Good Morning, Volatility

FASB's latest accounting rules for derivatives may not be the nightmare once feared. But compliance could still cost considerable sleep.
Andrew OsterlandJuly 1, 2000

D-Day is here. On June 16, the long-awaited and much-debated new rules on accounting for derivative transactions became part of generally accepted accounting principles in the United States. No more delays for Y2K-stressed treasury departments. No more opportunities to amend the rules. Beginning with their first fiscal year-end after the deadline, U.S. corporations — and foreign corporations with a stock listing in the United States — have to include their derivatives on balance sheets and adjust earnings to reflect changes in their market value.

Financial Accounting Standard (FAS) 133 is the first standard issued concerning derivatives since 1984 — a 16-year interval during which the use of derivative instruments by U.S. corporations has exploded. Not surprisingly, the standard is a complicated and controversial handful. It has 540 paragraphs and some 250 interpretations of how to apply the rules. At times, it gives explicit direction on how companies can qualify for hedge accounting treatment, where gains and losses on derivatives can be deferred until they mature. At other times, the guidance is vague. “The closer you look at [FAS 133], the uglier it gets,” says consultant Jeff Wallace of Greenwich Treasury Advisors, in Greenwich, Connecticut. “It will be a lot more difficult for companies to smooth out earnings.”

Ugly or not, FAS 133 is now part of GAAP. Not only will complying with the standard involve more work and more headaches for finance executives, it will also result in more earnings volatility. And with the derivative-induced blow-ups at such companies as Procter & Gamble Co. and Gibson Greetings Inc. a not-so-distant memory (not to mention Orange County and Long-Term Capital Management), many risk managers worry about how the market will react to the new information. “Derivative is still a four-letter word,” says Jonathan Boyles, director of financial standards at Washington, D.C.-based Fannie Mae, which held $240 billion worth of interest-rate swaps at the end of last year. “People may see our use of derivatives and think we’re taking on a lot of risk, when that’s not the case.” Indeed, with its multi- billion-dollar portfolio of mortgage loans, Fannie Mae relies on derivatives to mitigate its risk.

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Not Unworkable

At least, says Boyles, the current version of FAS 133 is an improvement over the board’s initial proposal. The first draft of 133 drew widespread criticism when it was issued in June 1998. Corporate risk managers and derivatives experts identified dozens of ways the new rules would increase earnings volatility and bias corporate hedging strategies in an effort to avoid that volatility. On March 3, however, FASB issued an exposure draft of four amendments to the standard. While risk managers are hardly happy with the new burdens FAS 133 will impose on their accounting and treasury departments, the amendments have smoothed some ruffled feathers. “It’s workable now,” says Boyles, who has spent the past 18 months preparing his accounting systems to comply with 133.

Here’s a look at FASB’s amendments:

1. Interest-rate risk. From Boyles’s perspective, the most important amendment relates to the use of derivatives based on a benchmark interest rate. Fannie Mae’s most significant risk exposure is to changes in prevailing interest rates. If market rates rise, the value of Fannie Mae’s fixed-rate mortgages falls. To hedge that risk, the company can enter into an interest-rate swap to exchange its fixed rate for a floating rate.

FAS 133, as originally proposed, defined the underlying risk in such a hedge as the risk-free rate of interest (that is, the U.S. Treasury bond rate) plus a credit spread appropriate to the debt instrument. The result: A derivative based on a risk-free rate alone would not be an effective hedge of overall interest-rate risk, and would not qualify for hedge accounting.

Worse yet, FASB decided the U.S. Treasury bond rate was the best measure of the risk-free rate of interest. Problem is, 95 percent of over-the-counter interest-rate swaps are based on the London Interbank Overnight Rate (LIBOR), not on U.S. Treasuries. FAS 133 would have forced U.S. companies to use expensive, customized swap agreements to hedge their interest-rate exposure, or exchange traded bond futures contracts and see their earnings fluctuate more widely as a result.

