bank that conducts derivative trading activities might disclose that realized and unrealized gains and losses from derivative trading activities are included in non-interest income as trading account profits, foreign exchange trading profits, and equity securities gains and report the amount of net gains included in each category.

Other Derivatives

For derivative financial instruments held for purposes other than trading, the exposure draft would require disclosure of objectives for holding or issuing the derivative financial instruments, the context needed to understand those objectives, and strategies for achieving those objectives. Those qualitative disclosures should help investors and creditors understand what the entity is trying to accomplish with its derivative financial instruments. For example, an entity with significant export sales might disclose that 1) its objective in holding derivative financial instruments is to keep its foreign exchange rate within defined limits, the context being that the dollar-equivalent price of anticipated cash flows resulting from the sale of products to international customers will be adversely affected if the dollar strengthens and 2) its primary strategy for achieving that objective is to purchase currency options and enter into forward exchange contracts.

The exposure draft would also require a description of how derivative financial instruments held for purposes other than trading are reported in the financial statements, including the policies for recognizing and measuring the derivative financial instruments held or issued. For example, the entity described above that purchases currency options and enters into forward exchange contracts might disclose that purchased currency options are recorded in the balance sheet at their intrinsic value at the current spot rate, with any gains deferred as other liabilities and the premium paid amortized to expense over the life of the option. In addition, the entity might disclose that gains and losses on forward exchange contracts undertaken to hedge firm commitments are recognized as part of the cost of the underlying transaction.

For derivative financial instruments designated as a part of an anticipatory hedging strategy (both for firm commitments and for forecasted transactions for which there is no firm commitment), the exposure draft would require a description of the types of transactions and risks involved, the amount of hedging gains and losses explicitly deferred, and a description of the transactions or other events that result in the recognition in income of those gains or losses deferred by hedge accounting. The entity described above might disclose the amount of deferred gains and losses on foreign currency options and forward exchange contracts and state that those deferred gains and losses will be included in income when the operating revenues are recognized.

Entities are also encouraged to disclose quantitative information assessing how well their derivative financial instrument strategies worked. The idea is to report the sort of information that management already uses to assess its strategies. Possible ways of disclosing such quantitative information include a) reporting more details by type of instrument or type of risk, b) reporting the hypothetical effects on equity or income of several possible changes in market prices, c) reporting a "gap analysis" of interest rate repricing or maturity dates, d) reporting the duration of the financial instruments, or e) reporting the entity's value at risk from derivative financial instruments. In order to present a more balanced view of an entity's risk positions, the proposed standard also encourages disclosure of similar information about the risks of other financial instruments or nonfinancial assets and liabilities to which the derivative financial instruments are related by a risk management or other strategy.

This proposed standard also amends Statement No. 107 to require that a) disclosures in accordance with Statement No. 107 be made either in the body of the financial statements or in one location in the accompanying notes, b) fair values disclosed be presented together with the related carrying amounts in a form that makes clear whether the fair value and carrying amount are favorable (assets) or unfavorable (liabilities), c) the required disclosures be made in a form that distinguishes between financial instruments held or issued for trading purposes or purposes other than trading, d) disclosure of the fair value of a derivative financial instrument not combine, aggregate, or net the fair value of separate financial instruments of a different class or within a single class except to the extent that the offsetting of carrying amounts is permitted under FASB Interpretation No. 39, Offsetting of Amounts Related to Certain Contracts.

This proposed standard applies to all entities that hold or issue derivative financial instruments and would be effective 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 position, who get a one-year postponement.

The exposure draft is available for public comment until July 1, 1994. The Board is interested in comments on all aspects, especially the 10 issues highlighted in the Notice for Recipients accompanying the exposure draft. The Board is also seeking any examples of good disclosure now being made voluntarily. Starting in July, the Board will reconsider each of those issues and will try to complete a final statement later this year.

McDONALD'S FRANCHISEES USE SWAPS

Two of the primary lenders to McDonald's U.S. franchisees use swaps to better accommodate franchisees' needs for financing. One of those lenders had accumulated a large portfolio of fixed-rate loans to the franchisees. It sold participations in those loans in the secondary market to investors who were willing to buy a portion of the portfolio if they could receive a floating-rate return. Interest rate swaps were used to convert the fixed interest payment stream on the participations to the floating-rate that investors desired. This freed its lending capacity so that the bank could make additional loans to franchisees. Another lender manages a special-purpose corporation that issues commercial paper to fund franchisee loans. It uses interest rate swaps to offer McDonald's franchisees either floating- or fixed-rate funding. (Adapted with permission from the Group of Thirty Global Derivatives Study, Derivatives: Practice and Principles, July 1993.)

A HEDGE THAT MISSED

Fear of a major financial disaster has been fueled by several incidents in which companies suffered significant losses resulting from misdirected or poorly controlled derivative activities. For example, the German company Metallgesellschaft A.G. narrowly avoided bankruptcy in late 1993 after it lost nearly $1 billion in oil futures and forwards. Reportedly, the company thought it had hedged its long-term forward contracts to supply American customers with petroleum products at fixed prices by entering into near-term futures contracts to purchase oil. When near-term oil prices plunged further than long-term contract prices after OPEC failed to reach an agreement limiting exports, unrealized profits on its long-term forward contracts with customers apparently were swamped by the cash drain from its losses on the near-term futures contracts.

