Accounting standards for derivatives in Korea: a comparison with U.S. GAAP and international accounting standards.

Jin, Jongdae ; Huh, Sung K.

ABSTRACT

The rapid changes during last several years in size and diversity of the Korean derivative market may warrant the introduction of new accounting standards for derivatives in Korea. One feasible and effective way to obtain ideas for new standards fitting into Korea derivative market is to compare Korean, US, and international accounting standards for derivatives. Thus, the objectives of this paper are two-fold. The first is to make a comparison between Korean, US, and international accounting standards for derivatives. The second is to make a recommendation for new accounting standards for derivatives in Korea. To achieve these objectives, the following steps were taken. First, compare current Korean, US, and international accounting standards for derivatives. Secondly, a literature survey on this issue of derivative accounting and examination on current trading practice of derivatives in Korea were conducted to draw an insightful inference for derivative accounting standards setting process. Finally, make a recommendation for new accounting standards for derivatives in Korea. Potential contributions of this study would be to setting new accounting standards for derivatives in Korea and to developing a general body of knowledge that provides meaning insights to accounting standards for derivatives.

INTRODUCTION

Derivative instruments (derivatives in short, hereafter) are instruments whose value depends on the values of other more basic underlying variables. In spite of relatively short trading history, derivatives become increasingly important in the Korean capital market (1). The derivative market in Korea has grown dramatically in terms of trading volume, trading value, the number of products, and their diversity. 17 derivatives, eight different types, are currently traded in two security exchanges: i.e., 8 derivatives in Korean Futures Exchange (KOFEX) and 9 derivatives in Korean Security Exchange (KSE).

Ever since its opening in 1999, KOFEX has been growing so much that the trading volume for the year 2001 surpassed 10 million contracts and the trading value exceeded 1,000 trillion Korean won (i.e., equivalent to approximately US$ 860 billion). The trading value of derivatives in KSE also increased dramatically that it reached about 1,176 trillion Korea won (i.e., equivalent to US$ 1,022,billion) in 2001. The growth of Korean derivative market has been significantly pronounced during the last two-year period starting late 2000. Korean derivative market increased more than 400% and ten new derivatives were listed in KOFEX or KSE during the period (2).

Accounting and reporting of derivatives are standardized in Korean Financial Accounting Standards (KFAS), Accounting Standards (AS) for security industry, & Accounting Standards for banking industry. KFAS were originally issued in April 1998 and revised in August 2000 by Korean Financial Accounting Standards Board, which is a Korean counterpart of FASB in US, while AS were originally issued in December 1998 and revised in December 1999 by Financial Supervisory Service of Korea, which is a Korean counterpart of SEC in US. Therefore, the above- mentioned significant changes in Korean derivative market during 2001 and 2002 were not incorporated in these standards. These standards require an entity to recognize derivatives as assets or liabilities at their fair value. Any gains or losses on derivatives due to fair value changes should be recognized as current income items unless the purpose of holding derivatives is hedging. There are brief disclosure requirements for derivatives in the standards, too. But, in general, the current standards are not articulate and specific enough to capture the diverse nature of derivatives traded in Korea. The rapid changes in size and product diversity of the Korean derivative market may warrant the introduction of more advanced accounting and reporting standards for derivatives in Korea. One feasible and effective way to obtain ideas for new standards fitting into Korea derivative market is to compare Korean, US, and international accounting standards for derivatives.

Thus, the objectives of this paper are two-fold. The first is to make a comparison between Korean, US, and international accounting standards for derivatives. The second is to make a recommendation for new accounting standards for derivatives in Korea. In order to achieve these objectives, the following three steps were taken. First, compare current Korean, US, and international accounting standards for derivatives. Secondly, a literature survey on this issue of derivative accounting and examination on current trading practice of derivatives in Korea were conducted to draw an insightful inference for derivative accounting standards setting process. Finally, make a recommendation for new accounting standards for derivatives in Korea based on the result from the previous steps. Potential contributions of this study would be to setting new accounting standards for derivatives in Korea and to developing a general body of knowledge about derivative accounting in general as well.

