FASB has come up with a list of new disclosures to be effective in financial statements for fiscal years that end after Nov. 15, 2008, in order to help investors get a grip on the financial implications for companies that have sold credit default swaps,
Credit Default swaps are derivative contracts in which one counter party (the buyer of protection) pays a premium to a second party (the seller of protection) for taking credit risk of an issuer or a security (the reference issuer). The second party makes no payments unless a specified credit event occurs like failure to pay, bankruptcy or debt restructuring for a specified reference asset. If the Reference Issuer suffers a “credit event,” then the seller of protection pays the loss on the Reference Security to the buyer, to the extent of the notional amount of the CDS and the swap then terminates.
The new standard introduced by FASB eliminates an odd inconsistency between two existing accounting standards. One of those rules, Interpretation 45, covers financial guarantees, which hold the same risks and rewards as credit derivatives. It requires extensive disclosure of contracts in which the buyer of the insurance owns the underlying instrument it is protecting.
But if the guaranteed party does not own the asset or instrument that is insured, the protection is classified as a derivative and falls under another accounting standard viz., FAS 133, requiring no disclosure.
This weird dichotomy is sought to be eliminated by the introduction of FAS 161. The risks of financial guarantee and a credit derivative being undertaken by a firm under either of these kinds of instruments are the same.
The FASB new standard would cover sellers of CDS instruments, namely the entities that act as insurers. They would have to disclose such details as the nature and term of the credit derivative, the reason it was entered into and the current status of its payment and performance risk.
In addition, the seller would provide the amount of future payments it might be required to make, the fair value of the derivative and whether there are provisions that would allow the seller to recover money or assets from third parties to pay for the insurance coverage it has written.