orporate hedging activity should be about risk management. It should not be an opportunity for earnings management, which became the public perception when certain cases of staggering losses involving derivatives made the news some years ago. After six years of extensive research and deliberation and to achieve its objective of measuring all financial assets and liabilities at fair value, the FASB issued Statement no. 133, Accounting for Derivative Instruments and Hedging Activities in June 19 98 (see “The Decision on Derivatives,” JofA, Nov.98, page 24 ). Statement no. 133 is one of the most complex FASB standards, and the board created the Derivatives Implementation Group (DIG) to assist in resolving implementation questions companies raised in advance of the standard’s effective date ( see “Special Task Force Addresses Implementation on Issues” ). The new accounting standard is effective for fiscal years beginning after June 15, 2000 (January 1, 2001, for companies with calendar-year fiscal years.)
CPAs need a blend of accounting and financial analysis skills and knowledge of specialized industry risk management practices to understand Statement no. 133. Companies preparing to adopt the standard had to coordinate the efforts of business units beyond treasury and audit to include, at a minimum, tax, investor relations and senior management. The SEC expects that Statement no. 133 will give investors, analysts, top management, public boards and creditors a clearer indication of the uses and effects of derivatives. CPAs are likely candidates to be the company representative with knowledge of the new standard to help achieve a successful implementation.
Under the old standard, FASB Statement no. 80, Accounting for Futures Contracts, many companies became lax in maintaining documentation of their hedge gains and losses. Now, says CPA James Bean, director of accounting policy at California Federal Bank in San Francisco, Statement no. 133 has focused management’s attention on determining exactly how effective their approaches have been. “I would expect that many companies, particularly smaller institutions, just assumed that their hedging strategies were at least 80% effective without actually calculating the correlation rate, and their outside accountants were reluctant to challenge their clients on the issue of documentation. Because Statement no. 133 articulates very specific requirements and requires the identification and recording of the exact level of any ineffectiveness, it was a wake-up call, forcing these companies to make an in-depth analysis of their hedging strategies. Quite often, a redesign of the existing hedging strategy and an increase in the overall level of effectiveness resulted from preparing to implement the new standard.”
Statement no. 133 may also prove valuable in the audit process. Bernard J. Schumacher, CFA, at AHCC Corp. in Middlebury, Connecticut, says, “The standard can improve the auditing process because it will clarify the definition of hedge accounting and reduce the need for interpretation. In the past, users of derivatives had little guidance from the audit side in terms of how to apply and document hedge accounting. As a result, conflicts would arise. The new standard should reduce the need for interpretation and ensure a more consistent and credible audit process.”
ELEMENTS OF THE STANDARD
Statement no. 133 establishes accounting and reporting standards for derivative instruments, including certain ones embedded in other host contracts (for example, a mortgage with a pre-payment option), and for hedging activities. The standard requires that all derivatives, with certain exceptions, be recorded at their fair value as either an asset or a liability, and changes the previous accounting definition of a derivative instrument, which focused on freestanding contracts such as options and forwards. Hedging transactions will be more transparent in financial statements. In addition to embedded derivatives, under Statement no. 133 the following items are eligible for treatment as derivatives: commodity contracts, certain loan commitments, some equity warrants and options on private companies. The most important exception to the definition of a derivative is the normal purchase and sale contract done in the ordinary course of business with probable physical delivery. For a summary of the key concepts of Statement no. 133, see the exhibit, above.
A derivative that qualifies as a hedge gets special accounting treatment that essentially matches gains or losses resulting from the changes in the value of the derivative with losses or gains in the value of the underlying transaction. However, any ineffectiveness from an imperfect risk offset between the hedged item and the derivative is recorded to earnings in the period incurred. A key provision of Statement no. 133 permits this special accounting for the change in value of derivatives designated and qualifying as fair value hedges, cash flow hedges or foreign currency hedges (see sidebar “FASB 133 Hedge Definitions” ).
Before Statement no. 133 was issued, accounting was more forgiving of hedge designs that were less than perfect, since ineffectiveness was generally deferred into the hedged item until the transaction being hedged was complete. Now all derivatives, including those that are not designated as hedges or that do not qualify for hedge accounting, are marked to market on the balance sheet with gains or losses on those instruments directly affecting income.
