FASB 119 & derivative financial instruments: disclosure & fair value.
Answer: They all suffered significant financial losses caused by derivatives. In fact, "derivatives trading brought the bank down," declared a press report soon after the news of the fall of Barings PLC was revealed in February 1995.
Highly publicized and unfortunate events like these have caused Congress, SEC, business and other groups to become highly concerned about derivative products. These groups have called upon the Financial Accounting Standards Board (FASB) to improve its disclosure requirements regarding derivative financial products.
The Board agreed that more disclosure was necessary because of the escalating size of the derivatives market and their importance to the business community. They also felt that many investors and creditors do not fully understand these complex financial arrangements. With its new pronouncement the Board intended to help financial statement readers understand why the companies use and how the companies account for derivatives. FASB No. 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments, builds upon the disclosure requirements of FASB No. 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, and FASB No. 107, Disclosures about Fair Value of Financial Instruments.
A derivative is typically defined as a financial contract whose value is designed to track the return on stocks, bonds, currencies or commodities. Derivatives may also be contracts derived from an indicator like interest rates or from a stock market or other index. The derivative instruments that result include swaps, forwards, futures, caps, puts and calls. For example, swaps are typically tied to interest rates or currencies. A company that issues floating interest rate debt might protect itself from increasing interest rates by swapping into a fixed rate. Inverse floaters is a type of derivative whose value changes inversely to the movement of interest rates, stock indexes and the like. Generally, derivatives fall into two broad categories: forward type contracts and option type contracts. They may be listed on exchanges or traded privately.
For the purpose of FASB No. 119, the Board considers a derivative financial instrument as a future, forward, swap or option contract or other financial instrument with similar characteristics of options. Other financial instruments with similar characteristics to option contracts include interest rate caps or floors and fixed-rate loan commitments. A cap is an option that protects the purchaser from a rise in a particular interest rate above a certain level. A floor is an option that protects the purchaser from a decline in a particular interest rate below a certain level.
The Board decided to include fixed-rate loan commitments in their definition because they believed that these commitments have characteristics similar to option contracts because they provide the holder with the advantages of favorable price movements of the underlying asset or index with minimal or no exposure to losses from unfavorable price movements. Similar to options, the issuer is the party who is faced with the market risk. Even variable rate loan commitments and variable rate financial instruments that are similar to options would be included.
The Board's definition of a financial instrument does not include contracts that permit settlements by exchanging a financial instrument for the actual item or commodity. The exchange or delivery has to be between financial instruments. The definition does include, however, those commodity-based contracts that must be settled in cash.
FASB No. 119's derivative financial instrument definition does not include on balance sheet items like mortgage-backed securities, interest only and principal only debt and instruments indexed to the price of gold, silver or equity securities. The definition also excludes optional features that are embedded in an on balance sheet receivable or payable, such as the conversion and call provisions of convertible bonds.
Risks of Using Derivatives
Derivatives can be dangerous because they are generally highly leveraged. This leverage greatly multiplies the returns and the losses of the parties. This risk is further compounded because of the overall size of the market. According to the United States General Accounting Office, $12.1 trillion in notional or principle amount of derivative contracts were outstanding at the end of 1992.(1) Besides the risk from leverage, other types of risks include:
* Valuation risk: The chance that the profit on a transaction will be misstated.
* Management (operational) risk: The risk that internal errors may result in avoidable losses.
* Legal risk: The possibility a court may declare the contract illegal.
* Market risk: The chance the market value of the underlying instrument may move in favor of the counterparty.
* Credit risk: The risk that the other party to a contract may financially fail, leaving the contract unfilled. An example of credit risk is hedge funds.
Dealer Notional Value
Chemical Bank $3,266 Citicorp $2,672 J. P. Morgan $2,297 Bankers Trust $1,981 BankAmerica $1,463 Chase $1,450 Merril Lynch $1,448 Salomon $1,261
(Source: Fortune magazine, Mar. 7, 1994 and Mar. 20, 1995).
