The question of derivatives.

ROGER H. D. MOLVAR, CPA, is senior vice-president and comptroller of First Interstate Bank of California. He is a member of the American Bankers Association accounting committee and a former member of the American Institute of CPAs banking committee. JAMES F. GREEN, CPA, is a technical manager in the AICPA federal government division, Washington, D.C.

Mr. Green is an employee of the American Institute of CPAs and his views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.

Wall Street's financial engineers have created many new products in the past decade. These innovations involve taking traditional financial instruments such as loans, bonds and stocks and isolating their basic components: agreements to pay, receive or otherwise exchange cash or other financial consideration. Limited only by computing power and their own imaginations, these financial wizards are reengineering these basic components to exploit their unique risks and rewards by creating new combinations and relationships. Since they generally derive their value from underlying traditional financial instruments, the new instruments are collectively called derivatives.

Derivatives usually include futures, forward, swap and option contracts and other financial instruments with similar characteristics. Some define derivatives to include asset-backed securities (such as collateralized mortgage obligations, interestand principal-only securities, residual securities and stractured notes), which generally are recognized in a user's statement of financial position. (For examples of some derivatives contracts, see the sidebars on pages 57 and 58.)

THE BROADER VIEW

Asked to define derivatives, one chief financial officer joked, "Any transaction this year that resulted in a loss." And an instructive joke it is. Derivatives have been labeled the culprit in many recent financial losses, including Orange County, California, but that label may be a distraction from fundamental issues of financial risk.

Perhaps in recognition of this concern, some observers have begun to steer the public discussion of derivatives to broader issues of how entities manage financial risks. At the November 1994 American Institute of CPAs National Conference on Banking, Federal Reserve Board member Susan M. Phillips said, "It is not derivatives per se that are troublesome, but management's ability to identify, measure and control risk."

At the same conference, outgoing Securities and Exchange Commission Chief Accountant Walter Schuetze suggested entities' public disclosures about all kinds of financial instruments "be supplemented with information that brings the entire risk management function together so that investors can understand better how the company manages its overall financial risks."

On December 6, 1994, life offered an example that may hasten this expanded view. Orange County, California, filed for bankruptcy after acknowledging that rising interest rates had driven an estimated $2.02 billion loss in value (since estimated down to $1.69 billion) of its $7.4 billion investment fund. Much of the resulting media coverage focused on the fund's investments in derivatives, including asset-backed securities called "inverse floaters" (whose contractual interest rates float inversely with market interest rate changes). Derivatives allegedly were just one component wound up in a heavily leveraged, interest-rate-sensitive portfolio that reportedly was managed with an aggressive investment strategy.

Were the Orange County losses isolated to a dalliance in derivatives or were they the result of the more complex interaction of various investment risks? Who should have been aware of, understood and taken responsibility for the assumption and management of the related financial risks? As investors and decision makers sift through the facts, participants in the debate about derivatives eagerly await some answers.

CONCERNS AND REACTIONS

One thing about derivatives is clear--they are popular with all types of users. Insurance companies, manufacturers, banks, not-for-profit organizations and governments--even the federal government--all use derivatives. Because they can buy the risks and rewards they want most, users have created the demand to support a multitrillion-dollar market. Some users buy derivatives that involve risks they hope will help offset or round out existing on- and off-balance-sheet financial risks. Others buy them hoping that assuming greater potential risk will mean greater potential rewards. The effectiveness of derivatives for a particular purpose, however, often depends on many factors. And therein lies the rub.

As with major innovations in any discipline, the fast-growing world of derivatives involves risks and uncertainties that have stirred intense public debate. Some of the underlying risk relates to market price changes (including the effects of interest rate changes) or demand for an instrument (market and liquidity risks). Control risk depends on management's competence with and control over its entity's transactions; credit risk relates to whether a counterparty will make promised payments; and legal risk is that the risk contracts are not complete and enforceable.

