This analysis aims at reviewing the Statement of Financial Accounting Standards (SFAS) No. 119 in terms of its underlying rationales and applications relating to the current issues in risk management practices in corporations and financial innovation process in the banking industry. Since this Statement was first issued four years ago while several approaches to quantifying and controlling risks of various kinds of derivative financial instruments have been proposed and improved upon, it is worthy that the Statement be revisited, reviewed, or even revised.  The focus of this analysis would be on the disclosure requirements and encouragement of derivative financial instruments held or issued for the purposes of hedging and financial innovation, rather than those of trading. Previously, several disclosure requirements have been established about the nature, terms, and uses of financial instruments with credit risk (SFAS No. 105) and with market risk (SFAS No. 107). These two Statements had become a basis for SFAS No. 119 in light of the holding or issuing of derivative financial instruments for trading purposes. However, this Statement, in turn, offers amendments to both SFAS No. 105 and 107 about the detailed disclosures of classification of financial instruments, categorization of risks, and the presentation of fair value amount of both derivative and non-derivative financial instruments. Still, the analysis of such a topic would be less emphasized than the impending issues of risk management and financial innovation.  It is expected that this analysis would offer some insights as to how the Financial Accounting Standards Board can integrate the new but proven risk assessment technology into the financial accounting standards. Some disclosures that are encouraged in SFAS No. 119 can now be standardized and required with less difficulty on the part of preparers or discontent on the part of users.

The pervasive uses of financial instruments and derivative financial instruments in corporations today has complicated the disclosure of their nature, notional amount, the extend to which the notional amount is put at risk, and the eventual effect on realized gains or losses to the end users of their financial statements. Financial instruments are mostly held or issued for the purpose of trading, whereas derivative financial instruments are held and issued for the purpose of hedging. The value of traded financial instruments can be determined and disclosed based upon their fair value or market value whichever is closely reflected their underlying riskiness. However, the value of derivative financial instruments is more difficult to determine since they are infrequently traded and held for the purpose of risk management rather than trading.

Financial Accounting Standards Board (FASB) had initiated the project on financial instruments since 1986 with an attempt to focus on the disclosure issue of the use of various types of financial instruments. Such a project has continually developed and resulted in the issuance of four related Statements of Financial Accounting Standards (SFAS), namely SFAS No. 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and with Concentration of Credit Risk, SFAS No. 107, Disclosure about Fair Value of Financial Instruments, SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and SFAS No. 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments. Many issues with regard to disclosure and valuation of traded financial instruments are satisfactorily resolved although some remain to be improved. But in the area of derivative financial instruments held or issued for the purpose of hedging, there are still controversies as to how the information can be disclosed in the more efficient and effective manners.

Current Solutions

The focus of SFAS No. 119 is on the qualitative disclosures about derivative financial instruments held or issued for purposes other than trading such as the objectives, context, and strategies for achieving those objectives. Much less is focused on the quantitative disclosures because of the lack of conventional approaches to recognizing and measuring the value of derivative financial instrument transactions. It was the decision of the FASB during 1994 that some semi-quantitative disclosures are required including:

1. Description of anticipated transactions whose risks are hedged with derivative financial instruments
2. Description of derivative financial instruments’ classes used to hedge the anticipated transactions
3. Description of the transactions resulting in the recognition of gains or losses deferred
4. Amount of hedging gains and losses explicitly deferred

Some encouraged disclosures about the risks of derivative transactions are included in SFAS No. 119:

In recent years, several proposals and criticisms have been forwarded to FASB both from within the U.S. and abroad. Some proposals recommended gradual changes in how derivative transactions should be recognized, others in a more drastic yet innovative fashion in both recognition and measurement of derivative financial instruments. For example, Breseford (1997) suggested that certain accounting treatments of derivative transactions could be modeled after the U.K. standards. Alan Greenspan (1997), chairman of the U.S. Federal Reserve Board, further suggested that a simple hedging framework based on the matching principle that reflects current best practices in the financial community can be used to determine the fair value of derivative financial instruments. Others including the U.S. legislators and representatives of international accounting standards committees (IASC) are concerned with the impacts of FASB's moves on disclosure practices and the value those proposals might add to market participants. In response to those comments, FASB has decided to differentiate the hedging activities based upon their comprehensive income effects on either firm commitments (fair value hedge) or expected future cash flows (cash flow hedge) in its SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, issued in June 1998. Unfortunately, this new FASB proposal still lacks some desirable features that can account for more complex risk management and financial innovation activities.

The purpose of this section is to present some highlights of the disclosure requirements extracted from the text of SFAS No. 105, 107, and 115 as they relate to derivative financial instruments, and SFAS No. 119. Historically, the financial disclosure requirements for derivative financial instruments have been developed by the FASB over a number of years and are currently found in three different statements issued by the board, since 1991, some of which are apply to financial instruments that are not derivatives. Each of the later statements also amends the earlier statements.

The FASB defines derivative financial instruments narrowly as "future, forward, swap, or option contracts, or other financial instruments with similar characteristics." Excluded are "all on-balance-sheet receivables and payables, including those that derive values or contractually required cash flows from the price of some other security or index such as mortgage-backed securities, interest-only and principal-only obligations, and indexed debt instruments. It also excludes optional features that are embedded within an on-balance-sheet receivable or payable, for example, the conversion feature and call provisions embedded in convertible bonds."

