What's normal in derivatives accounting.

• Author: Kawaller, Ira G.
• Position: Derivatives

The "normal purchase and sales" exemption in FAS 1 33 allows companies to ignore the fact that their purchase and sales agreements satisfy the definition of a derivative, as long as certain conditions are met.

As broad as the field of derivative accounting is, much of the concern over the rules is that they are too broad. And efforts to clarify the standards have created issues of their own.

During the formative stages of Financial Accounting Standard No. 133 -- the rule pertaining to derivative instruments and hedging transactions -- many observers voiced concerns that a host of contractual arrangements, including many purchases and sales agreements, satisfied the definition of a derivative and had to be accounted for as such.

These concerns were mollified to a large degree, however, when the standard was amended (by FAS 138), and the "normal purchase and sales" exception was clarified. For those qualifying under this exception, FAS 133 accounting rules are not applied even if their contracts have features of derivatives.

Two problems have emerged: (1) The exemption is narrowly defined, such that many purchases and sales must still be accounted for as derivative contracts, and, in any case, the effort to assess whether FAS 133 applies has not been obviated; and (2) applying the normal purchase-and-sales exemption may mask a company's risks and opportunities.

In the pre-FAS 133 world, derivatives were reasonably well understood by financial professionals. Used either for hedging or trading purposes, derivative instruments simply allowed counterparties to realize the performance of some underlying price (interest rate or currency exchange rate), without having to hold a position in the underlying instrument, per se. FAS 133 introduced somewhat of a new twist by formally defining a derivative in a brand new way, requiring that three specific conditions be satisfied:

1. The instrument in question has to have at least one underlying reference (such as a price, interest rate, or currency exchange rate), at least one notional amount (such as a size variable), and/or a payment provision, such that prospective settlement amounts can be readily determined.

2. The instrument in question is initially traded at (a) a price equal to zero or (b) a value that is smaller than the initial net investment required for other contracts that could be expected to generate a similar market response. (Think about an option premium, which is always smaller than the...