FASB initially set the effective date for Statement no. 133 for all fiscal quarters of all fiscal years beginning after June 15, 1999. However, in response to the various difficulties encountered by companies in implementing the standard, FASB postponed the effective date by one year. While all companies that use derivative and hedging strategies will have to work with the new standard, banks, insurance companies and utilities in particular will feel its effects. It is widely anticipated that revamping the way companies report the use of derivatives will create some earnings volatility.
Regulators and investors hope that financial statements and the risk management process, along with its success or failure, will become more transparent under Statement no. 133. In some situations, the new standard’s implementation will influence how hedges are designed and measured. Some key questions companies should answer on an ongoing basis include:
How will an entity determine fair values?
Will derivatives that were previously designated as hedges qualify as such under Statement no. 133?
Will earnings volatility increase due to hedges that are partially ineffective or for “economic” hedges that are not qualified for hedge accounting treatment?
What justification will a company offer to investors and analysts for earnings volatility that is caused by hedge ineffectiveness?
Will volatility in equity attributable to cash flow hedges affect debt covenant ratios?
Can the entity begin to use new strategies or derivative instruments that will now qualify as hedges under Statement no. 133 (particularly when dealing with foreign currencies)?
Will the entity incur additional costs in order to meet hedge effectiveness criteria?
Implementing Statement no. 133 has involved substantial effort and resources for companies and presented some complex technical accounting challenges. According to an article in The CPA Journal (October 1998), the Financial Executives Institute projected the implementation would cost companies an average of more than $100,000. More statistics on Statement no. 133 implementation costs can be found on the Global Treasury News Web site at www.gtnews.com/articles2/1121.html and www.gtnews.com/articles2/1297.html.
Moody’s Investors Service Priority of the Claim/Accounting Committee surveyed the 100 largest and smallest Fortune 1000 companies last fall to assess how they intended to implement both Statement no. 133 and its amendment, Statement no. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities—an Amendment of FASB Statement no. 133, and what effects the standards would have on their derivative strategies. Sixty-five companies responded, 42 large and 23 small. All but five used derivatives in some form. The survey’s conclusions were:
Nearly all companies believe they understand the standards’ effects, but some uncertainty remains.
Standards have helped a minority better understand their risk exposures.
Only seven companies indicated they would assume more unhedged risk.
About a third of the companies think the standard will change their use of derivatives and hedging strategies.
Almost half think the changes will lower the quality of reported net income and overall financial reporting.
Most companies think there will be no difference in how investors understand risk exposure/hedging strategies.
Companies think the standard is more likely to improve investor understanding than diminish it.
Financial companies were much more negative about the changes than nonfinancials.
(For additional survey information on companies’ implementation plans, see “Companies Focus on Derivatives Compliance,” JofA, Feb.01, page 26 .)
The new standard requires companies to formally document, designate and assess the effectiveness of transactions that qualify for hedge accounting; corporations formed steering committees to develop procedures necessary to implement this standard. The steering committees included individuals from accounting, audit, cash management/treasury, risk management/trading, external/financial reporting, purchasing, information technology, legal, finance, tax and other functions. A typical implementation plan had to identify and inventory derivative instruments; evaluate the overall risk management philosophy and how it complies and relates to Statement no. 133; establish derivative hedging strategies for existing derivative instruments; and assess the system capabilities needed to adopt and support this standard. Here are some implementation steps (some procedures can be performed concurrently).
Inventory derivatives. The initial step is to identify all potential derivatives to analyze the potential impact the standard will have on them. Users of hedge strategies should take particular care in this step since items not historically considered derivatives, such as purchase orders for inventory, may be deemed derivatives under this statement. FASB decided that contracts that permit but do not require settlement by delivery of a commodity are often used interchangeably with other derivatives and present similar risks; therefore, they should be considered derivatives. As a result, the “normal purchases and normal sales” exception in paragraph 10(b) of Statement no. 133 does not apply to purchase orders for commodities contracts because they could be net settled or liquidated through a market mechanism that would facilitate net settlement. Several entities expressed concerns that many of their purchase orders for commodities, such as natural gas, would be considered derivatives under Statement no. 133, even though they had expected physical delivery under the contract and didn’t use these contracts as derivatives.
Before Statement no. 133, the commodities industry did not consider these contracts to be derivatives. Under Statement no. 138, however, FASB has allowed purchase orders for commodities contracts to fall under the “normal purchase and sales” exception. FASB amended the statement to exclude contracts, other than financial contracts, from the requirements of Statement no. 133 when physical delivery was probable; this fact must be documented. In the gas industry, “physical contracts” are typically settled by the delivery of natural gas to the customer.