ACCOUNTING STANDARDS FOR DERIVATIVES IN KOREA

The accounting standards for derivatives in Korea are stated in KFAS Article 70, AS for banking industry, and AS for security industry KFAS are primary accounting standards that apply to all enterprises, while AS are supplementary standards for a specific industry or a special type transactions. These statements require the followings.

All entities shall report the fair value of rights or obligations associated with derivatives contracts as assets and liabilities (contra accounts). The fair value should be the closing market price as of the balance sheet date. If no closing price available at balance sheet date, the most recent closing price before the balance sheet date should be used. The newly acquired derivatives should be recorded at the acquisition cost, which are all costs incurred to acquire and make them ready for the intended use.

The gain realized or loss incurred from derivatives transactions shall be recognized in operations, currently. Thus, gains or losses on dispositions of derivatives as well as valuation gains or losses on derivatives shall be recognized in the year of occurrence. When the purpose of the derivatives transaction is to hedge risk, however, a company may account for such gain or loss differently, to reflect the risk hedging activities. But there are no specific standards for hedging activities, hedged items, hedging items, or gains/losses on hedging items due to fair value changes. In case that the fair value of derivatives decline and the decline is not restorable, the difference between the previous book value and the fair value should be reported as investment impairment loss in the income statement. The recoveries of previously recognized impairment losses shall be recognized as gains in subsequent periods till the net realizable value equals the book value of the asset before the loss was recognized (3).

As to derivative transactions, the purpose and details of transactions shall be disclosed in the accompanying footnotes. Obligations concerning derivatives should be reported, too. In addition, when the objective of transactions is to hedge a risk, the details of hedged items and their scope, accounting method applied to reflect risk hedging activities and the deferred gain or loss should be disclosed in the accompanying footnotes.

ACCOUNTING STANDARDS FOR DERIVATIVES IN U. S. A.

Statements of Financial Accounting Standards (SFAS) 133, 138 & 140 present accounting and reporting standards for derivatives, including certain derivatives embedded in other contracts, (collectively referred to as derivatives) and for hedging activities (4). SFAS 133, 138, and 140 were issued in 1998, 1999, & 2000, respectively. They require that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment (referred to as a fair value hedge), (b) a hedge of the exposure to variable cash flows of a forecasted transaction (referred to as a cash flow hedge), or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction (referred to as a foreign currency hedge).

The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation. For a derivative designated as a fair value hedge, the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. The effect of that accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value.

For a derivative designated as a cash flow hedge, the effective portion of the derivative's gain or loss is initially reported as a component of other comprehensive income (outside earnings) and subsequently reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately.

As to foreign currency hedge, for a derivative designated as hedging the foreign currency exposure of a net investment in a foreign operation, the gain or loss is reported in other comprehensive income (outside earnings) as part of the cumulative translation adjustment. The accounting for a fair value hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of an unrecognized firm commitment or an available-for-sale security. Similarly, the accounting for a cash flow hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of a foreign-currency-denominated forecasted transaction.

For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change. With regard to embedded derivatives embedding in contracts that do not in their entirety meet the definition of a derivative instrument, embedded derivatives shall be separated from the host contract and accounted for as a derivative instrument, if certain conditions are met.

Financial assets should be derecognized if the transferee has the right to sell or pledge the asset; the transferor does not have the right to reacquire the transferred assets; and the transferred assets be legally isolated from the transferor even in the event of the transferor's bankruptcy. A financial liability is derecognized if the debtor is legally released from primary responsibility for the liability (or part thereof) either judicially or by the creditor. As to impairment loss, an entity should recognize write-down against net profit or loss for impairment or uncollectibility if the recoverable amount of the derivative is less than the carrying amount but reversal of value shoud not be recognized because write-down results in new cost basis under SFAS.

Regarding disclosures of derivatives, an entity that holds or issue derivatives shall disclose its objectives for holding or issuing those instruments, the context needed to understand those objectives, and its strategies for achieving those objectives. The description shall distinguish between derivatives designated as fair value instruments, derivatives designated as cash flow hedging instrument, derivatives designated as hedging instruments for hedges of the foreign currency exposure of a net investment in a foreign operation, and all other derivatives. The description also shall indicate the entity's risk management policy for each of those types of hedges, including a description of the items or transactions for which risks are hedged. For derivatives not designated as hedging instruments, the description shall indicate the purpose of the derivative activity. Qualitative disclosures about an entity's objectives and strategies for using derivatives are not required but encouraged. Additional disclosure requirements for each type of hedges are stated in the statements.

