Regulatory requirements and accounting standards on derivative financial instruments

Globalization of financial markets, increased volatility of interest rate and currency exchange rates coupled with major advances in finance, computerized information processing and communication technology, among others, have encouraged entities to issue and/or hold derivative financial instruments (derivatives). Derivatives are defined as financial products, such as swaps, options, futures, forwards, and unstructured receivables, which derive their value from underlying financial instruments such as stocks, bonds, or foreign currencies. The Wall Street Journal article (August 25, 1994) estimated the "notional value" of outstanding global derivatives at $35 trillion, which indeed exceeds the estimated total value of the world's bonds and stocks of $32 trillion.(1) While this estimated notional value may overstate the actual amount of derivatives traded, it clearly underscores the significance and role of derivatives in the global financial markets.

Participants in derivatives markets such as dealers, financial institutions, commercial firms, mutual and pension funds, state and local government, as well as other businesses and individuals, are using derivatives for primarily four purposes: (1) to manage (hedge) their financial risks; (2) to speculate on the price of an interest-bearing security, on the value of equity indexes, and on foreign exchange prices; (3) to reduce the cost of raising capital; and (4) to maximize return on investments through asset management activities, tax planning opportunities, and regulatory restrictions. Derivatives can be traded through organized exchanges (NYSE, AMSE) or through contracts negotiated privately between two parties (over-the-counter, OTC).

Derivatives have grown significantly in the volume and complexity from the traditional interest-rate and currency swaps to more sophisticated computer-driven risk management derivatives. The magnitude, complexity, nature, and extent of the use of derivatives and recent losses by some derivatives end-users have raised numerous issues of concern among the financial community, accounting profession, and regulators as to the appropriate use, proper risk assessment, and adequate disclosures of various risks associated with derivatives by the users of these financial products. Improved oversight and educational initiatives by legislators and regulators, as well as accounting standards and guidelines by the accounting profession, have been suggested as a means of addressing these concerns. However, regulatory requirements and controls, as well as tax and accounting standards of derivatives, have not been sufficiently addressed in the literature. The primary purposes of this paper are to: (1) examine regulatory requirements and accounting standards related to financial derivatives; and (2) discuss implications of these authoritative guidelines for proper measurement, classification, and disclosures of the nature, amounts, and risks of derivatives.

REGULATORY REQUIREMENT OF DERIVATIVES

The concerns and issues of derivatives have been addressed in several authoritative reports. In June 1992, Congress asked the General Accounting Office (GAO) to investigate financial derivatives markets to determine proper risk management and sufficient regulations among the dealers and end-users of derivatives. The GAO, in conjunction with the Government Finance Officers Association (GFOA), conducted a survey of over 4,600 state and local government entities in 1993.(2) Although the survey results are limited to the GFOA-member government entities and the private pension plans, they reveal that: (1) the extent of usage of derivatives varied from four percent of localities to 72 percent of private pension plans; (2) local entities mostly used interest rate swaps while large pension plans utilized future, options, and foreign exchange derivatives; (3) there was a positive relationship between the size of the entity and the extent of usage of derivatives; and (4) hedging of risks and maximization of return on investment were considered as the most important reasons for using derivatives.

To determine further the applicability of derivatives in the municipal market, the GFOA and the Municipal Bond Investors Assurance Corporation (MBIA) conducted a survey of over 1,600 government finance professionals throughout the United States in 1994.(3) Their survey reveals that approximately 44 percent of the respondents indicated that they either have used or would consider using derivatives, while only six percent actually had used derivatives for debt financing.

The Group of Thirty, an international financial policy organization consisting or representatives of central banks, international banks, securities firms, and academia, published its report entitled, "Derivatives: Practices and Principles," in July 1993.(4) This report made 20 recommendations to help dealers and end-users manage derivatives transactions and continue benefits from them. It also called for proper disclosure of information about nature, risks, managerial policies, and accounting standards on derivatives.

Based on the previous reports on derivatives, GAO, in 1994, made several recommendations to Congress, financial regulators, the SEC, and the FASB to take proper actions to: (1) close regulatory gaps related to dealers of derivatives (securities firms and insurance companies); (2) ensure investors protection by clarifying and promulgating new rules for derivatives brokers, dealers, and investment managers; (3) accelerate the FASB's deliberation process in issuing accounting standards for accounting and disclosure of derivatives by dealers and end users of derivative products; and (4) examine and test reasonable capital requirements for derivative brokers and dealers to provide protection from unexpected losses or failures.

Derivatives transactions are typically regulated by the entities involved in the transactions as well as underlying assets and financial instruments. For example, exchanged-traded derivatives such as options on securities and commodity futures are regulated by both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). Recently, the increased use of derivatives transactions, especially OTC derivatives, called for congressional action. In 1994, two bills were introduced on derivatives.(5) The chairman of the House Committee on Banking, Finance and Urban Affairs, Rep. Henry Gonzalez (D-Texas), introduced H.R. 4503, the Derivatives Safety and Soundness Supervision Act of 1994. Senator Bryan Dorgan (D-North Dakota) also introduced S. 2123, the Derivatives Limitations Act of 1994. Both bills focused primarily on derivatives held by financial institutions and require federal regulatory agencies to examine various derivatives issues.