The amendment makes two big changes to the standard. First, companies can separate interest-rate risk from credit risk in regard to their debt instruments. That way, changes to a benchmark interest rate, such as U.S. Treasury bonds, can be designated as the risk being hedged. The Board also decided that LIBOR was a stable and reliable indicator of interest rates and could thus be used as a benchmark to hedge rate risk. The changes will make life under FAS 133 far easier for companies like Fannie Mae.

2. Currency risk. The favored instrument for hedging foreign currency denominated debt is the cross-currency interest-rate swap. It enables a party to swap, for example, a fixed-rate Eurobond exposure for an equivalent in U.S. dollars. The original FAS 133 would not allow nondollar debts to be treated as a hedged item because they were revalued on a periodic basis, and reported in earnings already, per FAS 52. What’s more, foreign debt carries two underlying risks: foreign currency prices and interest-rate changes. FAS 133 permitted only one risk to be hedged per transaction. “Companies would have to buy two different instruments to hedge both risks,” says Enrique Tejerina, a partner with KPMG LLP’s national office in New York.

Not only would that increase the cost of hedging for companies, it would affect earnings dramatically. Because only one instrument could hedge an exposure, one of the derivatives — possibly a foreign- currency forward contract or an interest-rate swap — would have to be treated as a speculative investment, with all changes in its fair value flowing directly to earnings rather than deferred to other comprehensive income on the shareholders equity statement. The amendment now permits companies to hedge both risks with the one swap.

3. Subsidiary risk. The third amendment relates to the practice of offsetting similar risk exposures among a company’s subsidiaries, and hedging from a central treasury department. This would allow a company to take advantage of natural hedges from foreign currency cash flows within its operations. Say one subsidiary was forecasting sales of £200 million in the next three months, and another expected to purchase £100 million worth of supplies in the same period. In that case, the net exposure would be a long position of £100 million and the company could hedge its risk by selling that amount forward or buying a put option for the £100 million.

Again, FAS 133 originally held that each exposure had to be hedged separately to receive hedge accounting treatment. The amendment, however, now allows the netting of similar risks, as long as the entire resulting exposure is hedged with an outside party.

4. Normal purchase and sales. The final amendment proposed by FASB expands the exceptions from the new accounting rules for normal purchases and sales of goods. Companies that consume or produce commodity goods often enter contracts with cash settlement provisions in case one party decides not to deliver or accept delivery of the goods. Under FAS 133, this option rendered the contract a derivative, requiring appropriate accounting treatment. The amendment now allows for the provision as long as the company rarely exercises the option. It will reduce the implementation burden for heavy commodity users.

No Options

As welcome as these four rule changes are, many corporate risk managers hoped for more. The most glaring omission from the board’s amendment list involves the treatment of options contracts. Currently, companies that hedge an interest-rate or price risk with an option contract can amortize the cost of the option (the premium) over the life of the contract. The model for FAS 133, however, is to measure derivatives and the underlying risks they hedge on a fair-value basis. Thus the measure of a hedge’s effectiveness depends on how closely its value counters the value of the hedged item.

For forward contracts, the correlation is usually near perfect. But for options contracts, which give the holder the right, but not the obligation, to exercise the contract, the market values rarely move in lock step with the underlying risk. That’s because options have time value.

An option to buy Japanese yen at a rate of 100 to the dollar six months in the future has an intrinsic value of ¥10 if the market rate is currently 90 to the dollar. But the cost of that option might be ¥12 because of the value of holding it for six months.

The intrinsic value of the option, which effectively caps the cost of buying yen for six months, changes with the underlying currency. But the time value of the option reflects the expectations of the market and is volatile. Under FAS 133, the whole option has to be marked to market, not just its intrinsic value. In some cases, swings in the time value will be large enough that the option may not qualify for hedge accounting treatment. Even when it does qualify, the volatility of option time values could cause dramatic swings in earnings.