Recent sudden losses by some users have fueled the debate and inspired various reactions. Some financial market observers fear derivatives are generating systemic risks that could bring down entire markets. Others argue derivatives aren't really new--the underlying risks, and even some of the instruments, have been around for centuries. Still others believe derivatives can, on balance, be helpful tools if their use is properly understood and controlled. The related concerns and reactions are broad, ranging from matters of regulation and reporting to corporate governance and internal controls.

Some parties to the debate wonder whether further regulation of derivatives dealers and end-users would be beneficial. But these instruments don't fit neatly into any single regulatory category, so commodities, banking, securities and insurance regulators all are involved--and Congress as well. Federal banking regulatory agencies, for example, have issued specific guidance for banks. In May 1994, the U.S. General Accounting Office--the audit arm of Congress-presented a key report, Financial Derivatives: Actions Needed to Protect the Financial System, which emphasized that

* Derivative risks require comprehensive oversight.

* Unregulated activities increase systemic risk.

* Accounting principles haven't kept pace with business practices.

* Efforts to address international risk should be coordinated.

The GAO also suggested federal regulation of all major U.S. dealers in certain derivatives--filling gaps in the U.S. regulatory system and improving regulators' ability to anticipate and respond to any related financial crisis.

Several derivatives bills have been introduced in the 104th Congress. They include proposals that range from requiring the SEC to oversee derivatives activities of currently unregulated dealers to requiring the federal banking regulatory agencies to jointly establish specific principles and standards for supervising financial institutions engaged in derivatives activities. (For information on the use and regulation of derivatives in mutual funds, see the sidebar at left.)

The debate also has raised questions about how financial reporting by derivatives users should inform investors, creditors and other financial statement users about the related risks and uncertainties. Further, the SEC has increased its inquiries about derivative disclosures in filings by public companies. It also has requested more details about derivative holdings and internal policies for monitoring and controlling these securities.

Financial Accounting Standards Board.

In 1986, the FASB began a broad project to address whether accounting principles provide adequate guidance on the recognition, measurement and disclosure of financial instruments. The latest of several resulting pronouncements focuses on derivatives (see the sidebar on page 61). The FASB is considering other parts of the project that could result in significant changes in the way entities recognize and measure derivatives. One part of the project also might develop consistent and comprehensive standards for derivatives transactions involving hedging relationships.

AICPA. The AICPA has been considering the related question of what approach auditors of the financial statements of entities engaged in derivatives transactions should take. The result is a summary of existing guidance from representatives of the AICPA accounting standards executive committee and the auditing standards board. (See the sidebar on page 56 for details.)

There are questions about whether corporate oversight is adequate to ensure derivatives activities are well managed and controlled. Acting in the interest of the public and its members in industry, the AICPA published six commonsense questions on derivatives to be used by the board of directors and management of entities that engaged in derivatives activities as a "reality check" on related corporate oversight. The AICPA based its questions on corporate governance aspects of two key reports--the May 1994 GAO report and a study by the Group of Thirty, a Washington D.C.-based international financial policy organization. The group's report, Derivatives: Practices and Principles, contains 20 recommendations for users and dealers and several regulatory recommendations.

Some parties are studying what features contribute to effective internal controls over derivatives. Such controls may relate to whether

* Operational objectives are being achieved.

* Published financial information is reliably prepared.

* Users are complying with applicable laws, regulations and contractual agreements.

The Committee of Sponsoring Organizations of the Treadway Commission (COSO) has a project under way to develop tools to help entities use COSO's September 1992 report Internal Control--Integrated Framework to develop or assess controls over derivatives activities.

UNCERTAIN OUTCOMES

Concerns raised about derivative financial instruments relate ultimately to the risks and uncertainties of transactions that involve them. How much financial risk should entities assume? How much uncertainty can investors and decision makers-corporate managers, boards of directors, regulators or Congress--tolerate? Wherever these questions ultimately lead, users must be aware of and take responsibility for the risks these instruments pose. Through continuing improvements to the financial reporting and attestation functions, CPAs in industry and public practice can play an important role in improving the quality of related information. Moreover, the question of derivatives can be an end in itself: Those with some interest--be it financial, regulatory, fiduciary or otherwise--in an entity that uses them can better understand whether and how that enduser is at risk.

