Innovations: Current Issues in Accounting for Derivatives
J. OF DERIVATIVES, Spring 1996
Posted: 20 Dec 1998
Although the Financial Accounting Standards Board has been developing standards for reporting and disclosing derivatives activity for many years, current guidelines are still neither comprehensive nor widely accepted. With regard to recognition of profit or loss from these instruments, the difficulty arises from the fact that some balance sheet items are marked to market, while others are measured at cost. This means that offsetting gains and losses in hedging relationships may be recognized in different reporting periods. Both existing and newly proposed accounting rules address this problem by allowing firms to defer certain derivatives gains and losses until offsetting gains and losses are realized.The problem remains that, because hedging relationships are often complex and dynamic, this approach can be effective only if firms have flexibility in deciding which gains and losses to defer. Yet that very flexibility makes financial statements difficult to interpret and creates the potential for income manipulation. One way to resolve this conflict would be to recognize all gains and losses as they occur, but this solution has always generated controversy. Is it too costly, or just too radical?The problem with regard to disclosure is that the important information about derivatives positions is often not their size and market value, but rather their impact on the probability distribution of future earnings, an aspect that is beyond the scope of traditional accounting. Rulemakers defend the lack of requirements for quantitative risk disclosure by citing the cost of obtaining relevant risk measures and a lack of agreement about them. Yet many derivatives dealers estimate and track quantitative measures of risk on a daily basis. If corporate managers are unable to quantify the risks associated with their derivatives positions, is it prudent for them to expose shareholders to those risks?
JEL Classification: G13, G32, M4
Suggested Citation: Suggested Citation