Derivative wars: a battle has been brewing on the accounting for derivatives--pitting corporate America's finance executives against regulators/standard-setters. The growth of standardized, exchange-traded derivative contracts is causing a greater sense of urgency for resolution.

In a prescient 1995 speech, Robert Herz, then a future Financial Accounting Standards Board (FASB) chairman, joked that the word "derivative" is Spanish for "evil" and foretold the rise of "derivatives wars," where practitioners and regulators would clash along varied battle fronts, with each group arguing it is trying to do the right thing.

Now, in 2007, we have a situation where standard-setters want financial contracts to be marked to market while management teams of public firms seek to avoid reporting volatile earnings. Those wars have begun.

Accounting for derivative contracts is arguably the biggest financial reporting controversy today as derivatives and restatements are putting dozens of well-known U.S. firms on the front pages of the business press.

What's raising the stakes is the explosive growth in these financial tools. By one estimate, the global value of derivative contracts is four times that of all stocks and bonds combined. And, as if to underscore the importance of those numbers, it's recently been reported that the venerable New York Stock Exchange has announced plans to become a player in derivatives trading.

This article frames accounting issues concerning derivative contracts and offers three historical case studies suggesting that the derivative wars can be settled in a peaceful manner.

Basically, a derivative confers the right or obligation to exchange something at a future date at an agreed-upon price. This is a good thing. Contracts permit organizations to hedge fickle interest rates, commodity prices or costs of foreign currency, while giving others the chance to make trading profits. Treasurers now know how to hedge without exposing firms to the leveraged, speculative bets that garnered so much attention in the early 1990s.

Standard-setters argue that derivatives represent assets and liabilities that should be shown on the balance sheet at fair value. They point out that readily-available market prices for commodities, foreign exchange and credit make marking contracts to market rather easy.

Controllers, on the other hand, worry that when the exposure to be hedged is a future cash flow stream, it can be a challenge to establish a perfect hedge. Changes in derivative contract values may not exactly offset movements in the underlying exposure. A well-constructed contract may provide an effective economic hedge and still cause an unpredictable gain or loss at interim measurement dates. Firms that seek to report smooth earnings trajectories want to avoid recognizing these pesky differences.

Accounting to the Rescue

Financial accounting helps outsiders project the amount, timing and certainty of a firm's future cash flows. How the firm reports its periodic results can affect its reputation with investors in the capital markets.

Many practitioners share the view of Jerome York, the former CFO of Chrysler Corp. and IBM Corp., who said that financial markets may be efficient, but they hate volatility and surprises. Volatile income statements can be perceived as blemishes when outsiders evaluate a firm's earning power. Reporting smooth, predictable earnings, the theory goes, engenders investor enthusiasm and boosts a company's security prices. To this end, some management teams attempt to recognize gains and losses in such a manner to smooth earnings and avoid a decline.

Standard-setters worry that active smoothing confounds investors' ability to make inter-firm comparisons. Many regulators want reported results to alert outsiders to the presence of blips on a corporate earnings trajectory.

Accounting Treatment Evolving

This tension traces back to the late 1930s, when some firms began to use a Last-In, First-Out (LIFO) cost flow assumption to minimize taxable income. This accounting treatment matches revenues with the cost of the most recently acquired inventory. Cost of sales, and thus reported income, can depend on recent purchasing activity.

The University of Michigan's William Paton, a de facto accounting standard-setter, charged that LIFO represents a device for equalizing earnings, to avoid showing income fluctuations that are inherent in certain business fields. He said it was not good accounting for, say, a copper company exposed to volatile metal prices to issue reports that made it appear to have the stable earning power of, say, an AT & T.

Since that time, standard-setters and statement preparers have found a way to work through such controversy. This collaboration can make one optimistic about the prospects of resolving the derivative wars, especially in that history seems to be paving the way.

The rise of multinationals after World War II forced accountants to cope with foreign currency accounting. Currency translation seeks to express transactions denominated in other currencies as if they had been initially recorded in dollars. The problem is that many transactions remain open when the firm issues financial statements.

Bookkeepers typically select among three exchange rates: the rate in effect when a transaction began, the rate as of the most recent balance sheet or an average for balances flowing through an income statement. Since these values rarely coincide, accountants need a way to balance the books.

In the 1970s, the world economy moved to a system of floating exchange rates, where market forces continually revise the dollar's value in other currencies. FASB issued Statement 8--requiring the balancing translation adjustment to be included in the income statement--and managers revolted.