PROTECTING THE FINANCIAL SYSTEM FROM DERIVATIVE RISK

In May 1994, the U.S. General Accounting Office (GAO) issued a report, Financial Derivatives--Actions Needed to Protect the Financial System (The Report). GAO's objectives for studying the complex world of derivatives were to determine--

* what risks derivatives might pose to individual firms and to the financial system and how firms and regulators were attempting to control these risks,

* whether gaps and inconsistencies existed in U.S. regulation of derivatives,

* whether existing accounting rules resulted in financial reports that provided market participants and investors adequate information about firms' use of derivatives, and

* what the implications of the international use of derivatives were for U.S. regulation.

The GAO survey of practices and the need for regulation focused primarily on the over-the-counter (OTC) dealers and traders of derivatives products. According to the GAO, it is in this market that derivatives activity is concentrated among a relatively small number of dealers that are extensively linked to one another, end-users, and the exchange-traded markets.

The Report says the best available data indicate that the total volume of worldwide derivatives outstanding as of year-end 1992 was at least $12.1 trillion in terms of the notional, or principal, amount of derivatives contracts. The notional amount, however, is not a meaningful measure of risk. According to GAO, the actual amount at risk varies based on the type of product and the type of risk--credit, market, legal, and operational. Based upon GAO's survey of 14 major U.S. financial institutions, their gross credit risk--possibility of loss from a counterparty's failure to meet its financial obligations--at the end of 1992 was $114 billion on a notional amount of $6.5 trillion or 1.8%.

Other kinds of risk, says the Report, are more difficult to measure than credit risk. GAO defines these risks as follows: 1) market risk (adverse movements in the price of a financial asset or commodity), 2) legal risk (an action by a court or by a regulatory or legislative body that could invalidate a financial contract), and 3) operations risk (inadequate controls, deficient procedures, human error, system failure, or fraud). Major losses at one firm were blamed on poor operations controls.

The GAO concluded the following:

* There are no comprehensive industry or federal regulatory requirements to ensure that U.S. OTC derivatives dealers followed good risk-management practices. Regulators have issued guidelines for certain bank dealers, and both regulators and market participants said improvements in risk-management systems have already been made as a result of these recommendations and guidelines. But no regulatory mechanism exists to bring all major OTC dealers into compliance with them.

* New participants entering the market may not be as knowledgeable or control conscious as present dealers and may take on unwarranted risk to gain market share.

* Accounting standards for derivatives, particularly those used for hedging purposes by end-users, are incomplete and inconsistent and have not kept pace with business practices. The GAO acknowledges the work FASB has done so far and the proposal for expanded disclosures. It feels however, progress toward the ultimate objective of measurement of these instruments has been slow. It also believes market value accounting should be FASB's ultimate objective.

As a preface to its recommendations, GAO states that because of the interrelationships among OTC dealers and markets worldwide, any crisis involving derivatives will be global. Derivatives activities in foreign countries (which tend to be concentrated in 11 countries) are subject to varying degrees of regulation.

GAO's Recommendations

To Congress. Require federal regulation of the safety and soundness of all major U.S. OTC derivatives dealers. The primary need is to bring insurance company and securities firm affiliates under the purview of one or more of the existing federal regulators. Congress should also systematically address the need to revamp and modernize the entire U.S. financial regulatory system.

To the Regulators. Strengthen and make more uniform existing regulatory requirements OTC derivatives dealers are presently subject to including such things as requiring independent, knowledgeable audit committees and internal control reporting.

To the FASB. Proceed with the finalization of the proposed statement for additional disclosures and move towards completion of final guidance on accounting rules for derivative products including measurement and additional disclosures. This latter step should include consideration of a market value accounting model.

To the SEC. Ensure that SEC registrants that are major end users of complex derivative products establish and implement corporate requirements for independent, knowledgeable audit committees and public reporting on internal controls.

The Report strongly reflects GAO's point of view that a industry-wide financial crisis can be avoided by a high level of regulatory activity and effective corporate governance and oversight by OTC dealers through the use of independent audit committees and external reporting on the effectiveness of internal controls.

Greenspan Disagrees

Alan Greenspan, chairman of the Federal Reserve Board, in testimony before the House Telecommunications and Finance subcommittee of the Energy and Commerce Committee, said there was "negligible" risk that the rapidly growing market for financial derivatives might someday require a taxpayer bailout and therefore no need for new legislation to supervise derivatives. Greenspan is quoted as saying, "In a more important sense, today's markets and firms, especially those firms that deal in derivatives, are heavily regulated by private counterparties, who, for self-protection, insist that dealers maintain adequate capital and liquidity."

Halsey G. Bullen is a project manager at the Financial Accounting Standards Board.

Laura J. Porterfield, is a post-graduate intern at the Financial Accounting Standards Board.