By John Thackray

The April 4 unveiling of latest ideas on derivatives accounting from the Financial Accounting Standards Board (FASB) was at first blush a victory to critics of the earlier and much-disliked prototype. The new version, the guts of a full exposure draft to be issued at the end of June, "modified the approach so that it is no longer a mark-to-market accounting model for derivatives," according to FASB's Robert Wilkins, manager of the project.

But instead of being greeted by cheers from derivatives creators and users, the FASB proposal has met with hostility and dismay from both corporate and financial institutions. Some of these critics are girding for battle, but for the time being are talking off the record. Reportedly, several of the major accounting firms are also critical, though they are not likely to be openly negative. If most users thought the proposal too radical and a poor reflector of economic realities, some accounting purists believed it was quite the opposite-that the Board has "bowed to constituent pressure," said one, i.e. sold out.

Four Years For What?

Both camps feel that the FASB draft seems to be an inglorious conclusion to four years of debate and deliberation of various trial balloons out of FASB's Stamford, Connecticut, headquarters. It calls for all derivatives to be recorded in the balance sheet at fair value. If they are held for hedging purposes, gains and losses are booked to earnings, while the gains and losses on the items hedged are accelerated and recognized in earnings for the same period. Thus a perfect hedge will come out at zero. Although both matching sides apparently get marked to market, changes in value of the underlying cash security will be limited to the change in the value of the derivatives. An institution reporting a $10 gain in a derivative would only report a $10 swing in the price of the hedged item, even if that hedge item actually lost $20.

For derivatives that are used against forecast transactions, FASB wants gains and losses booked to equity, to be recognized in earnings when the forecasted transaction occurs. Gains and losses of all other derivative types, trading securities, or hedges of other derivatives are booked to earnings. Most futures, forwards, swaps, options and structured notes are included.

Bankers were some of the first on the attack. "The banking industry isn't going to like this at all," said Donna Fisher, director of tax and accounting at the American Bankers Association. "It is just another step to value accounting," widely disliked because it would introduce volatility into quarterly earnings instead of the stability banks enjoy from currently practiced offsets of derivatives against other assets.

Though perhaps an ugly duckling, the proposal does satisfy two goals urged by reformers: 1) it brings derivatives into financial statements for the first time; 2) it lays the groundwork for a later, fuller implementation of mark-to-market accounting. The SEC, which clearly has been pretty disgusted with FASB prevarication on this issue, has announced its approval of this attempt to rid derivatives accounting of the imperfections of current practices based on FASB Nos. 52 and 80, some ad hoc pronouncements of the Emerging Issues Task Force, and generally accepted accounting practices for synthetic instruments. In response to this "accounting hodgepodge," a duo of FASB staffers have issued a memo supporting the new standard. It states, in part, "many derivatives are carried off balance sheet regardless of whether they are part of a hedging strategy, and since practices are inconsistent among entities and for similar instruments held by the same entity, users of financial reports are confused and even misled." (A survey by the University of Pennsylvania's Wharton School, released March 29, found that 57 percent of 300 companies polled claim that the current hodgepodge accounting treatment of derivatives forces them to use the products in less than optimal ways.)

No Big Deal

FASB is probably surprised that it has not won more friends for its new approach. "They believe they've done a good job and that it should be a big issue for corporate or financial institutions to fall into line," says an accounting specialist at a major money center bank. "But as we've looked at some of the pieces in more detail, we think it would represent a substantial change in the way financial statements are looked at," she continues. "A lot of people don't understand this exposure draft. As more details get understood, we may have an outcry."

Derivatives groups are sure to be in the forefront of protest. For one thing, the Board has set a high hurdle for hedge accounting treatment. A derivative has to be designated in advance as hedging a specific asset, liability, firm commitment, or forecast transaction; the hedged item must present an exposure to changes in price that would materially affect reported earnings; the hedging instrument is not a written option or cash instrument, FX deals excepted.

Exchanges Unhappy, Too

Forecast transactions also only qualify for hedge accounting in a fairly narrow band. And one of these restrictions, that the maturity of the hedge match that of the designated asset, has made the futures industry unhappy. Paul Bjarnason, chief accountant of the trading and markets division at the CFTC, explains why: "We are disappointed because we wanted full equivalence between OTC products and exchange traded futures. What FASB is proposing will make exchange traded futures less attractive than OTC products for use in longer-term hedges." Often a year-long exposure will be offset with four successive three-month listed contracts. But under the proposed rules, as each contract matures the profit or loss gets booked in the income statement, resulting, of course, in greater volatility. Another piece of bad news for commodity futures is that farmers' crops in the ground aren't eligible for hedging treatment.

FASB members frequently deride the patchwork of present practices and the lack of uniformity in accounting practices and published reports. But this latest proposal, critics argue, is also beset by contradiction. One such is the suggestion that a cash instrument that is hedged gets an entirely different treatment than one that isn't. The former gets marked-to-market, but not the latter. Result? "There will be two separate lines on the asset side of the balance sheet," says an accounting consultant to a major derivatives trade group, "one for hedged assets, the other for unhedged assets. Or there will be only one line, but the assets on it will be carried according to two different accounting rules."

One current practice that would be penalized is corporate hedging of anticipated debt issuance. Companies would no longer buy forward swaps and Treasury options and sell them just before issuance of the debt as a means of locking in current rates. Gains and losses on the hedge would not qualify for hedge accounting treatment and gains and losses on the swaps and options would be pumped into earnings. "There will be no basis adjustment for the debt-that's a big difference from what we do today," notes Deidre Schiela, a Price Waterhouse partner.

Another possible objection is that hedging fixed rate and floating rate obligations may get very different accounting treatments. For fixed rate debt, the standards would treat a swap to floating rates as a hedge of an existing liability. Changes in the value of both swap and debt would be recognized in regular earnings. But a floater's uncertain interest rate obligations would probably be treated as a hedge of a forecasted transaction, to sit in "comprehensive income".

"What's that?" you might wonder. The all-new "comprehensive income" basket is one feature that is sure to get up the dander of corporate users. It is to this quasi-slush account within retained earnings that profits and losses on forecast transactions get deferred. Separately FASB is working on an exposure draft for "comprehensive income," scheduled to come out this summer.

Cynics feel that FASB doesn't have a home for a lot of things they want to do, so they've created this new and sure-to-be-confusing line in the accounts. FASB has even proposed a statement of comprehensive income per share, which is guaranteed to trigger corporate protest, if only because of the difficulties of explaining what it means to shareholders. At a public meeting in mid-April, FASB representatives were asked by an academic to define the conceptual doctrine separating comprehensive and regular income. The representatives said FASB hadn't tackled that issue because it was in too much of a hurry.

Full Court Press

Haste certainly has marked FASB's deliberations. "In the past when FASB came up with proposals for derivatives accounting," says one CFO who follows the accounting scene, "they'd share their ideas informally with people. And there were always so many problems that they'd go back to the drawing board again and again. The feeling this time was: 'We're not going to be beaten back, in the hope of some dream of a better answer. This exposure draft is going to see the light of day, and after a little tweaking will become a standard-no matter what.'"

Some authorities feel that this plan, which passed by a five-to-two vote among the mandarins of Stamford, isn't as bad as some of their earlier ideas and represents a forward step that may be the best possible compromise. "This is more likely to gain acceptance than anything FASB has proposed recently," says Jim Johnson, partner at Deloitte Touche. "It will add flexibility in certain areas. For example, you can select the risk you want to cover, interest risk, or currency, without an overall enterprise test to see if derivatives are risk reducing. So this is a more modern-day view of risk management. There is definitely stuff to like here."