Accounting & Tax

FAS 133 And the New Facts of Life

Is a new derivatives accounting rule crimping long-standing practices at some companies?
Joseph RadiganMarch 7, 2001

The broad cross section of corporate America began adjusting its derivative contracts to reflect their fair market value at the beginning of the year, and next week, a Financial Accounting Standards Board panel charged with writing rules for derivatives accounting will hold its first meeting since then. But don’t expect the Derivatives Implementation Group to assess the early experiences under the new rule.

Jim Leisenring, the DIG’s chairman, and director of international activities for FASB, says some older issues, such as mortgage servicing rights will dominate the agenda next week. A subsequent meeting in June will probably be the panel’s first chance to size up the early experiences under FAS 133.

That said, Leisenring readily acknowledges that companies may have their hands full under the new regime. The last few decades have been chock full of changes to financial markets and corporate accounting. Even routine contracts with a bank or insurer or a payment to foreign supplier that includes payments in a foreign currency could be vastly affected by the new rule.

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“They may have an embedded foreign currency option that they haven’t thought of,” Leisenring says. “The biggest problem people are having is identifying derivatives under the new rule.”

FAS 133 went into effect last June 15. Any corporation with a fiscal year that has begun since that date has to adjust its financial statements to reflect the fair market value of their derivatives positions. Given the large number of companies that are on calendar years, Jan. 1 was the starting date for compliance with the new rules.

Not all derivatives contracts need to show up on the income statement, however. For example, so-called, plain-vanilla interest rate swaps benchmarked against a common interest rate such as the London Interbank Offered Rate (LIBOR), where the impact on a company’s finances falls within a predictable range, are exempt. In addition, Leisenring says the accounting rules for commodities futures contracts were established years ago, and they haven’t been altered by FAS 133.

CFO magazine recently outlined the issues companies will have to address as they comply with the rule.

Some pockets of corporate America have managed to adjust relatively painlessly. For example, some banking companies that already have rigorous accounting standards in place are finding life under FAS 133 may not be that different from what came before. The same goes for a handful of other large corporations that may already employ some sophisticated use of hedging instruments.

But some accounting professionals who have been closely following FAS 133 say that beyond the top tier of banks and large companies, problems may be cropping up.

Robert Royal, a partner with Ernst & Young’s professional practices group in New York expects the adoption of FAS 133 to lead to more earnings volatility and greater uncertainty on Wall Street regarding earnings forecasts and stock market values.

“Companies are very nervous about another source of volatility,” Royal says. “They’re hoping that analysts will not consider that as part of the recurring operating figure.”

For now, many companies are in a holding pattern of sorts. They haven’t had their first financial audit since the adoption of the rule, and until they do, the precise treatment of the rule won’t be clear.

Mark Scoles, a partner with the Chicago-based accounting firm, Grant Thornton, says the rule is slowing down the sales of derivatives contracts by the commercial and investment banks that package these risk management products.

Scoles also says that contracts with caps on the rate on one side of a product or embedded options that may, for example, permit one party to exit a derivatives contract before it expires, have become more of a problem.

According to Scoles, firms that don’t already have a sophisticated derivatives accounting operation in place are left with two choices: Either step up their controls to comply with the new rule, or just cut back on their hedging.

Ira Kawaller, a Brooklyn, NY, consultant, and a member of FASB’s DIG, says the impact of the new rule may only become better understood as more companies discover just how much they’ll have to change their operations to comply.

“Corporates tend to be at ground zero,” Kawaller says. “There was a real sense, that for the most part, the vast majority of corporates were just using plain vanilla instruments. There wasn’t any question that these things worked, so there wasn’t much need for sophisticated financial tools to manage them.”

That’s not true any more.

“The world has changed dramatically,” Kawaller says. “Now, it’s imperative that any derivative must be identified.”

Kawaller observes, “Unquestionably the new statement does some things that are laudatory. That the use of derivatives is more transparent is a step forward, and it forces management to understand what they’re doing in a way that you hope they did before. It also forces them to explain it. But there are a lot of people who will have difficulty with the standard because it might force them to change their behavior.”