Derivative accounting, because of the forced use of fair value measurements, can deliver all manner of unexpected results to a set of financial statements. None have a more bizarre impact than freestanding and embedded derivatives tied to a company’s own stock. When these derivatives are carried as liabilities, the liability balance will move up and down with the value of the company’s stock. So when the liability increases because the value of the company’s stock has increased, there is an offsetting debit (expense) which is usually recorded in the income statement. This of course drives down the company’s earnings which will often negatively impact the company’s stock…which in turn pushes the liability down with an offsetting credit (income) to the income statement.
For some reason this financial statement result is considered beneficial financial reporting. Sophisticated investors will typically ignore the impact of these fair value measurement impacts knowing that they do not provide any information about the true operational results of the entity. Unsophisticated investors may see the huge expense or income swings and misinterpret the cause or the true economic effect on entity.
In practice there can be disparity among accounting professionals in the application of derivative accounting. This is of course not unique to this area, but the complexity of the rules appears to have made disparity more prevalent. Take, for example, a default rate of interest that kicks in upon an event of default in a debt instrument. This usually meets the definition of an embedded derivative. Some accounting firms have taken the position that certain events of default do not have risks and characteristics that are clearly and closely related to the debt-host contract. One of the most baffling of these is the failure to issue audited financial statements. These firms evaluate this default provision as not debt-like in nature, yet financial reporting is a key consideration to any loan.
So now you have an event of default that must be bifurcated from the host contract and accounted for separately at fair value. Yes, fair value! Think about the process of determining the fair value of an event of default. What would you pay for the right to receive a default rate of interest should the company default on it’s debt? interestingly, before the 2008 financial crisis, most people would say that fair value for this feature is not determinable. Yet, we saw billions and billions invested in credit default swaps which is merely a bet on the probability of a borrower defaulting on its debt.