Derivatives

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According to Peter Coy of the International Swap & Derivative Association, the estimated derivative market worldwide encompasses over150 trillion dollars. This is in far excess of the yearly Gross National Product of the entire United States!

But what exactly are derivatives? Derivatives are financial contracts in which two or more parties take opposite positions as to how a price, index, or interest and currency rates are going change. They, in effect, "derive" their value based on an underlying asset. According to Arnold J. Pattler, these measurable values are based on common stocks and bonds, commodities such gold and oil, broad based indexes, and rates. According to the Federal Reserve Bulletin, derivatives can be classified as forwards and futures, which are agreements to buy or sell something at a specific price and at a specific date, and options which allows the holder of the derivative the opportunity to sell or buy something at a specific price. Basically, derivatives are used to better manage business and revenue risk through hedging, although they are also used for arbitrage and speculation purposes. Peter Coy explains that derivatives primary purpose is to transfer the risk from people that do not want it to speculators who are willing to expose themselves to it in order to generate a profit (as in hedging). As mentioned before, the market for derivatives is and will continue to be immense, and one of the primary concerns was how to properly record the derivatives in the financial statements and how make them easier to understand.

Prior to the issuance and implementation of the Financial Accounting Statement (FAS) 1 "Accounting for Derivative Instruments and Hedging Activities", the accounting procedures to record derivatives was unclear and imprecise. According to Angela Hwang and John S. Patouhas, under FAS 80 "Accounting for Futures Contracts," which preceded FAS 1, many companies did not properly record their derivatives and/or their hedging gain and losses. In addition, they comment that people who relied on the derivatives information did not received any guidance from auditors of how treat hedge accounting. Financial users and CPA's often didn't thoroughly understood how to handle derivatives. Another problem before the implementation of FAS 1 is that commodity industries did not considered their contracts on the sale or purchase of gold, oil and other commodities as derivatives. Instead they consider them as a normal sale or purchase contract.

Statement 1 was issued by the Financial Accounting Standard Board (FASB) in June 18 and became effective in June 15, 000. FAS 1 stipulates the following rules regarding derivatives and the effects upon the financial statements.

1.Derivatives are contracts that creates' rights and obligations that meet the definition of assets and liabilities.

.Fair value is the only relevant measure of reporting derivatives.

.Only assets and liabilities should be reported on the balance sheet.

4.Gains and losses on derivatives must be reported currently in earnings, except in specific situations where they are reported in Other Comprehensive Income. Special hedge accounting may offset those earnings based on gains or losses by the hedged item.

Some of the items that should be considered as derivatives are commodity and futures contracts, certain loan commitments, forwards, some equity warrants, and options contracts on private companies. This new standard allows the hedging transactions to be more "transparent in the financial statements". In addition, this statement applies to all types of entities, both private and non-private, profit and non-profit organizations.

But the reasoning behind the creation of FAS 1 wasn't based only on the previous inconsistencies established within FAS 80. The 10's saw unprecedented losses by both financial and non-financial institutions with regard to derivative trading. Most notably was the collapse of Barings, a British bank that suffered a total loss in excess of $1 billion, all due to the trading of Nick Leeson, who made large bets on the direction of the Nikkei 5 (Japan) index. The Japanese bank, Sumitomo, suffered nearly $ billion in losses in the copper spot, futures, and options market. Domestically, Orange County treasurer Robert Citron also lost $ billion by speculating on interest rates, thus sending the county into bankruptcy. Scores of other companies also saw dramatic losses through the use of improper derivative trading, and were often perpetrated by a lone individual with unlimited trading power within the company. As regulators of accounting standards, it was clear that FASB had to take further steps toward dictating how derivatives must be reported in order to stop much of the careless risks that many companies were willing to accept.

Many have been critical of FAS 1, mainly due to the excessive costs and resources companies have incurred in implementing them. For some large companies with significant hedging activities, training in excess of 1 months for FAS 1 is not unusual. But, an incalculable benefit to the requirements of FAS 1 is that more information about a companies hedging program will be revealed to investors, and a more thorough understanding of hedging practices is now needed. For companies to justify their use of hedge accounting, they must now prove that their fair value and cash flow hedges are "highly effective." In addition to the more detailed requirements, companies will also have to provide an expanded description of its risk management philosophies and strategies. From this, investors and analysts will now be able to better determine if critical financial exposures are being hedged effectively or not. In the long run the market will reward those companies with prudent hedging programs.

It is essential that companies define ways to limit financial risk. FAS 1 now provides insight into how derivatives may be reported, whether it is used for hedging, speculation, or arbitrage. Tempting as it is to turn a blind eye to those who violated risk limits as long as profits occurred, the new rules will require closer monitoring by company leaders as to how derivatives may be used and whom may trade them. Clearly it should limit the tendency for top management to take unreasonable risks in order to realize greater profits. It has also brought attention to the fact that it is extremely dangerous to try and outguess the market. Liquidity risk should also be on the forefront of every derivative trader. Many exotic and less actively traded derivatives can often times sell at steep discounts to their theoretical value. This is what happened to Long Term Capital Management, whose arbitrage opportunities disappeared when the Russian Bond market collapsed in 18. What appeared as a sure fire way to make money vanished overnight, and the hedge fund was bailed out to the tune of $4 billion. Risk limits will now be set much lower than previously allowed due to the need to recognized derivative liabilities within the balance sheet.

Despite the efforts of the FASB to require companies to report their derivative transactions, there still some companies that dislike derivatives for their inherent risk and think that they should be treated ass off-balance sheet items. In the Securities Litigation & Regulation Report, America's foremost investor Warren Buffet warned called derivatives "financial weapons of mass destruction" because they can bring down profitable industries. Buffet continues to mention that derivatives are contracts with varying durations and that their value is tied to complex variables. In addition, Buffet explains that other drawbacks of the derivative markets is that they generate earnings that are reported in overstated amount, that the risk of the derivatives are concentrated in few dealers, and that it is often difficult to determine their actual value. Parties involved in derivative risk management tend to lie as to how they account for them, and that derivatives have facilitated numerous frauds.

Focusing on certain derivative instruments, the SEC explains that they have been used in structuring off-balance sheet arrangements. Basically, derivatives that are index to stock options and classified as stock holders equity are treated as off-balance sheet arrangements because those derivatives are not transparent to users of the Financial Statements and because since they are classified as equity, any change in the fair value may not be periodically recorded on the Financial Statements (SEC web-site).

Although derivatives are not well understood and arguments about the correct accounting treatment still persist, the FASB has worked hard to ensure proper accounting for them. Statement 1 will help is making audit process more efficient, with derivatives marked to market on the balance sheet, and now more disclose information is required. This will reduce off-balance sheet transactions, and gives a clearer picture of the risk inherent in trading derivatives. To make derivative accounting clearer, FASB issued statement 14 "Accounting for Certain Financial Instruments with Characteristics of Liabilities and Equities", which is an amendment of FAS 1. The amendments on the issued standard will improve the reporting of derivatives by requiring that contracts with similar characteristics be accounted in the same manner. Further more, it stipulates which contracts meet the characteristics of derivatives, and what components of derivatives require special reporting. This statement will become effective on June 15, 00. It is clear that this issue will continue to be highly controversial within the business world and may never be fully remedied.

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