Derivative wars: a battle has been brewing on the accounting for derivatives--pitting corporate America's finance executives against regulators/standard-setters. The growth of standardized, exchange-traded derivative contracts is causing a greater sense of urgency for resolution.

• Author: King, Tom
• Position: ACCOUNTING

In a prescient 1995 speech, Robert Herz, then a future Financial Accounting Standards Board (FASB) chairman, joked that the word "derivative" is Spanish for "evil" and foretold the rise of "derivatives wars," where practitioners and regulators would clash along varied battle fronts, with each group arguing it is trying to do the right thing.

Now, in 2007, we have a situation where standard-setters want financial contracts to be marked to market while management teams of public firms seek to avoid reporting volatile earnings. Those wars have begun.

Accounting for derivative contracts is arguably the biggest financial reporting controversy today as derivatives and restatements are putting dozens of well-known U.S. firms on the front pages of the business press.

What's raising the stakes is the explosive growth in these financial tools. By one estimate, the global value of derivative contracts is four times that of all stocks and bonds combined. And, as if to underscore the importance of those numbers, it's recently been reported that the venerable New York Stock Exchange has announced plans to become a player in derivatives trading.

This article frames accounting issues concerning derivative contracts and offers three historical case studies suggesting that the derivative wars can be settled in a peaceful manner.

Basically, a derivative confers the right or obligation to exchange something at a future date at an agreed-upon price. This is a good thing. Contracts permit organizations to hedge fickle interest rates, commodity prices or costs of foreign currency, while giving others the chance to make trading profits. Treasurers now know how to hedge without exposing firms to the leveraged, speculative bets that garnered so much attention in the early 1990s.

Standard-setters argue that derivatives represent assets and liabilities that should be shown on the balance sheet at fair value. They point out that readily-available market prices for commodities, foreign exchange and credit make marking contracts to market rather easy.

Controllers, on the other hand, worry that when the exposure to be hedged is a future cash flow stream, it can be a challenge to establish a perfect hedge. Changes in derivative contract values may not exactly offset movements in the underlying exposure. A well-constructed contract may provide an effective economic hedge and still cause an unpredictable gain or loss at interim measurement dates. Firms that seek to report...