Under these statements, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk.

These statements apply to all entities. A not-for-profit organization should recognize the change in fair value of all derivatives as a change in net assets in the period of change. In a fair value hedge, the changes in the fair value of the hedged item attributable to the risk being hedged also are recognized. However, because of the format of their statements of financial performance, not-for-profit organizations are not permitted special hedge accounting for cash flow hedge. These statements do not address how a not-for-profit organization should determine the components of an operating measure if one is presented.

These statements preclude designating a nonderivative financial instrument as a hedge of an asset, liability, unrecognized firm commitment, or forecasted transaction except that a nonderivative instrument denominated in a foreign currency may be designated as a hedge of the foreign currency exposure of an unrecognized firm commitment denominated in a foreign currency or a net investment in a foreign operation. Key terms such as derivatives, underlyings, notional amounts, initial net investment are clearly defined and qualification criteria for those key terms are also addressed in the statements.

INTERNATIONAL ACCOUNTING STANDARDS FOR DERIVATIVES

Accounting and reporting standards for financial instruments including derivatives are standardized in International Accounting Standards (IAS) 32 and 39. Disclosure and presentation of financial instruments are prescribed in IAS 32, while recognition and measurement of financial instruments are addressed in IAS 39. The most recent amendment on IAS 32 was made in October 2000 to eliminate disclosure requirements that become redundant as a result of IAS 39 (5).

These standards require that financial instruments including derivatives should be classified into assets, liabilities or equity and recognized on the balance sheet, where classification reflects substance, not form. Split accounting is required for compound financial instruments such as convertible securities and embedded derivatives. Offsetting on the balance sheet is permitted only if the holder of the financial instrument can legally settle on a net basis. Terms and conditions, interest rate risk (repricing and maturity dates, fixed and floating interest rates, maturities), credit risk (maximum exposure and significant concentrations), fair values of financial instruments, financial assets carried at a value in excess of fair value should be disclosed.

Financial instruments including derivatives are initially measured at acquisition cost, which are all costs incurred to acquire and make those ready for their intended uses. Subsequent to initial recognition, all financial assets are remeasured to fair value. An enterprise should recognize normal purchases and sales of financial assets in the market place either at trade date or settlement date. Certain value changes between trade and settlement dates are recognized for purchases if settlement date accounting is used.

For those financial assets and liabilities that are remeasured to fair value, an enterprise will have a single, enterprise-wide option either to (a) recognize the entire adjustment in net profit or loss for the period; or (b) recognize in net profit or loss for the period only those changes in fair value relating to financial assets and liabilities held for trading, with the non-trading value changes reported in equity until the financial asset is sold, at which time the realized gain or loss is reported in net profit or loss. For this purpose, derivatives are always deemed held for trading unless they are designated as hedging instruments. Impairment losses should be recognized for a financial asset whose recoverable amount is less than carrying amount.

IAS 39 establishes conditions for determining when control over a financial asset or liability has been transferred to another party. For financial assets a transfer normally would be recognized if (a) the transferee has the right to sell or pledge the asset and (b) the transferor does not have the right to reacquire the transferred assets. With respect to derecognition of liabilities, the debtor must be legally released from primary responsibility for the liability (or part thereof) either judicially or by the creditor. If part of a financial asset or liability is sold or extinguished, the carrying amount is split based on relative fair values.

Hedge accounting is permitted only if an enterprise designates a specific hedging instrument as a hedge of a change in value or cash flow of a specific hedged item, rather than as a hedge of an overall net balance sheet position. Three types of hedges are defined: fair value hedge, cash flow hedge, hedge of a net investment in a foreign entity. Fair value hedge is a hedge of the exposure to changes in the fair value of a recognized asset or liability. However, a hedge of an unrecognized firm commitment to buy or sell an asset at a fixed price in the enterprise's reporting currency is accounted for as a cash flow hedge under IAS. Cash flow hedge is a hedge of the exposure to variable cash flows of a forecasted transaction. The portion of the gain or loss on the effective hedging instrument is recognized initially directly in equity. Subsequently, that amount is included in net profit or loss in the same period or periods during which the hedged item affects net profit or loss. (e.g., period or periods when depreciation expense, interest income or expense, or cost of sales is recognized) The ineffective portion of the gain or loss is reported in earnings, immediately. For cash flow hedges that result in the recognition of an asset or liability, the gain or loss on the hedging instrument will adjust the basis (carrying amount) of the acquired asset or liability. A derivative designated as a hedge of a net investment in a foreign entity should be accounted for same as a cash flow hedge under IAS. On initial adoption of IAS 39, adjustments to bring derivatives and other financial assets and liabilities onto the balance sheet and adjustments to remeasure certain financial assets and liabilities from cost to fair value will be made by adjusting retained earnings directly.