A complication in the identification step is that a derivative does not have to be a stand-alone instrument; it can be embedded in an otherwise nonderivative instrument or it can be a compound derivative. An embedded derivative must be separated from the host contract and accounted for as a derivative only if it meets all of the following criteria: (1) its economic characteristics and risk differ from or are not clearly and closely related to the characteristics and risks of the host instruments; (2) the host contract is not remeasured at fair value and (3) a separate instrument with the same terms as the embedded derivative would be a derivative subject to the standard’s requirements. The complexity of the issues relating to embedded derivatives led to considerable implementation guidance from FASB. For more information see www.rutgers.edu/accounting/raw/fasb/tech/index at Derivatives Implementation Group, Section B: Embedded Derivatives, Guidance on Statement 133 Implementation Issues.
Another difficulty is that the FASB has defined derivative instruments based on their characteristics, which may differ from risk managers’ current definitions. Risk managers typically think in terms of trying to control the cost of key inputs, such as metals or petroleum purchased by the entity, or they attempt to protect against changes in interest or exchange rates. FASB defines derivatives as financial instruments or other contracts with all three of the following: (1) one or more underlying contracts and one or more notional amounts and/or payment provisions; (2) no required initial net investment or a smaller initial investment than other types of contracts that have a similar response to changes in market factors and (3) a required or permitted net settlement.
Document risk management philosophy. Companies should address how they will use derivative instruments to achieve the company’s risk management objectives, which should be specific and documented in writing. Identifying the nature of the risk being hedged and using a hedging derivative consistent with an entity’s established policy for risk management are essential components of hedging strategies and will permit auditors to verify the hedge transaction was conducted in accordance with management’s strategy.
Identify hedging relationships for hedge designation. Hedge designations are critical to the implementation and the ongoing accounting of derivative strategies. Classification as either a fair value or cash flow hedge can depend on a slight change in facts. Once a company chooses how to document (or designate) the hedging relationship, different accounting results may occur. Gains and losses on derivative instruments are either offset against corresponding gains or losses of the hedged item through earnings in a fair value hedge, or accounted for in other comprehensive income for a cash flow hedge. Derivatives that are not designated as hedges or that do not qualify for hedge accounting are marked to market on the balance sheet with gains or losses on those instruments affecting earnings in the period of the change.
Document the hedging relationship. This step formalizes all of the analysis performed above. Existing standards already required designation of the hedging purpose of derivatives, but the requirements of Statement no. 133 are far more extensive. Each hedging relationship should fit into the overall risk management objective and strategy documented in the company’s overall risk management philosophy/policy. Without proper documentation or hedge designation, an entity could retroactively identify a hedged item, a hedged transaction or a method of measuring effectiveness to achieve desired accounting results.
The SEC has challenged early adopters with inadequate documentation and has required that all derivatives not documented with the specific risk at the inception of the hedge (date of adoption) be marked to market. The commission required that one registrant restate its financial results because it had not formally documented hedging relationships anew in conformity with the standard upon initially adopting it. Hedge accounting was permitted prospectively only from the date the registrant had completed the required formal documentation.
Determine effectiveness. If it is to qualify for hedge accounting, FASB requires that an entity must expect a hedging relationship to be “highly effective” in achieving offsetting changes in fair value or cash flows for the risk being hedged. For example, if the hedged item decreases in value by $10, will the derivative increase by an offsetting amount? If there is not a direct offset, the difference is considered to be ineffective. FASB intends “highly effective” to be essentially the same notion as “high correlation” in Statement no. 80, Accounting for Futures. The SEC staff has interpreted high correlation to mean a correlation ratio between 80% to 125% (this is the change in the fair value attributable to the hedged risk of the derivative divided by the change in fair value of the hedged item; this interpretation applies to the dollar offset method but not to other statistical methods).
Statement no. 133 does not specify how a company should determine high effectiveness, but it does require inclusion of the ineffective portion of a hedge in earnings in the current period. Under Statement no. 133, if a hedge is 115% effective, the entity can apply hedge accounting, but the 15 percentage points of ineffectiveness would be recorded in current earnings. Before Statement no. 133, if the correlation was 80% to 125%, companies were allowed to use hedge accounting but they recorded nothing in earnings until the hedge transaction was settled.
