ACCOUNTING FOR CIRCUS SWAPS: AN INSTRUCTIONAL CASE  
Brian T. Simmons
International Accounting Theory
Dr. Robert Jensen

Note:  This project was completed on April 15, 1998 prior to the issuance of SFAS 133.

Disclaimer:  This case is for educational purposes only.  The information in this case is fictional, and any similarities to actual companies, past or present, is not intended.  The methods of how to measure and present risk of derivative instruments are my own opinions.
 
  ABSTRACT

        This case examines a basic circus swap which involves not only the exchange of floating interest rate for fixed, but also one currency for another.  Separation of the effects from both interest rate and foreign currency fluctuations is no simple matter.  In fact, no formal accounting pronouncements specifically address this issue.

        The introduction first reviews the history and reasoning of pronouncements leading up to Exposure Draft 162-B.  For years, institutions have relied on settlement accounting to record their derivative instruments.  With growing concern over the risk of these instruments, however, the SEC and FASB have attempted to increase the detail of disclosure regarding the value and risk of their derivative portfolio.  The case provides an example of a hybrid instrument in the form of a circus swap.  The case questions review the accounting for these types of instruments under the current settlement accounting guidelines as well as the new fair-value method.  Additionally, a simplistic measure of Risk Per Contract (RPC) is developed.  By using information that is easy for management to obtain, the likelihood of the benefits of RPC outweighing the costs is greatly enhanced.
 

 
  CASE OBJECTIVES

1)  Review the recent developments with regards to accounting for and disclosure of derivatives.
2)  Understand the circus swap and the risk present in such an instrument.
3)  Compare the settlement accounting method with the new Exposure Draft method.
4)  Introduce the RPC method of measuring risk in a derivative instrument.

INTRODUCTION

        "A derivative is simply a transaction, or contract, whose value depends on, or derives from, the value of an underlying asset or index." (FN1)   When correctly implemented, derivatives can provide a company with a great deal of security by counterbalancing existing risks.  Potential losses can be limited and cash flows stabilized.  Improperly used, however, derivatives can become a nightmare as recently discovered by the tremendous losses at Proctor & Gamble, Orange County, and many others.  Why would companies such as Proctor & Gamble enter into contracts which might produce such enormous losses?  The answer is simple, derivatives are extremely complicated and are constantly becoming more so. (FN2)   Chances are, management did not understand the contracts and the risks associated with them.  Worst of all, investors were completely surprised by the enormous losses because of the lack of disclosure about the instruments and their risks.  Thus, the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) have desperately been searching for a new method of accounting for derivatives and ways to increase the disclosure of the risk inherent in these instruments.

 In quick response, the FASB issued Statement of Financial Accounting Standards No. 119, "Disclosures about Derivative Financial Instruments and Fair Value of Financial Instruments" (FAS No. 119).

Subsequent reviews by the SEC discovered that while FAS No. 119 did improve the quality of disclosures regarding derivative financial instruments, three significant disclosure issues remained.
 

        Thus, while the FASB set out to standardize the accounting for derivatives, the SEC contemplated ways to increase disclosure.  The long and hard road for the FASB has resulted in Exposure Draft 162-B.  As originally exposed, the Exposure Draft is effective for fiscal years beginning after December 15, 1997.  By requiring that companies record their derivative instruments on their balance sheets, the FASB has taken a big step forward.  The SEC, fulfilling its objectives, issued "Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative Information about Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments" in 1997.  The new disclosure rules require enhanced footnote description of accounting policies as well as quantitative and qualitative information about the instruments in a company’s derivative portfolio.  Specifically, the SEC will allow three quantitative market disclosure alternatives: tabular presentation, sensitivity analysis, and value-at-risk (VAR).

 Most argue that the best method available at this date is VAR, which has been defined as "the worst case loss in market value for an existing portfolio, expressed in terms of some confidence level, given a change in the relevant volatility and correlation variables under normal market conditions over a predefined period." (FN5)   However, many others argue that VAR is based on unrealistic assumptions and because there are so many discretionary choices regarding variables, it is as much an art as it is a science.  Additionally, the mathematics of the equation will probably not be understood by most people.  Add this to the extremely high cost of accumulating the data necessary for the equation, and the benefits will not outweigh the costs for most companies.

