Derivatives: The New Disclosure Rule

Corporate users of credit-default swaps and similar instruments soon must show where they report them on their balance sheets and income statements.

If you think the Financial Accounting Standards Board’s new disclosure statement on derivatives doesn’t change things very much, ask one of the investors duped by Enron at the turn of this century.

Operating in those prehistoric days, before FASB declared war on historic-cost accounting in favor of a rigorous brand of fair value, the bloated energy giant was free to mark vaporous ideas to market — and fiddle with its balance sheet.

Listen to Charles Mulford, a professor of accounting at Georgia Tech and director of GT Financial Reporting & Analysis Lab: “If you look at Enron’s last balance sheet, ‘customer deposits’ are listed as an asset and a liability. These were, in fact, oil contracts that were derivatives used to misreport cash flow.” The contracts covered payments to Enron by its off-balance-sheet entities. Those entities were financed by bank borrowings guaranteed by Enron, which received the cash for oil to be delivered later. In short, as Mulford wrote in his book Creative Cash Flow Reporting and Analysis, labeling the contracts as “customer deposits” enabled the company to portray what was really a loan as operating cash flow.

Under FASB’s Statement No. 161, “Disclosures about Derivative Instruments and Hedging Activities,” such deception would be a whole lot harder to achieve, the accounting professor thinks. Issued earlier this month, the new standard is aimed at improving financial reporting about derivative instruments and hedging activities “by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows,” according to FASB. It’s effective for financials issued for fiscal years after November 15, and the board is encouraging early application.

Under the new rule, issuers must disclose the fair values of derivatives they use, as well as their gains and losses from the instruments, in tables accompanying their financial statements. Perhaps with a nod to the current credit crunch — FASB was in the last stages of hatching the standard as the subprime crisis deepened — the standard requires companies to reveal features of their derivatives that are related to credit risk.

To be sure, the standard changes nothing about the accounting for derivatives. But it does make the often-cloudy reporting of them much more transparent to the users of financial statements, Mulford thinks. “With these tables, derivatives can’t be hidden from view in a way they were on, say, Enron’s balance sheet and income statement,” he told CFO.com. “Investors will be better able to assess the contribution of derivatives to earnings and financial risk, and in the process, they’ll be better able to judge earnings sustainability.”

The new standard requires employers to reveal where they put the results of their derivatives investments on their financial statements and spell out how much they are; how derivatives are accounted for; and how derivatives affect their balance sheet, income statement, and future cash flows. (While 161 requires companies to disclose where they report derivatives’ effects on their income statements and balance sheets, it doesn’t require such reporting in cash-flow statements. FASB plans to address disclosures of derivatives’ location on cash-flow statements in the context of its ongoing project on financial-statement presentation.)

Further, corporate users of derivatives must report each instrument’s main underlying risk exposure — for instance, “interest rate, credit, foreign exchange rate, interest rate and foreign exchange rate, or overall price,” according to the new rule. Companies must also distinguish between derivatives used for risk management and those used for speculation. With derivatives speculators said to be gobbling up credit-default swaps in anticipation of more carnage from the subprime unwinding, that distinction seems sure to make news if the current downturn continues.

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