Despite the risks of using derivatives, major United States corporations use them heavily. Exhibit 1 is a list of major banks and the principal value of their contracts.
Disclosure Requirements for Derivatives
FASB No. 119 can be broken down into three major parts. First, it requires the disclosure of the amounts, nature and terms of all derivative financial instruments, not just those with off balance sheet risk of loss. Second, it differentiates between financial instruments held or issued for trading versus other purposes. Third, it further amends Statement Nos. 105 and 107 to require that a greater distinction be made regarding specific disclosures.
The Board believed that some businesses were not disclosing material positions in their financial statements. Furthermore, the investors and creditors may not fully understand the company's purpose for holding or issuing the instruments that are disclosed. FASB No. 119 amends FASB No. 105 to include derivative financial instruments without off balance sheet risk of loss.
The disclosed amounts should include the face or contract amount. The notional principal amount should be used if there is no face or contract amount. The minimum disclosure regarding the nature and terms should include the credit and market risk and cash requirements of those instruments along with the related accounting policies.
Purpose for Holding or Issuing Derivatives
The Board believed that most financial statement users would benefit by knowing why the company uses derivatives. They decided that the best way to help show the reason for holding or issuing would be to separate trading reasons from other reasons.
Held or Issued for Trading Purposes
For the purpose of this statement, trading refers to the active and frequent buying and selling with the intention to create a profit on short-term differences in price or rates. Dealing activities are also included as part of trading purposes. Dealers sometimes enter into derivative contracts to act as a hedge for their own account. Entities that hold or issue derivative financial instruments for trading must disclose two items either in the body of the financial statements or in the footnotes: the average fair value, and the net gains and losses from trading.
Average Fair Value: The average fair value of derivatives during the accounting period will be presented along with the period-end fair value. Including the average value will help to show the degree of risk assumed by the company during that period. When calculating the average fair value, it should be based on the most frequent information that a trader has produced for management and regulatory reasons. However, the Board does prefer that the calculations be done based on daily balances. The FASB requires that the average fair market value be disclosed on instruments held or issued for trading because the necessary information may not be available for those that are used for other purposes.
Net Gains and Losses From Trading: Statement No. 119 allows net trading gains/losses to be disclosed according to any category that is consistent with the management of those activities. The Board also stipulated that for each category there should be a description of the classes of instruments that make up the net trading revenue. For example, net trading gains and losses may be by business activity or risk.
Held or Issued For Purposes Other Than Trading
Many corporations use derivatives as a strategic tool in their risk management program. FASB No. 119 aims, in part, to help investors and creditors understand what the company is trying to accomplish by using derivative financial instruments. This disclosure requirement can be broken down into three major descriptive parts and applies mainly to end-users of derivatives.
Part one should describe the [TABULAR DATA FOR EXHIBIT 2 OMITTED] purpose for holding or issuing these instruments, the rational for doing so and the ways to obtain them. It should also include the classes of derivative financial instruments used.
Part two adds to APB Opinion 22, Disclosure of Accounting Policies. This is to help financial statement users comprehend how derivative financial instruments held or issued for reasons other than trading are presented in the financial statements. This disclosure requires the following:
* A description of how each class of derivative is reported in the financial statement and their inherent risks.
* The accounting policies used for recognizing - or failing to recognize - and measuring derivative financial instruments held or issued.
* Where to report it in the financial statements. (See Exhibits 2 and 3.)
Amendments to FASB Nos. 105 and 107
Disclosures are needed when derivative financial products are held or issued as hedges towards expected transactions such as firm commitments and Forecasted transactions having firm commitment. The Board determined that current hedge-related disclosures were mostly aimed at exchange-related futures contracts. However, such derivative financial instruments commonly used for hedging such as interest rate swaps and forward contracts were not fully covered by any disclosure statement. The Board concluded that additional information was needed that would allow financial statement users to determine if the company was successful in its hedging activities. The new disclosures are:
* A description of the expected transactions including their time periods;
* A description of the types of derivative financial products used for hedging purposes;
* The deferred hedging gains and losses; and
* A description of the events that will arise in recognizing gains or losses of the amounts deferred in the income statement. (See Exhibit 4.)