        While VAR and sensitivity analysis concentrate exclusively on market risk, there are several other components of risk associated with derivatives as well.

        In order to demonstrate the various types of risk inherent in a derivatives contract, I have developed a very simplified method to measure the risk present in a single derivative contract, the Risk Per Contract (RPC) method.  This method is not by any means a replacement for VAR or sensitivity analysis.  It is merely an illustrative equation of risk based on common information which is easy to obtain thereby keeping costs to a minimum.
 
 

  THE RPC METHOD FOR MEASURING RISK OF DERIVATIVE CONTRACTS   RPC = H{0.5G + 75J + 0.25N} + 3K + 0.2L + (1.5/M) + 0.5P + Q + 5R

 
  ACCOUNTING FOR CIRCUS SWAPS: AN INSTRUCTIONAL CASE

        From 1990 through late 1993, Gertan Company, a worldwide producer of exhaust systems for automobiles, suffered significant losses due to increasing competition and poor management.  In September of 1993, new management at Gertan initiated a complete restructuring including a plan to automate all of their production plants.  Their production plant in Detroit, however, was over fifty years old and in dreadful condition.  Therefore, in June 1994, Gertan was searching for $20,000,000 to build a new production plant outside of Detroit.  However, due to their poor credit history over the past few years, the best interest rate Gertan was able to obtain for a 42 month construction loan in the United States was 11.6 percent.  However, their Berlin production plant had enjoyed tremendous success since opening in 1981.  Thus, Gertan’s credit rating in Germany was currently much higher than in the United States.  Therefore, management believed they could borrow the money necessary in German Deutschmarks and enter into a foreign currency swap to obtain U.S. Dollars.

        UniStart Company, a U.S. tire manufacturer, was in a similar position.  Incorporated in 1965, UniStart had slowly increased their market share until the 1980s.  This decade was filled with mergers and acquisitions in the tire industry and had put enormous pressure on UniStart, one of the few remaining tire manufacturers with production in only one country.  Therefore, in June 1994, UniStart was interested in borrowing 32,000,000 DM to build their first manufacturing plant in Germany.  However, since the company was not very well known outside of the United States, UniStart found it difficult to borrow from German banks.  Thus, UniStart and Gertan negotiated a swap of U.S. Dollars and Deutschmarks.  Each company would borrow the money in the country where they had a competitive advantage, thus securing a better interest rate than their counterparty could in that currency.

        Since UniStart was in a much more stable position and looking for every possible chance to earn profits, they were much less risk averse than the new management at Gertan.  Thus, due to their belief that interest rates would fall over the next several years UniStart was interested in borrowing at a variable interest rate.  Gertan, however, was not in a position to take on any unnecessary risk since their restructuring plan was only in its beginning stages.  Therefore, Gertan was interested in a fixed interest rate loan.  After negotiations with their respective banks, both companies discovered that not only could they decrease their interest rates by swapping currencies, additionally they would benefit from UniStart borrowing at a fixed interest rate and Gertan borrowing at a variable interest rate and then swapping interest rates as well.  Specifically, Gertan would borrow 32,000,000 DM at LIBOR with interest paid semi-annually, while UniStart would borrow $20,000,000 at a fixed interest rate of 11.00 percent, also paying interest semi-annually.  When two companies such as Gertan and UniStart not only swap currencies but also interest rates, the hybrid instrument is termed a circus swap.

        For the purposes of answering the case’s questions, the following interest rates and exchange rates are provided.
 
