Accounting & Tax

How FAS 133 Cost Sears $270 Million

How many more companies will get nailed by the new derivatives accounting rule?
Joseph RadiganMarch 23, 2001

The $270 million charge against earnings that Sears, Roebuck reported this week in its 10-K filing with the Securities and Exchange Commission stems from the 1997 termination of an interest rate swap in its credit card portfolio, a company spokeswoman said.

But precise details on the terms of the swap or why Sears canceled it were not immediately available. The spokeswoman said Jeffrey Boyer, Sears’ senior vice president and CFO, was not available for comment.

The spokeswoman also said that Sears did not view the $270 million as a material loss, but rather a “balance sheet reclassification.”

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Some accounting experts familiar with the Financial Accounting Standards Board Statement 133 said the Sears situation underscores exactly why the ruling was adopted in the first place.

Despite the opposition of many auditors and financial executives, both FASB and the SEC argued that the rule was necessary to protect investors.

Jim Leisenring, the FASB staff member who chairs the Derivatives Implementation Group and oversaw the drafting of FAS 133, says, “People said the disclosures were already accurate, and a lot of people said there were no surprises.”

But if there are no unwelcome surprises buried in corporate financial statements, then companies won’t be harmed by spelling out their exposure under FAS 133, Leisenring reasons. If there are losses, then companies have an obligation to alert shareholders.

It’s entirely probable that Sears’ management already had a good grasp of its derivatives’ exposure, but the reclassifying of the hedging write-off makes the extent of the loss transparent to investors.

Jeff Wallace, managing partner for Greenwich Treasury Advisors in Greenwich, Connecticut, says the huge derivatives losses in the mid- 1990s by Orange County and Procter & Gamble spurred the initial movement to draft 133 in the first place. The fact that companies are identifying the true size of their derivatives losses is a sign that the rule is working as planned.

What’s more, Sears is not likely to be the last company to report a large charge stemming from the rule. Last year, Microsoft reported that it had a charge of $375 million, Wallace says.

But Microsoft is on a June fiscal year, and Sears, like most of the rest of corporate America is on a calendar year. As more 10-Ks for 2000 are submitted to the SEC in the next few weeks, more derivatives losses will be revealed.

“We haven’t seen an end to the surprises,” Wallace says.

But Wallace also says it’s also important to keep the loss in perspective. While $270 million is a large number by any standard, it amounts to barely 1 percent of Sears’ $26 billion credit card portfolio. The loss, while painful, is not catastrophic by that measure.

The spokeswoman said that when Sears terminated the interest-rate swap in 1997, it began amortizing the $270 million write-off on a 20-year schedule. The adoption of FAS 133 this year forced Sears to accelerate the charge-off and recognize the entire amount still outstanding in the first quarter.

According to Sears’ 10-K, the “transition adjustment includes the effect of recording an existing cash flow hedging relationship on the balance sheet and reclassifying deferred losses from previously terminated interest rate swaps from other assets to other comprehensive income.” The hedge caused a pre-tax charge of $56 million, or $34 million after taxes. The terminated swap had a pre-tax charge $389 million, or $236 million after taxes.

Sears’ filing said it will write off the derivative losses over the next 17 years “as a yield adjustment of the hedged debt obligations.”

Ira Kawaller, a Brooklyn, NY, consultant who specializes in derivatives, says, that although he’s not familiar with the specifics of the Sears’ charge-off, the company’s classification of the impact of the swap as other comprehensive income, or OCI, suggests that it funded some of its credit card portfolio with a variable-rate liability and hedged it with a fixed-rate contract. As the market moved against it in 1997, the retailer decided to unwind the contract rather than expose itself to further losses.

Such behavior, while hardly unusual in the derivatives world, also underscores the volatility of interest-rate-sensitive markets.

Kawaller says, “You’re likely to see more of these gee-whiz numbers during the first quarter.”