SUMMARY OF COMPARISONS

Scope

Relevant codes in IAS, SFAS, & KFAS apply to all enterprises. All of them cover recognition, measurement, and hedge accounting.

Definitions

IAS and SFAS share common ideas about the definition of derivatives. According to these international and US standards, a derivative is a financial instrument or other contract whose value changes in response to the change in underlyings such as a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable; that requires no initial net investment or little initial net investment relative to other types of contracts that have a similar response to changes in market conditions. SFAS have an additional requirement for derivatives that the terms of the derivative contract require or permit net settlement. Contrary to IAS and SFAS, KFAS do not have a definition of derivatives

Initial Measurement & Recognition

All three standards require that derivatives should be recognized at the acquisition cost, which is the sum of purchase cost and transaction costs. Under IAS, an enterprise will recognize normal purchases and sales of securities in the market place either at trade date or settlement date. If settlement date accounting is used for purchases, IAS require recognition of certain value changes between trade and settlement dates so that the income statement effects are the same for all enterprises. On the other hand, SFAS and KFAS do not address trade date vs. settlement date. Value change between trade and settlements dates may be included in or excluded from measurement of net income.

Subsequent Measurement

IAS, SFAS, and KFAS require that all derivative assets and derivative liabilities should be measured at the fair value, but they do have different exceptions for this principle. Under IAS, if derivatives are linked to and must be settled by an unquoted equity whose fair value cannot be measured reliably, they should be measured at cost. However, SFAS require fair value measurement for all derivatives, including those linked to unquoted equity instruments if they are to be settled in cash. KFAS do not have exceptions for this principle for subsequent measurement. IAS & SFAS require that certain derivatives that are embedded in non-derivative instruments should be measured and reported separately from the host instruments at the fair value, while KFAS do not have standards for embedded derivatives.

Impairment Loss

According to IAS, SFAS, and KFAS, an entity should recognize write-down against net profit or loss for impairment or uncollectibility if the recoverable amount of the derivative is less than the carrying amount. But those standards take different positions regarding reversal of impairment loss. Under IAS, reversal of write-down should be taken into net profit or loss if fair value recovers, while reversal of value is not recognized because write-down results in new cost basis, under SFAS. According to KFAS, the recoveries of previously recognized impairment losses shall be recognized as gains in subsequent periods till the net realizable value equals the book value of the asset before the loss was recognized.

Reporting Fair Value Change

Under IAS, an enterprise has a single, enterprise-wide option for derivatives to either (a) recognize the entire adjustment in net profit or loss for the period; or (b) recognize in net profit or loss for the period only those changes in fair value relating to financial assets and liabilities held for trading, while value changes in non-trading items should be reported in equity until the financial asset is sold or liabilities are terminated, at which time the realized gain or loss is reported in net profit or loss. SFAS & KFAS allow option (b), only (6).

Derecognition

IAS require that financial assets should be derecognized if the transferee has the right to sell or pledge the asset; and the transferor does not have the right to reacquire the transferred assets. (However, such a right does not prevent derecognition if either the asset is readily obtainable in the market or the reacquisition price is fair value at the time of reacquisition.) In addition to those criteria, SFAS require that the transferred assets be legally isolated from the transferor even in the event of the transferor's bankruptcy. According to IAS & FASB, a financial liability is derecognized if the debtor is legally released from primary responsibility for the liability (or part thereof) either judicially or by the creditor. There are no standards for derecognition in KFAS.