FASB's narrow definition was a result of the board's particular concern with the need for improved disclosures for derivatives with off-balance-sheet risk of loss as no authoritative pronouncement had covered them prior to the adoption of SFAS No. 105. An entity holding derivatives may be exposed to the risk of accounting loss because of counterparty default or adverse changes in market prices. For most on-balance-sheet items, the maximum exposure to such loss is usually evident from the carrying amount of the instrument. However that is not the case for most futures, forwards, swaps, options, and similar instruments because either no amount appears on the balance sheet or the amount recorded does not indicate the potential loss. Those instruments are referred to as "off-balance-sheet derivatives."

Disclosures for Off-Balance-Sheet Derivatives

1. All significant concentrations of credit risk whether from an individual counterparty or groups of counterparties.
2. Group concentrations of credit risk exist if a number of counterparties are engaged in similar activities or activities in the same region or have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions.
3. Disclose about each significant concentration any information about the shared activity, region, or economic characteristic that identifies that concentration including maximum accounting loss and policy on collateral as described with nature and amount disclosures.

1. Disclose the fair value of all financial instruments for which it is practicable to estimate that value.
2. Fair value disclosed in the notes shall be presented together with related carrying amount in a form that makes it clear whether the fair value and carrying amount represents assets or liabilities and how the carrying amounts relate to what is reported in the statement of financial position.
3. If disclosed in more than a single note, one of the notes shall include a summary table containing the fair value and related carrying amounts and cross-references to the locations of the remaining fair value disclosures.
4. Disclose the methods and significant assumptions used to estimated the fair value.

1. The average fair value during the reporting period, presented together with the related end-of-period fair value, distinguishing between assets and liabilities.
2. The net gains or losses (i.e., net trading revenues) arising from trading activity during the reporting period disaggregated by class, business activity, risk, or other category that is consistent with the management of those activities and where those net trading revenues are reported in the income statement.
3. If the disaggregation is other than by class, also describe for each category the classes of derivative financial instruments, other financial instruments, and non-financial assets and liabilities from which net trading revenues arose.

For derivatives that do not come within the FASB's definition of derivatives, such as the cash securities with embedded derivatives and mortgage-backed securities, the disclosures described above relating to fair value apply in addition to disclosures prescribed by SFAS No. 115. However, SFAS No. 115 applies to all investments in debt securities and certain equity securities and requires disclosure as follows:

1. For each major security type and distinguishing between securities classified as held-to-maturity (HTM) and those classified as available-for-sale (AFS) -- fair value, gross unrealized holding gains or losses, and amortized cost.
2. Information about contractual maturities combined in appropriated groupings.

For financial institutions:

1. Required major security types as a minimum are equity securities, debt securities issued by the U.S. Treasury and other U.S. government agencies, debt securities issued by states and local government organizations, debt securities issued by foreign governments, corporate debt securities, mortgage-backed securities, and other debt securities.
2. At least four maturity groupings are required:
1. within one year
2. after one year through five years
3. after five years through ten years
4. after ten years

All the disclosure requirements described in the preceding section that relate to concentrations of credit risk and fair values also apply to all financial instruments.

Disclosure if Measurement of Fair Value Not Practicable

Although SFAS No. 107 allows considerable latitude in measuring fair values of derivatives and other instruments provision is made for circumstances where measurement is not practicable as follows:

The FASB encourages, but does not require, entities to disclose quantitative information about interest rate, foreign exchange, commodity price, or other market risks pertaining to derivatives consistent with the way the entity manages those risks. Examples of disclosures that may be appropriate for some entities cited by the FASB are more details about current positions and perhaps activity during the period; the hypothetical effects on equity or on annual income of several possible changes in market prices; a gap analysis of interest rate repricing or maturity dates; duration of financial instruments; the entity's value at risk from derivative financial instruments at the end of the reporting period; and the average value at risk during the year.

In practice, few entities have made those encouraged but not required disclosures. However, the Securities Exchange Commission (SEC) has proposed requirements that would mandate additional disclosures for companies under its jurisdiction. They are briefly discussed in the next section.

Disclosures for Derivatives Proposed by the SEC

On December 28, 1995, the SEC issued proposed rules that would require additional detailed disclosures about accounting policies relating to derivatives as well as both qualitative and quantitative information about market risk. Comments were requested by May 21, 1996. After a review of the comments received, the SEC may decide to adopt the proposed rules, possibly with changes, or to defer the matter for further consideration and possibly issue a revised proposal.

The proposed disclosure requirements are intended to clarify and expand upon those required by the FASB. Distinguishing between derivatives used for trading and other derivatives, the proposals would require disclosure of:

• Each method used to account for derivatives (fair value accounting, deferral accounting, and accrual accounting).
• Types of derivatives accounted for under each method.
• The criteria required to be met for each accounting method.
• The accounting method used if the specified criteria are not met
• The accounting for the termination of derivatives designated as hedges or used to affect directly or indirectly the terms, fair values, or cash flows of a designated item.
• The accounting for derivatives if the designated item matures or is sold, extinguished, terminated, or if related to an anticipated transaction, is not likely to occur.
• Where and when derivatives and their related gains or losses are reported in the statements of financial position, cash flows, and results of operations.

Additionally, the proposed rules would require disclosure outside the financial statements of extensive quantitative and qualitative information relating to derivatives market risk -- basically requiring the information that is suggested but not required by FASB statements. The additional disclosures that would be required under the SEC proposal focus on forward-looking information whereas the disclosures required by the FASB relate to historical information.

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