Statement 105 requires that the disclosure of information regarding derivative financial instruments be provided by class of financial instrument. Statement No. 119 allows disclosure by category as optional. Disclosure can be disaggregated by any category that is in conformity with managing those instruments. If disaggregation is not by category of financial product, the company should furnish a description of the types of financial instruments by category.
Statement No. 107 allowed companies to disclose the fair value information in their financial statements any way they felt was appropriate. These fair value disclosures were difficult to understand and isolate because they were mixed throughout the financial statements footnotes.
Statement No. 119 still allows companies to disclose fair value information in more than one footnote. However, if so, a summary table must be included in a footnote. The table must include carrying values and fair values of all financial instruments and the location of the remaining information required by Statement No. 107.
In the past, it was difficult to determine if many off balance sheet fair value amounts disclosed under Statement 107 were assets or liabilities. FASB No. 119 now requires companies to clearly distinguish the fair value of the instruments as an asset or liability.
The Board concluded that the disclosure of the fair value of derivative financial instruments cannot be combined, aggregated or netted with the fair value of non-derivative financial instruments. It is also prohibited to net derivative financial instruments with the fair value disclosures of other derivative financial instruments except if the carrying amounts are permitted to be offset in the balance sheet according to FASB Statement No. 39.
Disclosures and Financial Statement Presentation
FASB No. 119 encourages, but does not require, companies to disclose quantitative information regarding derivative financial instruments such as interest rate, foreign exchange, commodity price or risks. This information must conform with the way the company manages its risk. Management must state if the company's strategies met their objectives. The Board also believed that voluntary quantitative disclosures about the risks of other financial instruments, or nonfinancial assets and liabilities that are connected to the derivative financial instruments by way of a risk management strategy, would be beneficial.
The Board suggests five different approaches a company may consider when reporting quantitative information in their financial statements. However, it acknowledged that these suggestions may not be feasible for certain entities.
The first approach is for the company to provide in-depth information about current positions. For example, a company engaged in a small number of swaps should disclose such information as fixed rates, floating indexes and term of every contract.
The second approach suggests giving hypothetical movements in market prices and the effects they may have on equity or on annual income. The company would use the theoretical market price changes that they actually use in their risk management model. The Board suggested they may disclose the effects of changes in all interest rates, all exchange rates and commodity prices that they buy or sell frequently. This approach is limited because it would only give the hypothetical value at a specific date. However, the Board pointed out that most financial information is reported "as of" a balance sheet date anyway.
The third approach could be a measurement of interest rate risk by providing a Gap analysis. This could be accomplished by taking the assets and liabilities that are rate sensitive and the notional principal amount of swaps and other unrecognized derivatives and group them according to expected repricing or maturity date. The interest rate gap would be the difference between assets and the liabilities. Gap analysis is no longer widely used because it does not incorporate the effect of options, and it may be erroneous if all of the financial instruments are not expressed in one currency.
Exhibit 5: Sizing Up the Big Derivatives Dealers
Notional principal and dollar amount at risk for derivatives and foreign exchange contracts at year-end 1993, in billions.
Notional Principal Amount At Risk
BANKERS TRUST $1,907 $24.7 CHEMICAL BANKING 2,479 16.9 CITICORP 1,975 23.5 J.P. MORGAN & CO. 1,653 20.7 MERRILL LYNCH 891 7.4 MORGAN STANLEY(*) 629 5.0 SALOMON BROTHERS 999 8.6
* At Jan. 31, 1994 Source: Annual Reports
The fourth disclosure may be the financial instrument's duration. Statement No. 119 describes duration "as the result of a calculation based on the timing of future cash flows and can be thought of as the life, in years, of a notional zero-coupon bond whose fair value would change by the same amount as the real bond or portfolio in response to a change in market interest rates."