If the hedge is not considered effective, the entity cannot use hedge accounting and the entire derivative is marked to market in earnings; no offsetting changes in fair value are recorded. The consequence for companies will be earnings volatility, so they should develop or reevaluate how they will assess effectiveness.
Many companies will use the following two approaches. The first is the “dollar offset” approach in which the cumulative changes in the value of the hedging instrument are directly compared with the cumulative change in the fair value or cash flows of the hedged item. The other method is correlation analysis, or statistical analysis of past changes in values or cash flows.
Because the ineffective portion recorded to earnings represents the net gain or loss computed under the “dollar offset” method, this method is required for recording current ineffectiveness in earnings. However, the method does not provide the best measure of a hedge’s expected effectiveness. The dollar offset method only analyzes the relationship between two data points (the summation of price changes in x and in y over time) and, therefore, cannot adequately measure the degree of relationship between two sets of variables. Also, the dollar offset method relates the offset of gains or losses on the hedged item to the losses or gains on the hedging instrument, so the correlation is actually expressed in terms of negative correlation. A correlation analysis is a superior approach for determining the relationship between two sets of variables. It measures the degree of relationship between two sets of variables and is concerned with how well they move together over time.
Because of the significantly different results under these methods, it is important that management properly evaluate which one to apply. Note that some software vendors provide systems designed to provide only the dollar offset method.
The difference between the derivative’s carrying value and its fair value on the date of implementation results in a transition adjustment. This is accounted for as a cumulative effect of accounting change in accounting principle in accordance with APB Opinion no. 22, Accounting Changes. For derivatives that hedge the fair value of an asset, liability or firm commitment, gains and losses are recorded as a transition adjustment through earnings. Concurrently, the entity also records offsetting gains and losses on the hedged asset, liability or firm commitment. Gains and losses on derivatives that hedged the variability in a cash flow exposure should be reported as a transition adjustment and recorded in other comprehensive income. When companies calculate the transition adjustments, the deferred tax effects of the transition should be addressed. Many of the adjustments necessary during transition create or reverse existing temporary differences.
If a company has a significant volume of derivative activities, it probably thoroughly reviewed whether its internal systems had the capacity to support and implement the standard. No software packages are 100% in compliance with the standard. Although FASB never said so explicitly, the significant requirements of enhancing and implementing systems to comply with Statement no. 133, in light of year 2000 computer issues, led to the amendment of the effective date. Systems concerns include:
Can the entity’s software determine the fair value of its derivatives?
Can the system differentiate between components of the change in fair value, such as time value and intrinsic value of an option, for purposes of assessing hedge effectiveness? (There are different bases for the intrinsic value of call and put options; the value of either type is never negative. The time value of an option is affected by four variables and is a function of the probability that the value may change before the option expires.)
Can the system track the components of other comprehensive income, including recording cumulative effectiveness of cash flow hedges and the required disclosures of amounts reclassified into earnings?
Can the system determine and track changes in the fair value of assets and liabilities involved in fair value hedges?
Can the system compile and store the required hedge documentation?
Does the documentation allow for designation of derivatives for federal income tax purposes?
TRAINING AND EDUCATION
Due to the complexity of Statement no. 133, companies have trained and educated both the staff and management who deal with or account for derivatives so they have a thorough understanding of the standard. For large companies with significant hedging activities, 18 months of staff training on Statement no. 133 was not unusual and was typically provided by a company’s outside auditors. All levels of management should have a basic familiarity with the standard to help them understand how their decisions may influence the company’s financial statements and ultimate access to debt and capital markets.
Because of the standard’s potential impact on earnings and equity volatility, entities must also educate investors, analysts and bankers about why the business entered into certain derivative transactions. Financial statements must clearly communicate the standard’s effect on operating results. While the entity may have reduced overall economic risk, it may have also created more volatility in the financial statements. The company should explain its risk management philosophy and the use of Statement no. 133.
The merits or benefits of using derivatives, such as risk reduction, are never significant news items. However, horror stories regarding the inappropriate use of derivatives and the resulting losses make the headlines, leading the public to believe that derivatives are trouble. Whether Statement no. 133 will ultimately improve the transparency of financial statements and disclose the effects of hedging activities may depend on whether the public’s perception of derivatives improves and how quickly the horror stories of “unexpected” derivative losses become a faint memory.