FASB considers measuring derivatives at fair value.

The Financial Accounting Standards Board is pursuing a new approach to account for derivatives and hedge activities: All derivatives would be carried on the balance sheet as assets or liabilities and measured at fair value.

This approach, proposed at the FASB January meeting and modified since, failed to win approval at the board's March 5 meeting, and an alternative model is being considered. However, the board's goal is to issue an exposure draft of its proposed standard for public comment by June 30, according to project manager Robert C. Wilkins.

Accounting for gains and losses on the financial instruments would depend on the reason they are being held. For example, gains and losses on derivatives that are designated as hedges of assets and liabilities would be included in earnings, and the offsetting losses and gains on the hedged item would be accelerated and recognized in earnings in the same period. For derivative instruments designated as hedges of forecasted transactions, gains and losses would be reported in equity (as a component of comprehensive income), then recognized in earnings when the forecasted transaction occurred. For all other derivatives, including both those not designated as hedges and those designated as hedges of other derivatives, gains and losses would be recognized as earnings.

The proposed standard will cover recognition and measurement of derivatives; hedges of existing assets, liabilities and firm commitments; hedges of forecasted transactions; instruments to be included in the scope of the proposed standard; foreign currency issues related to hedging; disclosures; and presentation.

Complex issues to be resolved

"People are beginning to realize there are a lot of side issues associated with market value accounting that surface as the standard setters try to put out guidance on marking these instruments to market," said John C. Compton of Cherry, Bekaert & Holland in Greensboro, North Carolina, member of the American Institute of CPAs accounting standards executive committee.

One issue, according to Compton, "is the lack of consistent specific guidance on the mechanics of dealing with premiums and discounts on financial instruments. Because of the choices that exist for various entities, there is an increased risk of distorting investment income. For example, if you are marking an instrument to market, you may have a big increase in value that you really didn't pay for, based on the accounting policy for premiums or discounts that is selected. If you do not properly amortize the premium or discount as an adjustment of interest income, you can have income distorted.

"For a lot of small firms and local practitioners, the FASB proposals would be more difficult to understand, because the board has proposed a totally new approach--valuing derivatives on the basis of their components," Compton said. "Till now, the old basis has led to the use of readily available market values and has not considered the other elements of risk associated with derivatives, such as their volatility and duration in terms of pricing"