RELATED ARTICLE: CURRENT ACCOUNTING AND AUDITING LITERATURE ON DERIVATIVES

The financial instruments task force of the American Institute of CPAs accounting standards executive committee compiled, with the assistance of representatives of the AICPA auditing standards board, a reference to existing literature on accounting for and auditing of derivatives transactions. The task force reported the results of its efforts in Derivatives--Current Accounting and Auditing Literature (AICPA product no. 014888JA).

The report describes current authoritative accounting and auditing literature and provides background information on basic derivatives contracts, risks and other general considerations. The report should be of interest to

* Investors, creditors and other financial statement users.

* Boards of directors and managements of entities that use derivatives.

* Auditors of the financial statements of those entities.

* Regulators in related industries.

Copies of the report are available by calling the AICPA order department at [phone]. Copies are $7 each for AICPA members and $7.75 each for nonmembers.

RELATED ARTICLE: EXCUTIVE SUMMARY

* DERIVATIVES DERIVE THEIR value from underlying financial instruments and include futures, forward, swap and options contracts. They have increased in popularity. Insurance companies, manufacturers, banks, not-for--profit organizations and governments use them to offset risk or realize higher returns. * THERE IS A FEAR THAT derivatives could generate systemic risks capable of bringing down entire financial markets. This has led to a debate about the need for further regulation of derivatives and who should undertake it. In its last session, Congress considered, but did not pass, several derivatives bills; more are likely in 1995. * THE FINANCIAL ACCOUNTING Standards Board issued Statement no. 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments, generally effective for fiscal years ending after December 15, 1994. The statement requires entities to disclose information about certain derivatives in the financial statements. * THE AMERICAN INSTITUTE OF CPAs issued a summary of existing accounting and auditing guidance on derivatives transactions. An appendix to the report contains six commonsense questions on derivatives for boards of directors to use in their oversight responsibilities.

RELATED ARTICLE: A WIDE VARIETY OF DERIVATIVES

Derivatives usually have characteristics of either traditional forward or options contracts. Although they come in many varieties, they usually are variants or combinations of these two basic contracts.

FORWARD-TYPE DERIVATIVES

Some derivatives (such as futures, forward and swap contracts) have elements of traditional forward contracts, which obligate one party to buy and a counterparty to sell an underlying financial instrument, foreign currency or commodity at a future date at an agreed-on price. Thus, a forward-based derivative is a two-sided contract in which. each party potentially has a favorable or unfavorable outcome resulting from changes in the value of the underlying position.

Basic futures contracts. ABC Co. produces bread products. Management knows in February 1995 that ABC Co. will need to buy 100,000 bushels of grain in July to meet production demand. If grain prices rise above $3.50 per bushel, ABC Co. will not profit on sales of its product. Thus, it wants to lock in a price for its July grain purchases. Management wants to buy futures because it expects changes in the price of grain will be offset by changes in the price of the futures contracts during the same time period.

On February 1, ABC Co. purchases 20 July 1995 futures contracts (each for 5,000 bushels) that allow the holder to buy the grain at $3 per bushel and take delivery in July. Assume grain prices rise to $3.25 per bushel by July, pushing up the price of ABC Co.'s futures contracts to $3.25 per bushel. ABC Co. sells the contracts and purchases the grain through its normal channels at $3.25 per bushel. The gain on the futures contracts of $.25 per bushel offsets the extra $.25 paid for each bushel. Thus, ABC Co. effectively locked in the cost of the grain using the futures contracts.

Because futures-type contracts are two-sided, the counterparty from whom ABC Co. purchased the futures contracts will incur a $.25-per-bushel loss on the contracts. If, instead, prices had fallen to $2.75 per bushel, the counterparty would have a $.25-per-bushel gain and ABC Co. would sell the futures contracts at an equivalent loss. However, ABC Co. would still have locked in the grain cost because its loss in the futures market would be offset when it pays $.25 less for each bushel purchased through its normal channels.