Hedge Accounting

In IAS, SFAS, & KFAS, hedge accounting is permitted in certain circumstances, provided that the hedging relationship is clearly defined, measurable, and actually effective. Contrary to IAS & SFAS, there are no standards for hedging accounting in KFAS. Under IAS & FASB, Three types of hedges are defined: fair value hedge, cash flow hedge, hedge of a net investment in a foreign entity.

Fair Value Hedge

According to IAS & SFAS, this is a hedge of the exposure to changes in the fair value of a recognized asset or liability. However, a hedge of an unrecognized firm commitment to buy or sell an asset at a fixed price in the enterprise's reporting currency is accounted for as a cash flow hedge under IAS, while it is accounted for as a fair value hedge under SFAS. Under both standards, the gain or loss from remeasuring the hedging instrument is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. The effect of that accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value. At the same time, the gain or loss on the hedged item attributable to the risk being hedged adjusts the carrying amount of the hedged item.

Cash Flow Hedge

According to IAS and SFAS, this is a hedge of the exposure to variable cash flows of a forecasted transaction. The portion of the gain or loss on the effective hedging instrument is recognized initially directly in equity. Subsequently, that amount is included in net profit or loss in the same period or periods during which the hedged item affects net profit or loss. (E.g., period or periods when depreciation expense, interest income or expense, or cost of sales is recognized) The ineffective portion of the gain or loss is reported in earnings, immediately. For an acquisition of a derivative designated as a cash flow hedge, the gain or loss on the hedging instrument will adjust the carrying amount of the acquired hedging instrument under IAS. However, the same gain or loss will not change the carrying amount of the acquired hedging instrument but remain in equity and will subsequently be included in net profit or loss in the same period as the instrument affects net profit or loss under SFAS. Thus, net profit or loss will be the same under IAS and SFAS, but the balance sheet presentation will be net under IAS and gross under SFAS.

Foreign Currency Hedge

A derivative designated as a hedge of a net investment in a foreign entity should be accounted for same as a cash flow hedge under IAS. According to SFAS, for a derivative designated as a hedge of a net investment in a foreign entity, the gain or loss is reported in other comprehensive income (outside earnings) as part of the cumulative translation adjustment. SFAS require that the accounting for a fair value hedge described in the preceding section for accounting standards for derivatives in US applies to a derivative designated as a hedge of the foreign currency exposure of an unrecognized firm commitment or an available-for-sale security. SFAS also require that the accounting for a cash flow hedge described in the preceding section for accounting standards for derivatives in US applies to a derivative designated as a hedge of the foreign currency exposure of a foreign-currency-denominated forecasted transaction.

Specific Designation

Under IAS and SFAS, an enterprise must designate a specific hedging instrument as a hedge of a change in value or cash flow of a specific hedged item, rather than as a hedge of an overall net balance sheet position. However, the approximate income statement effect of hedge accounting for an overall net position can be achieved, in some cases, by designating part of one of the underlying items as the hedged position.

TRADING PRACTICE OF DERIVATIVES IN KOREA

There are 8 derivatives traded in KOFEX, which are Korea Stock Dealers Association Quote (KOSDAQ) 50 index futures, KOSDAQ50 index options, US dollar futures, US dollar options, Korean Treasury Bond (KTB) futures, KTB future options, gold futures, Certificate of Deposit (CD) interest rate future. In addition, Korean Stock Price Index (KOSPI) 200 futures, KOSPI 200 options, stock options for 7 major Korea companies' common stocks are traded in Korean Security Exchange. Trading orders of these derivatives are executed electronically where priority is given based on price and then time.

Two derivatives whose underlying index is KOSPI 200 are KOSPI 200 future and KOSPI 200 option. KOSPI 200 is a capitalization-weighted index composed of 200 stocks from wide range of industries whose base index was 100 as of January 3, 1990. The component stocks are weighted according to the total market value of their outstanding shares. The value of a KOSPI 200 future contract value is a product of KOSPI 200 and 100,000 Korean won. There are 4 contract months, which are March, June, September, and December. On any given day, any remaining KOSPI 200 future contracts will be settled in cash on the following trading day at the closing price of the most recent trading day. The final settlement shall be made on the last trading day against open positions. The value of a KOSPI 200 option contract is a product of KOSPI 200 and 100,000 Korean won. There are four contract months, which are three consecutive near term months plus one nearest month from quarterly cycle (March, June, September, and December). The options may be exercised on their expiration date because KOSPI 200 option is a European option. The settlement amount from exercise shall be equal to the difference between the exercise price and the exercise settlement price of the option. The exercise settlement price shall be the day's final KOSPI 200 index multiplied by 100,000 Korean won. The settlement method for both KOSPI 200 based derivatives is cash settlement.

