GAAP and IFRS

Enron’s Derivative-Accounting Legacy

A FASB ruling issued in the wake of the failed energy giant's implosion may be up for some fine tuning.
Ed ZwirnAugust 8, 2005

In 2002, when the Financial Accounting Standards Board came out with its recommendations in Emerging Issues Task Force (EITF) Issue 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities,” there was little doubt as to its aim.

The board had been the subject of criticism in the financial media in the months since the late 2001 Enron scandal and seemed to want to respond to the barbs. Commentators questioned FASB’s interpretation of generally accepted accounting principles that enabled the troubled energy trading company to boost earnings by claiming the “unrealized gain” based on the difference between bid and ask prices at the inception of derivative deals that it controlled. That was particularly effective, given that it could value the derivative based on its own pricing models, rather than on a quoted market price.

The often huge spreads between what buyers of an energy-futures contract are willing to pay and the amount sellers were trying to get for it provided fodder for the pre-scandal Enron earnings mill in those heady days when the company was still estimated to be the seventh-largest one in the United States.

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FASB’s ruling in EITF 02-3 put an end to the practice, specifying that “an entity should not recognize an unrealized gain or loss at inception of a derivative instrument unless the fair value of that instrument is obtained from a quoted market price in an active market or is otherwise evidenced by comparison to other observable current market transactions or based on a valuation technique incorporating observable market data.”

That was where the matter stood until June. At that time, responding to issues raised by the Fair Value Measurements exposure draft it had issued in June 2004, the board decided to “effectively nullify” the guidance contained in EITF 02-3. Now, according to a project update issued by the FASB on July 25, the board plans to take up discussion of a proposed staff position to provide new guidance to companies looking to value their derivative contracts. The fourth quarter will see issuance of the staff position at the same time as FASB presents its long-awaited final statement on Fair Value Measurements, according to the update.

What happened in the two years in between the issuance of EITF 02-3 and this past June’s board discussions? Corporate legal departments, concerned about the broader applicability of the guidance the task force provided, were reluctant to approve the recognition of similar gains on other types of derivatives.

After all, the issues involved in recognition of the value of a derivative aren’t confined to the energy realm. “When 02-3 came out it was principally aimed at energy,” said one senior vice president of accounting policy at a top-tier U.S. bank. Companies have generally shied away from recognizing upfront gains on interest-rate swaps, forward contracts, and other “derivative contracts whose value is principally derived from internal models,” added the bank executive, who refused to be quoted by name.

Although 02-3 said that “you shouldn’t have upfront recognition,” he said, FASB “didn’t tell us how [the gain or loss] should be recognized.”

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