 

DATE 

SPOT EXCHANGE RATE (DM/$)

LIBOR

FIXED INTEREST RATE

06/30/94

1.60

9.90%

11.00%

12/31/94

1.55

10.13%

11.24%

06/30/95

1.38

11.00%

11.04%

12/31/95

1.43

10.72%

10.60%

06/30/96

1.52

10.25%

10.15%

12/31/96

1.55

10.25%

9.55%

06/30/97

1.74

10.50%

9.14%

12/31/97

1.79

10.50%

9.10%

 
 

  TEACHING NOTES

        While this case is fictional, it is has been designed to be as realistic as possible.  For the most part, the interest rates and the exchange rates are the actual rates for the period.  Some modifications were made to better illustrate their effects on the hybrid instrument, a circus swap.

        Designed for students with at least an intermediate accounting background, the case is aimed at students who have had exposure to vanilla interest rate swaps and vanilla foreign currency swaps, but not to hybrid instruments.  Combining the two instruments into one usually proves to be no simple task and therefore scares most students.  By breaking the contract down into its two components, an interest rate swap and a foreign currency swap, this case walks students through the accounting for such an instrument step by step.  By first illustrating the swap settlements without using netting procedures and then with netting procedures, the net accounting will make more sense since the students will understand the components of the net cash settlement.

        At the time of writing, Exposure Draft 162-B had been exposed and was pending revision before the release of a formal standard.  Students should be familiar with the new Exposure Draft but not to the point of mastering the new methods.  The case distills some of the apprehension of the new Exposure Draft accounting methods by constructing a chart which allows the student to trace the fair values of the different components of the debt and circus swap.  Then, by comparing the old settlement accounting with the new Exposure Draft accounting, students will not be as apprehensive toward the new method.

        Please note, as their are no formal accounting pronouncements that specifically address circus swaps, the accounting methods for the new Exposure Draft are a modification of the FASB’s example of a cash flow hedge of an interest rate swap (Appendix B: Example 1, pg. 73).
 
 
  CASE QUESTIONS Note:  For purposes of this case, the spot and forward exchange rates are assumed to be equal throughout the period of the contract.  If they are not the same, Exposure Draft 162-B requires that the change in fair-value of the derivative be measured using forward rates and then discounted to reflect the time value of money.
 
To view the answers to the case questions click on the links below the question.  

Question 1:

Question 2:

Question 3:

Question 4:

Question 5:

Question 6:

Question 7:

Question 8:

Question 9:

Question 10:

Assume the following information for questions 11 and 12:
 
 

 

Gertan

UniStart

Beta

1.16

0.89

Total Assets

$2,300,000,000

$800,000,000

Total Derivative Notionals

$371,000,000

$119,000,000

Employee Review

5

2

Consultant Review

NO

NO

Legal Review

NO

YES

Question 11:

Question 12:

 
  REFERENCES

1.  Battagila, Paul.  "Derivatives: Managing the Risks,"  The Internal Auditor.  Institute of Internal Auditors.  Volume 52, Issue 6: page 50.

2.  Baril, Charles, Ralph Benke, and Gerald Buetow.  "Managing Risk with Derivatives," Management Accounting.  Institute of Management Accountants.  Volume 78, Issue 5: page 20.

3.  Linsmeier, Thomas and Neil Pearson.  "Quantitative Disclosures of Market Risk in the SEC Release,"  Accounting Horizons.  American Accounting Association.  Volume 11, Issue 1: page 107.

4.  Linsmeier and Pearson, page 108.

5.  Kiss, Robert and Dennis Valenti.  "Derivatives Usage and Computer Risk Management Practices of Money Managers,"  Journal of Investing.  Institutional Investor Systems, Inc.  Volume 6, Issue 1: page 63.

6.  Battagila, p. 52.

7.  American Institute of Certified Public Accountants.  Exposure Draft 162-B.  Paragraph 20(d).
 
 

Dear Bob,

 

Your URL http://www.trinity.edu/rjensen/acct5341/1998sp/simmons/case.htm references the URL http://www.fea.com/endsearchvar.html (at the word “mathematics”), and this URL no longer exists.  I would suggest changing the latter to http://www.fea.com/library.htm.

Thanks,

Mark

 

Mark B. Garman, President

Financial Engineering Associates, Inc.

2484 Shattuck Avenue, Suite 225

Berkeley, CA 94704-2029

mailto:mark@fea.com

http://www.fea.com/