US Dollar future and US Dollar option are derivatives based on US Dollar. Trading unit of US Dollar future is US$50,000. There are 6 contract months, which are three consecutive months including spot month plus three months out of March, June, September, and December. Settlement is made on final settlement day that is the third Wednesday of the contract month. Trading unit of US Dollar option is US $10,000. The options may be exercised on the last trading day of the contract month because it is a European style option. Settlement method for both US Dollar based derivatives is delivery settlement.

Two derivatives based on Korea Treasury Bond with 8% coupon are KTB future and KTB future option. Trading unit of KTB future is 100 million Korean won. Settlement method is cash settlement. Final settlement day is the third Wednesday of the contract month, which is March, June, September, or December. Trading unit of KTB future option is one KTB contract. Options are exercisable at anytime before expiration, which is the last trading day of the contract month (i.e., American style option). Contract months are 3 consecutive months including spot day plus one month from March quarterly cycle. Upon exercise of the option, the option will be converted to the KTB future.

KOSDAQ 50 index future and KOSDAQ 50 index option are based on KOSDAQ 50 index that is a capitalization-weighted index composed of 50 stocks from wide range of industries listed in KOSDAQ stock market. The component stocks are weighted according to the total market value of their outstanding shares. The value of a KOSDAQ 50 future contract is a product of KOSDAQ 50 index and 200,000 Korean won. There are 4 contract months, which are March, June, September, and December. The final settlement price shall be KOSDAQ 50 closing value of the last trading day. The value of a KOSDAQ 50 index option contract is a product of KOSDAQ 50 index and 100,000 Korean won. There are four contract months, which are three consecutive months including spot month plus one month out of March, June, September, and December. The options may be exercised on their expiration date because the options are European style. The exercise settlement price of the option shall be KOSDAQ 50 closing value of the last trading day. Exercise settlement amount is the difference between the exercise settlement price and the strike price of the option multiplied by 100,000 Korean won. Settlement method for both KOSDAQ 50 index based derivatives is cash settlement.

Gold future is based on 99% pure gold bars and its trading unit is 1 kg. Settlement method is delivery settlement. There are 6 contract months, which are all even months. Final settlement day is the last business day of the contract month. CD interest rate future is a derivative based on 3-month CD interest rate and has a trading unit of 500 million Korean won. There are four contract months of March, June, September, and December. Settlement method is cash settlement. Common features among those derivatives traded in Korea are, first, cash settlement is a dominating settlement method for all derivative instruments trade in Korean derivative markets, except Gold futures and two US Dollar based derivatives. Since US Dollar based derivatives are settled in US Dollars, their settlement methods are, in substance, cash settlements, too. Gold futures are settled in gold that is frequently deemed as means of trade and easily convertible to cash, settlement method for gold future may be de facto cash settlement; second, market prices of all derivatives traded in Korean market are readily available at all time.

SUGGESTIONS FOR NEW ACCOUNTING STANDARDS IN KOREA

As discussed in previous sections, current KFAS may be neither comprehensive nor specific enough to capture current practices of derivatives in Korea, possibly due to rapid growth of Korean derivative market since the year 2000. Following suggestions are made for development of new accounting standards for derivatives in Korea.

Definition

Derivatives should be clearly defined so that there will not be confusions in choosing relevant accounting standards for financial instruments under consideration. Selection among standards for asset, marketable securities, investment in securities, and derivatives is difficult under current KFAS without definition of derivatives. Other key terms like type of hedge, underlying, and initial net investment need to be defined.

Initial measurement & Recognition

Derivatives should be recognized at the acquisition cost, which is all costs incurred to acquire and make them ready for the intended use, because the acquisition cost is objective and reflects the fair value.