OPTION-TYPE DERIVATIVES

Other derivatives (such as options, interest rate caps and interest rate floors) have elements of traditional option contracts. An option contract provides one party (the option holder) with a right, but not an obligation, to buy or sell an underlying financial instrument, foreign currency or commodity at an agreed-on price on or before a set date. The counterparty (the option writer) is obligated to sell or buy the underlying position if the holder exercises the right. Thus, an option-based contract is one-sided; if the right is exercised, only the holder has a favorable outcome and the writer can have only an unfavorable outcome. If market conditions result in an unfavorable outcome for the holder, the holder will allow the right to expire unexercised. Expiration is a neutral outcome for both parties (except for the premium the writer paid the holder).

Basic option contracts. Assume ABC Co. instead enters options contracts in February to buy the needed bushels of grain in July at $3 per bushel. When prices rise to $3.25 by July, management can exercise the option contract and purchase the grain bushels at $3 each. Excluding the premium paid for the contracts, the company has effectively locked in the cost of the grain. In this example, the counterparty that wrote the option will incur a loss of $.25 per bushel, but the gains and losses would not be reversed if prices fell. For example, if prices fell to $ 2.75 by July, ABC Co. would purchase the grain at that price through its normal channels and let the option expire.

The one-sided risk of option-type derivatives is again significant. While ABC Co. (the option holder) had only a potentially favorable outcome (or at most lost the premium it paid) the counterparty that wrote the option had only a potentially unfavorable outcome. Most such counterparties accept this risk because they theoretically are working with a broader portfolio or with transactions that have compensating risks. However, derivatives can involve a role reversal whereby a user writes an option to the counterparty. Thus, users that do not carefully understand the nature of derivatives and how options work could be exposing themselves to much more risk than they normally might accept.

RELATED ARTICLE: DERIVATIVES AT A GLANCE

Derivatives are financial instruments that "derive" their value from underlying assets such as stocks, bonds, mortgages, market indices or foreign currencies. Because of this link, the prices of derivatives change when the underlying asset's price changes, although not always proportionately. In fact, changes in the underlying asset's value often are magnified in the derivative's price.

DERIVATIVES: SIMPLE AND COMPLEX

Derivatives can be divided into two classes: simple and complex. As the names suggest, there are significant differences between the two categories.

Simple derivatives. Many simple derivatives, such as futures, options and currency forwards, have been around for more than 20 years. They trade on established exchanges in standardized contracts or over-the-counter. Exchange-traded derivatives (futures and most options) are closely regulated and their prices are posted frequently during market hours. Simple derivatives generally can be easily bought and sold. However, they also can become quite volatile and illiquid, especially under unstable market conditions.

Complex derivatives. Complex derivatives are relatively new, and thus do not have an established track record. Most complex derivatives are not exchange-traded. Some are highly specialized and frequently are customized to meet the needs of individual institutional investors. Sometimes complex derivatives are based on relationships between diverse markets, such as fluctuations in European interest rates and the price of copper. As a result, complex derivatives are highly illiquid and difficult to price accurately.

DERIVATIVES: COMMON AND UNCOMMON

Derivatives frequently are used to manage risk in financial markets. Here are some common, and not-so-common. examples.

Collateralized mortgage obligations (CMOs). Mortgage-backed bonds that separate mortgage pools into short-, medium and long-term portions to allow for greater flexibility in the repayment of investor capital. CMOs pay a fixed interest rate at regular intervals.

Floating rate notes. Debt instruments with a variable rate generally tied to prevailing short-term interest rates. These investments are relatively insensitive to interest rate changes.

Forwards. Contracts that enable a specific quantity of a particular commodity, foreign currency or other financial instrument to be bought or sold at its current price, with delivery and settlement at a specified future date. Forwards are not publicly traded.

Futures. Contracts representing an agreement to buy or sell a specific quantity of a commodity, financial instrument or interest payment at a particular price on a stipulated future date. Futures are publicly traded.