Initiatives regarding oversight regulations for derivatives have been considered in the 104th Congress.(6) In 1994, both Representatives Henry Gonzalez (D-Texas) and Jam Leach (R-Iowa) introduced bills that deal with derivatives markets. The Gonzalez proposal would require banks to disclose their derivatives transactions in full, while the Leach proposal would require establishment of proper standards for federal supervision of derivatives activities. Although these bills were not passed in 1994, it is possible that combination of these bills will be reconsidered in 1995. These initiatives range from requiring the SEC to oversee derivatives activities of currently unregulated dealers to requiring regulators to establish guidelines for creating and using derivative products. While, as d this writing, no derivatives bills have been passed by e U.S. Congress, the FASB has accelerated its standard-setting process by issuing a new statement on derivatives.

ACCOUNTING STANDARDS ON DERIVATIVES

Traditionally, the accounting treatment for derivatives has been based on how the underlying financial instruments were accounted for, which may not always reflect the economic reality and substances d derivatives. The financial community is concerned with the lack of adequate disclosures provided by holders and issuers of derivatives in the published financial statements. Complexities and risks associated with derivatives should be addressed and senior management, especially the board of directors, should take a proactive role in decisions involving issuing or holding derivatives, and in communicating relevant information regarding derivatives to users of financial statements.

The FASB issued SFAS No. 119, entitled "Disclosure About Derivative Financial Instruments and Fair Value of Financial Instruments," in October 1994.(7) SFAS No. 119 requires disclosures about amounts, nature, and term of derivatives. The Statement requires that a distinction be made between derivative financial instruments held or issued for trading purposes and those held or issued for purposes other than trading. For "trading derivatives," the average fair value and net trading gains or losses should be disclosed. Other derivatives should also be disclosed to reveal their purposes and how they are reported on financial statements. If derivatives are accounted for hedges of anticipated transactions, their anticipated transactions or other events that result in recognition of the deferred gains or losses should be disclosed in earnings.

SFAS No. 119 encourages, rather than requires, disclosure of quantitative information bout interest rates, foreign exchange, commodity price, or other market risks of derivatives and risks of other financial instruments or nonfinancial assets and liabilities to which the derivatives are related. The way of reporting the quantitative information depends on the entity's methods of managing and adjusting those risks. Effected entities should identify the key drives that impact the risks and returns of derivatives and perform sensitivity analysis to quantify risk.

IMPLICATIONS OF AUTHORITATIVE GUIDELINES ON DERIVATIVES

Disclosures about management objections in using derivatives for risk management purposes and/or for taking speculation positions should be useful and provide relevant information for financial statement users. Management may use derivatives for two primary purposes: (1) risk management and (2) speculation position taking. Although SFAS No. 119 did not differentiate between these purposes, analysis and disclosure of management intent can be useful for issuers and users of financial statements. Complexities and risk associated with derivatives should be addressed, and proper information on them should be communicated to the users of the financial statements.

New authoritative guidelines (e.g., SFAS No. 119, GAO recommendations) present issuers and users of financial derivatives with a set of challenges. Proper compliance with these authoritative guidelines requires careful assessment of: (1) risk management policies regarding issuing or holding derivatives; (2) how derivatives are classified, recorded, measured, disclosed, and adjusted for fair value; (3) how derivatives are issued and used; and (4) how derivatives risks are controlled. Thus, the effective and efficient implementation of these guidelines requires entities issuing and holding derivatives, especially financial institutions, establish an internal implementation committee to prepare policies and procedures for derivatives and to ensure compliance with authoritative guidelines on derivatives, including regulatory initiatives and new accounting standards.

CONCLUSION

Derivatives have recently grown rapidly primarily because of fundamental changes in global financial markets, improvements in computer technology, and ever-lasting volatility in the interest and currency exchange rates. Businesses, individuals, and governmental entities have used derivatives for the purposes of managing risks, obtaining feasible financing, earning desirable return on investments, tax planning opportunities, and/or speculations activities. Authoritative bodies are concerned with complexities and risk associated with derivatives activities and, accordingly, have considered several policy issues regarding proper creation, use, and disclosure of derivatives transactions.

The increased use of derivatives transactions presents new challenges for the accounting profession and financial regulators. Several bills pertaining to derivatives have been introduced; however, as of this writing, no derivatives bills have been passed by Congress. It is expected that some derivatives bills will be reconsidered and possibly passed in 1995. In response to recommendations of the GAO and other regulatory bodies, the FASB issued its SFAS No. 119, which requires disclosures about amounts, nature, and terms of derivatives. The new initiatives on derivatives require management and accountants to prepare implementation plans to ensure compliance with regulatory requirements and accounting standards about derivatives presented in this article.

* Associate Professor of Accounting, College of Business, Middle Tennessee State University, Murfreesboro, TN 37132, Phone (615) 898-5764, Fax (615) 898-5045

(1)Smith, Randall, and Steven Lipin, "Beleaguered Giant: As Derivative Losses Rise, Industry Fights to Avert Regulations," The Wall Street Journal (August 25, 1994), p. A1, A4.

(2)U.S. General Accounting Office, "Financial Derivatives: Actions Needed to Protect the Financial System," GAO/GGD (May, 1994), Appendix 1, p. 130.

(3)Ibid.

(4)Global Derivatives Study Group, "Derivatives: Practices and Principles," The Group of Thirty (July 1993), Washington, DC

(5)Barlas,, Stephen, "Questions Raised About Beese Safe Harbor Proposal," Management Accounting (August, 1994), p. 10.

(6)Molvar, Roger H., and James F. Green, "The Question of Derivatives," Journal of Accountancy (March 1995), pp. 55-61.

(7)Financial Accounting Standards Board, 1994, "Disclosure About Derivative Financial Instruments and Fair Value of Financial Instruments," Statement of Financial Accounting Standards (FASB, Norwalk CT).

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