Subsequent Measurement

Considering that almost all derivatives traded in Korean market are settled in cash or near cash and their fair values are readily available at all time, fair value may be the best measure of derivatives. With objective, reliable, and readily available fair value, cost is not a good value measure of derivatives, because cost may not reflect market value when the balance sheet date is different from the settlement date of derivatives. Theoretic value may not be a good value measure of derivatives, either, because theoretic value usually has valuation model problems, which hurt its reliability.

Impairment Loss and Fair Value Change

Accounting standards for impairment loss and fair value change are stated in AS or other parts of SFAS than the article for derivatives in SFAS. It caused some speculations as to which ones are relevant standards for derivatives regarding these issues. Thus it is necessary to include accounting standards for impairment loss and fair value change in the article for derivatives in SFAS.

Derecognition

Standards for derecognition are needed to be established to minimized accounting manipulations, which are currently hot issues ignited by such cases as Enron, Global Crossing, and WorldCom. Lack of standards for derecognition may create off-balance sheet items. Economic substance and/or legality should be taken into consideration in this standards setting process. If economic privileges & obligations of the ownership and/or legal title were transferred, related assets or liabilities should be derecognized.

Hedging

In spite of the fact that hedging is the main cause of buying and/or holding derivatives and there are various types of hedgings practiced in Korean derivative market, there is no standards for hedging. Accounting for hedging should vary with hedged asset, intension, type, and effectiveness of hedging instruments, because there will be different hedging activities or different results of hedging activities depending on those factors. Therefore, it is necessary to establish accounting standards for hedging in which separate standards for each type of hedging are stated. Derivatives for hedging can be classified into fair value hedge, cash flow hedge, and foreign currency hedge as IAS & SFAS do, because all these types of hedges are available and currently used in Korean market and distinctive features of each hedge warrant different accounting treatments for each type.

Disclosure

In addition to current disclosure requirements for derivatives in KFAS, type of hedge, entity's risk management policy for each type of hedges including the hedged items, entity's general risk management policy, method to assess the effectiveness of the hedging should be disclosed.

CONCLUSIONS

In this study, we try to make suggestions for new accounting standards for derivatives in Korea and additions to a general body of knowledge that provides meaning insights to accounting standards for derivatives. In order to achieve these goals, a comparative analysis on Korean, US, and international accounting standards for derivatives were conducted. Then a literature survey on derivative accounting and examination on current trading practices of derivatives in Korea were conducted to draw a meaningful inference for establishing derivative accounting standards.

We found that there was significant growth in Korean derivative market over two year period starting from late 2000. Korean derivative market increased more than quintuple over that time period to become the 11th largest market in the world. The number of derivative products traded in Korean market increased from 7 to 17 over the same time period. Current accounting standards for derivatives issued in March, 2001 are neither comprehensive nor specific enough to capture the diverse nature of derivatives traded in Korea, now. This rapid changes during last several years in Korean derivative market in terms of size and diversity coupled with outdated current standards may warrant the introduction of new accounting standards for derivatives in Korea.

We recommended that derivatives be measured at acquisition cost upon acquisition and fair value, subsequently. Hedge accounting providing separate standards for each type of hedges (i.e., fair value hedge, cash flow hedge, foreign currency hedge) and full disclosure about derivatives and related hedging activities were recommended, too.

ENDNOTES

(1) Korean Stock Exchange began trading derivatives in 1996. The first derivative instrument traded was Korea Stock Price Index (KOSPI) 200 future.

(2) The growth trend continues in the year 2002. For example, the trading value of derivatives in KSE reached about 942 trillion Korean won (i.e., US$ 820 billion) during the first 6 months of 2002, which is a 60% increase relative to the same period in 2001.

(3) KFAS do not address this, explicitly in article 70: accounting for derivatives but implicitly in articles (55), (59), and (60).

(4) Exposure draft: amendment on SFAS 133 is under will be effective as of the first day of the first fiscal quarter beginning after November 14, 2002, except for certain provisions.

(5) IAS 32 was originally issued in March 1995 and IAS 39 became effective for the fiscal year beginning on or after January 1, 2001.

(6) KFAS do not address this, explicitly in article 70: accounting for derivatives but rather implicitly through out the whole standards.

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Jongdae Jin, University of Maryland-Eastern Shore

Sung K. Huh, California State University-San Bernardino