Indexed securities (also know as structured notes). These are highly customized short-term debt instruments that allow investors to create and capitalize on short-term investment opportunities without liquidating or restructuring sound long-term investment positions. These instruments often are called "customized bonds" because they are designed with "yield" features and their interest rates or principal amounts are indexed to an unrelated indicator.

Interest-only strips (IOs). Th interest part of a mortgage security that has been stripped into two parts; the other part is a principal-only strip. IOs receive cash flow from interest payments and offer an attractive yield as long as mortgage rates are stable or rising.

Inverse floaters. Debt instruments whose yields rise as short-term rates fall, and vice versa. Inverse floaters act like very long-term bonds.

Options. Securities transaction agreements tied to stocks, commodities or stock indices involving the right to buy or sell those instruments for agreed-upon sums. Options are publicly traded on many different exchanges.

Principal-only strips (POs). The principal part of a mortgage security that has been stripped into two parts; the other part is the interest-only strip. POs receive cash flow from principal payments.

--Sid Mittra, PhD, is professor of finance at Oakland University, Rochester, Michigan.

RELATED ARTICLE: YES! MUTUAL FUNDS USE DERIVATIVES

Mutual funds employ professional managers who promise to deliver investment returns that typically are higher than most investors can obtain on their own. To achieve these returns, many fund managers use derivatives--a term frequently used to explain a broad array of financial instruments whose common feature seems to be that they are not "traditional" equity, debt or money market securities.

Securities and Exchange Commission rules for mutual funds require disclosure in a fund's prospectus of all material investment practices and risks, including the use of derivatives. Mutual funds also are subject to diversification requirements and limits on illiquid securities.

It's important for CPAs and their clients to review the prospectus to determine a fund's investment strategy and risks and make sure they match their own. Because the descriptions of these risks in a prospectus can be difficult to understand, the SEC is considering policy changes designed to protect fund shareholders. The changes would

* Make mutual funds more responsive to investor needs by requiring enhanced disclosures of derivatives and more understandable prospectuses to help unsophisticated investors better understand the risks derivatives pose.

* Require brokers to obtain continuing education to keep them informed about "exotic" new products.

* Prevent funds from putting more than 10% of their money in illiquid investments--including many types of derivatives. Today, all funds except money markets can have as much as 15% in such assets.

--Phyllis Bernstein, CPA, is director of the American Institute of CPAs personal financial planning division.

Ms. Bernstein is an employee of the American Institute of CPAs and her views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.

RELATED ARTICLE: FINANCIAL ACCOUNTING STANDARDS

BOARD DERIVATIVES DISCLOSURES

In October 1994, the Financial Accounting Standards Board issued Statement no. 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments. The statement requires all kinds of entities to disclose information about amounts, nature and terms of certain derivatives (as defined), distinguishing between those held or issued

* For trading purposes (including dealing and other trading activities measured at fair value with gains and losses recognized in earnings).

* For purposes other than trading.

For entities that hold or issue derivatives for trading purposes, Statement no. 119 requires, among other things, disclosure of average fair value and net trading gains or losses. Entities that hold or issue derivatives for other purposes are required to make disclosure about those purposes and about how the instruments are reported in financial statements.

For entities that hold or issue derivatives and account for them as hedges of anticipated transactions, the statement requires disclosure about these transactions, the classes of derivatives used to hedge them, the amounts of hedging gains and losses deferred and the transactions or other events that result in recognition of the deferred gains or losses in earnings. Statement no. 119 also encourages, but does not require, quantitative information about market risks of derivatives and other assets and liabilities that is

* Consistent with the way the entity manages or adjusts risks.

* Useful for comparing the results of applying the entity's strategies to its objectives for holding or issuing the derivatives.

The statement amends existing requirements of FASB Statement no. 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, and Statement no. 107, Disclosures about Fair Value of Financial Instruments.

Statement 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. For those entities, the statement is effective for financial statements issued for fiscal years ending after December 15, 1995.