“The perfect economic solution can generate accounting ineffectiveness,” explains Ira Kawaller, a consultant specializing in derivatives and risk management. Kawaller, a member of the Derivatives Implementation Group, which was set up by FASB in 1998 to advise the board on FAS 133 implementation issues, says that the board’s rules regarding assessment of hedge effectiveness may not just bias companies against derivative instruments like options, which increase earnings volatility, he fears it may also cause companies not to hedge their risks at all.

At this point, Kawaller says, the main objective of companies with respect to interest-rate exposures is to reduce their workload. “It’s all about getting short-cut treatment now,” says Kawaller. If a derivative and the item it hedges match in terms of amount and timing of the cash flows, the transaction qualifies for short-cut accounting treatment. The company can then simply mark the derivative to market and adjust the underlying exposure by the same amount, without having to calculate and recalculate the values of the items. “People will go to extreme lengths to avoid having to do the effectiveness tests,” he says.

How much will the accounting demands of FAS 133 distort corporate risk management strategies? “Our decisions will be based on the economic benefit to the company and the materiality of the accounting treatment,” says Cheri Kalman, senior treasurer and manager of the foreign exchange group for Lucent Technologies Inc.

For some companies, living with increased earnings volatility may be easier and less costly than jumping through hoops to qualify for hedge accounting. One foreign exchange manager says his company is considering simply marking all its derivatives to market and communicating better with the investment community. “We’re still evaluating our threshold for pain,” he says. So, no doubt, are other companies.

FAS 133 Amendments

Below are the recent revisions made by FASB to its derivatives accounting rules.

  1. The risk of changes in a benchmark interest rate can be designated the underlying risk in an interest-rate hedge.
  2. Foreign currency denominated debt may be hedged with a single cross-currency swap.
  3. Multinational companies may offset foreign currency exposures and hedge the net result from a central treasury.
  4. The normal purchases and sales exception for commodity users and producers is expanded.

FAS 133’s I’s and T’s

Academics can argue derivatives accounting theory until the cows come home. The bottom line for CFOs, however, is determining what it will take to pass muster with the auditors and the Securities and Exchange Commission.

To a degree, FAS 133 compliance is a moving target. The Derivatives Implementation Group is still hashing out details on specific transactions and the appropriate accounting treatment for them, and will likely continue into next year. Furthermore, in the early going, the five major accounting firms are apt to have varying interpretations of the standard.

One thing is certain. There will be a lot of extra paperwork for accounting departments. “The documentation required is the heftiest part of initial compliance,” says Cheri Kalman, senior treasurer and manager of the foreign exchange group for Lucent Technologies Inc.

SEC accounting fellow Pascal Desroches outlined the requirements for a room full of CPAs last December. Companies using derivatives to hedge risk have to produce a written explanation of the objective and strategy with each hedge at the outset. That includes a description of the underlying asset, liability, or forecasted transaction being hedged; details on the derivative instrument; and a description of how the company will assess whether the hedge is and remains effective throughout its term.

“If clients don’t have their documentation in order, they won’t get hedge accounting” regardless of whether their hedges are effective, says Enrique Tejerina, a partner with KPMG LLP’s national office in New York.

To prove hedge effectiveness, treasury departments need to mark their derivatives to market. For foreign currency forward contracts, it’s straightforward. It gets more complicated for options and swaps. While large derivatives users may have developed their own software, many need outside help. According to research by Deloitte & Touche LLP late last year, 33 vendors were selling FAS 133 software. The systems value derivatives and their underlying exposures and determine where gains and losses on the cash flow hedges go. The part of the hedge that effectively offsets the change in value of the hedged item goes to other comprehensive income on the shareholder’s equity statement, while the remaining, ineffective, part goes to earnings.

Some vendors, such as Wall Street Systems, which sells treasury management software, will host the application on the Internet, producing documentation for the auditors and spreadsheet-based data easily imported back into a company’s accounting system.

If only the transition to FAS 133 compliant reporting were so easy.