FAS 161 Debuts to Clarify Derivatives

Companies must start preparing new disclosures on how they use derivatives and hedging activities to manage risk.

The Financial Accounting Standards Board completed another new accounting standard last week: Financial Accounting Standard No. 161, Disclosures about Derivative Instruments and Hedging Activities. Its purpose is to increase disclosure about an entity’s financial position, financial performance, and cash flow. It takes effect for reporting periods beginning after Nov. 15, 2008, so calendar-year companies will adopt it with their 2009 financial statements.

FASB hopes the new standard will help investors better understand the risks companies assume through the use of increasingly complex derivative instruments and hedging activity, according to board member Tom Linsmeier. Investors complain that existing disclosure requirements contained in FAS 133, Accounting for Derivative Instruments and Hedging Activities, do not provide an adequate view of the risks, he says.

FAS 161 will not, however, provide any new insight into the kinds of risks companies face these days in the turbulent credit markets, Linsmeier says. Those instruments—complex, credit-based derivatives now languishing on balance sheets with little or no determined value—are largely separate from the derivatives and hedging activities companies employ to manage risks, he explains.

Linsmeier

“This standard is in response to complaints by users of financial statements several years ago of being not able to understand the derivative risks that companies are managing or to see the effects they have on financial statements,” Linsmeier says. “This concern predated the current credit crisis. The only connection to the current circumstances is if you have derivatives with credit risk-related problems.”

Linsmeier admits “it would be lovely” to say FAS 161 is in response to the credit crisis roiling world markets, but FASB cannot move that quickly. The Board is working to revise FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities and Financial Interpretation No. 46R: Consolidation of Variable Interest Entities, to address some of the transparency problems seen in securitization of sub-prime and prime mortgage assets.

“We’re working amazingly quickly for FASB” to get those rule revisions in place, Linsmeier says. He anticipates exposure drafts will be published in June. The objective is to issue any revised standards so that they would be effective by the end of this year (in other words, for the next fiscal year), he says.

What FAS 161 Does

The new standard establishes a tabular format for disclosing the fair value of derivatives instruments along with their gains and losses. It requires companies to provide more information about liquidity by requiring disclosure of derivative features that are credit risk-related. It also requires cross-referencing within footnotes so readers can more easily locate information about derivatives.

FULL DISCLOSURE

The following is an excerpt from FAS 161 on derivative and hedging disclosures:

An entity that holds or issues derivative instruments … shall disclose for every annual and interim reporting period for which a statement of financial position and statement of financial

performance are presented:

A. The location and fair-value amounts of derivative instruments

reported in the statement of financial position

B. The location and amount of the gains and losses reported in the statement of financial performance (or when applicable, the statement of financial position, for example, gains and losses initially recognized in other comprehensive income [OCI]) on derivative instruments and related hedged items

C. For derivative instruments that are not designated or qualifying as hedging instruments under this Statement, if an entity’s policy is

to include those derivative instruments in its trading activities

An entity that holds or issues derivative instruments … shall disclose for every annual and interim reporting period for which a statement of financial position is presented:

A. The existence and nature of credit risk-related contingent features and the circumstances in which the features could be triggered in derivative instruments that are in a net liability position at the end of the reporting period

B. The aggregate fair-value amounts of derivative instruments that contain credit risk-related contingent features that are in a net liability position at the end of the reporting period

C. The aggregate fair-value of assets that are already posted as collateral at the end of the reporting period and (1) the aggregate fair value of additional assets that would be required to be posted as collateral and/or (2) the aggregate fair value of assets needed to settle the instrument immediately, if the credit risk-related contingent features were triggered at the end of the reporting period

Source

Financial Accounting Standards Board (March 2008).

The objective, FASB says, is to improve transparency about the location and amount of derivatives in a company’s financial statements, how derivatives and related hedged items are accounted for under FAS 133, and how those items affect the financial position, financial performance, and cash flows.

Lee

Hee Lee, chairman for the North American Accounting Committee of the International Swaps and Derivatives Association, says the new standard expands significantly the amount of information companies will need to provide in their financial statements, which will increase the workload. “Some of these disclosures are pretty onerous,” he says.

Lee credits FASB with responding to feedback during the exposure and deliberation process by removing some of the more burdensome, less critical disclosures that the Board originally planned to require. He still has lingering doubts about how useful some of the required information will be for users of financial statements.

On the other hand, Lee adds, companies may find places in the standard where companies find they won’t be required to disclose information that a user might find meaningful. “A lot of companies use derivatives to hedge exposure, but elect not to qualify for hedge accounting,” he says. “Under this requirement, the hedge item related to what we call ‘economic hedges’ is not required to be disclosed. One could argue that you’re only disclosing one side of the risk … It could mislead readers of financial statements. Hopefully in those situations companies will supplement the disclosure in a qualitative manner.”

Thomas Rees, director for FTI Consulting, says the new disclosures will generally improve the quality and amount of information available to investors and analysts. “But it is only one step in requiring entities to provide more useful information about their risk exposures, particularly their credit risk and liquidity exposures,” he says.

Rees says he likes that FAS 161 requires companies to provide information about credit-risk related contingent features, including circumstances that would trigger contingencies and the fair value of assets that would be needed to settle the instrument. “Currently, such triggers are fairly common but are rarely disclosed,” he says. “This type of information would be particularly valuable in today’s market environment in which there is so much uncertainty about an institution’s credit exposures and liquidity.”

On the other hand, FAS 161 pertains only to derivatives and not all financial instruments, he says. “Other financial instruments have similar risk exposures,” he notes. “The new standard will not require entities to provide a complete picture of its risk exposures. In today’s market, investors in financial institutions are very concerned about liquidity and want information about the types of liquid resources available to an entity, like back-up lines of credit, and the demands that could be placed on its liquidity.”