Currency markets could determine a company's reported income for the year. FASB reconsidered and issued Statement 52, which permitted recording the translation adjustment as a separate component of shareholders' equity, outside of the income statement.

Pension plans also sprouted after World War II to guarantee payments to retirees based on wages and years of service. Many compounding periods in the liability calculation made interim pension expense estimates sensitive to discount rates selected, and actual investment returns rarely matched accountants' projections. Standard-setters worried about the reliability of pension accruals.

A fractious dialogue between managers and regulators started in 1948, with many attempts to improve disclosure, and an interesting compromise emerged with issuance of Statement 87 in 1985. The standard permitted employers to spread changes in actuarial and investment projections over many years, once again using shareholders' equity as a holding tank. Interim adjustments did not flow through the income statement.

A third case study of how regulators and managers learned to work together came in the valuation of financial securities held in corporate portfolios. Controllers struggled to reconcile historical cost accounting with the prevalence of market prices for liquid financial securities. It doesn't seem logical that identical securities purchased over time should be valued on the balance sheet at varied purchase prices.

Use of historical cost also invites trouble. An opportunistic manager could sell appreciated securities in periods when the firm wanted to report more income. Such "cherry picking" would give the appearance of steady earnings growth but saddle the firm with poorly performing investments, and FASB took up the issue in reaction to the '70s equity bear market.

Continuing dissatisfaction in 1992 led the board to propose valuing all debt and equity securities at fair value. Management teams once again expressed concern about subjecting a firm's earnings to the vagaries of the stock market. Learning from experience with pensions and foreign currency, FASB issued Statement 115 in 1993, permitting unrealized gains and losses to be stored in shareholders' equity.

In all three of the cases cited above, regulators allowed consequences of certain transactions to be accumulated in shareholders' equity and not flowed through earnings. The result is that an interim mark-to-market adjustment receives a private burial on the balance sheet instead of a public funeral on the income statement.

The Present and Future

The basis for derivative accounting is now Statement 133, which was issued in June 1998. With a balance sheet focus, FASB wants organizations to recognize derivatives as assets or liabilities and measure them at fair value, while management teams simply want to avoid reporting bumpy earnings.

If the hedged item is a predictable transaction at a known date, this accounting treatment is no big deal. What's messy is when the transaction to be hedged is a payment stream that cannot be forecast with precision. Drawing on experiences with accounting standards for foreign currency, pensions and investment portfolios, FASB built a safety valve into Statement 133.

Certain cash flow hedges may qualify for "hedge accounting," where gains and losses of both the derivative and underlying exposure are deferred and accumulated in shareholders' equity until a realization event. At that point, the net difference is removed from this holding tank, recognized in the current income statement and given a final resting place in retained earnings.

The rub is determining whether a cash flow hedge qualifies for this special treatment. Cash flow hedges that fail to meet certain technical requirements lose their special status. A common example is a breakdown in the correlation between price movements of the derivative contract and the underlying exposure. Mark-to-market adjustments must then flow through the income statement and expose a firm's earnings to the volatility of credit, commodity or currency markets.

This does not bother regulators one bit. Flowing gains and losses through earnings, they argue, is simpler and alerts outsiders to the presence of outsized derivative positions. Some firms have accumulated derivative positions many times the size of the underlying exposure to be hedged. An international widget manufacturer could really be a foreign currency dealer in disguise.

The trick now is for regulators and practitioners to agree upon the technical requirements of what constitutes acceptable correlation between derivative contracts and exposures to be hedged. The sense of urgency comes from the growth of standardized, exchange-traded derivative contracts that may supplant customized, over-the-counter transactions.

This standardization will make derivatives contracts even more widespread and correlation issues more prevalent. The ascendance of exchange-traded derivatives will thus create a greater sense of urgency to resolve the derivative wars.

TOM KING is Treasurer of Progressive Insurance Co. and author of More than a Numbers Game: A Brief History of Accounting, published by John Wiley & Sons, 2006. He can be reached at [e-mail].

RELATED ARTICLE: TAKEAWAYS

* In 1995, the now-FASB Chairman Robert Herz predicted "derivatives wars," where practitioners and regulators would clash, each side arguing it was trying to do the right thing.

* Standard-setters argue that derivatives represent assets and liabilities that should be shown on the balance sheet at fair value.

* Management teams simply want to avoid reporting bumpy earnings.