The last voluntary quantitative disclosure that may be provided is the entity's value at risk. The company would determine the probability of an expected loss from changes in the market over a specific period of time.
Many organizations advised the Financial Accounting Standards Board to require the disclosure of quantitative information. The Board believed that when these approaches incorporate quantitative information about risk, they would not be well defined or understood. Therefore, they decided that mandatory disclosure would be inappropriate at this time.
FASB No. 119 has been criticized for not going far enough in disclosing the way an organization manages its derivative risks. The Board did stress that the overall purpose of this statement was narrowly focused to try to answer the questions of why companies use derivatives, how do they account for them and to what extent they are used. Businesses don't have to disclose potentially risky derivative transactions unless they are material.
Note 1 - Significant Accounting Policies
"In addition to its trading activities, the Corporation, as an end user, utilizes various types of derivative products (principally interest rate and currency swaps) to manage the interest, currency and other market risks arising from a number of categories of its assets and liabilities. Revenue or expense pertaining to management of interest rate exposure is predominantly recognized over the life of the contract as an adjustment to interest revenue or expense. Realized gains and losses on hedges of equities classified as other assets are included in the carrying amounts of those assets and are ultimately recognized in income when those assets are sold. Derivatives are also used to manage the risks associated with securities available for sale. These derivatives are carried at fair value, with the resulting net unrealized gains and losses recorded in stockholders' equity as securities valuation allowance. The discount or premium on foreign exchange forward contracts and the interest on swaps used as hedges of net investments in foreign entities, as well as the net unrealized gains and losses from revaluing these contracts to spot exchange rates, are recorded in stockholders' equity as cumulative translation adjustments."
A company's revenue consists of approximately 38% from export sales to Japan. The company is expecting to increase its export sales to Japan by 10% in the following eleven months. To manage its foreign exchange risk, the company has entered into foreign currency option contracts to hedge its anticipated foreign transactions. The Yen option contracts will expire in one year. Gains and losses on these specific options are deferred and recognized as export revenue at the same date as the transaction that it is hedging. As of December 31, 1994, a net realized loss of $112,000.00 was deferred on these Yen options. This loss will be recognized in sales from exports.
1 Financial Derivatives - Actions Needed to Protect the Financial System. United States General Accounting Office, Report to Congressional Requesters. May 1994, p3
2 Bankers Trust New York Corporation. Annual Report, 1994, p48.
1 Bankers Trust New York Corporation. Annual Report, 1994, p. 48
2 Berton, Lee. "Losses Related To Derivatives Can Be Masked." Wall Street Journal (Eastern Edition). (April 15, 1994, A4.
3 Financial Accounting Standards Board of the Financial Accounting Foundation. "Statement of Financial Accounting Standards No. 119: Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments". October 1994.
4 Grantino, Barbara Donnelly, and Torres, Craig. "Many Americans Run Hidden Financial Risk From Derivatives." Wall Street Journal. August 10, 1993, A6
5 Lipin, Steven, and Raghavan, Anita. "GAO to Join Hot Debate on Derivatives." Wall Street Journal. May 18, 1994.
6 United States General Accounting Office. "Report to Congressional Requesters - Financial Derivatives, Actions Needed to Protect the Financial System." May 1994.
Steven Woodward, MBA, is an investment accountant at Derivatives Portfolio Management, LLC.
Joel G. Siegel, PhD, CPA, is a consultant and professor at Queens College.
Anique A. Qureshi, PhD, CPA, CIA, is a consultant and an assistant professor at Queens College.
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|Author:||Woodward, Steven; Siegel, Joel G.; Qureshi, Anique A.|
|Publication:||The National Public Accountant|
|Date:||Jan 1, 1996|
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