Introduction to FAS 133, FAS 138, and IAS 39
Accounting for Derivative Financial Instruments and Hedging Activities

This document was prepared initially for my
GGE Capital's Train the Trainer Workshops on June 21 and 29, 2000 in Stamford, CN

The document was subsequently revised for my KPMG Workshops on 
October 12 (Chicago), November 1 (NYC), and November 30 (Las Vegas)

Bob Jensen at Trinity University

Warning:  Many of the links were broken when the FASB changed all of its links.  If a link to a FASB site does not work , go to the new FASB link and search for the document.  The FASB home page is at http://www.fasb.org/ 

Bob Jensen's Glossary

Introduction

An Interview With Nobel Economist Kenneth Arrow  

Definitions

Flow Chart for FAS 133 and IAS 39 Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

Differences between FAS 133 and IAS 39 --- http://www.trinity.edu/rjensen/caseans/canada.htm

Derivative Financial Instruments Frauds --- http://www.trinity.edu/rjensen/fraud.htm 

Various FAS 133 and IAS 39 Tutorials --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#T

The following Ernst & Young document provides a nice summary of revisions.
"IAS 32 and IAS 39 Revised:  An Overview," Ernst & Young, February 2004  --- http://www.ey.com/global/download.nsf/International/IAS32-39_Overview_Febr04/$file/IAS32-39_Overview_Febr04.pdf
I shortened the above URL to http://snipurl.com/RevisedIAS32and39

Recognition and Measurement of Derivatives

• Introduction

• Hedge Accounting

• Fair Value Hedges

• Cash Flow Hedges

• Foreign Currency Hedges

• Assessing Hedge Effectiveness

• Macro (Portfolio Hedging) --- See Macro Hedge at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#M-Terms 

• Discontinuance of Hedge Accounting

• Disclosures

• Effective Date and Transition

I have created a summary document called "FAS 133 As Amended and DIGed:
Introduction to FAS 138 Amendments and Some Key DIG Issues" at 
http://www.cs.trinity.edu/~rjensen/000overview/mp3/138intro.htm 

Common Risk Management Strategies Under FAS 133

A Decision Flowchart for FAS 133 

Unfortunate Consequences of FAS 133 and IAS 39

A Condensed Multimedia Overview With Video and Audio from Experts --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm 

Canadian Workshop Topics --- http://www.trinity.edu/rjensen/caseans/000indexLinks.htm 

Bob Jensen's Online FAS 133 and IAS 39 Glossary

Various FAS 133 and IAS 39 Tutorials --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#Tutorials 

Video Tutorials on Accounting for Derivative Financial Instruments and Hedging Activities per FAS 133 in the U.S. and IAS 39 internationally --- http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/ 

• Video Tutorial:  Introduction to Accounting for Derivatives and Hedging --- 
  000FAS133introduction.wmv
  
• Video Tutorial:  Overview of Bob Jensen's Helper Documents on Derivatives and Hedging --- 
  010FAS133Helpers.wmv 
  
• Video Tutorial:  Two Cases on Accounting for Options and Intrinsic vs. Time Value Accounting --- 
  015FAS133options.wmv
  
• Video Tutorial:  Two Cases on Accounting for Futures Contracts --- 
  020FAS133futures.wmv
  
• Video Tutorial:  Accounting for Interest Rate Swap Hedges and Valuation of Swaps --- 
  030FAS133InterestRateSwapAccounting.wmv

Interest Rate Swap Valuation, Forward Rate Derivation,  and Yield Curves
for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments 
See http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

Topic:
Questions and Answers Related to Derivative Financial Instruments Held or Entered into by a Qualifying Special-Purpose Entity (SPE) --- http://accounting.rutgers.edu/raw/fasb/draft/q&a140_supplement.pdf 

In September 2000, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. The FASB staff determined that the following questions and answers should be issued as an aid to understanding and implementing Statement 140 because of certain inquiries received on specific aspects of that Statement. 

The Board reviewed the following questions and answers in a public meeting and did not object to their issuance. The questions and answers will be included in a future edition of the FASB Staff Implementation

Bob Jensen's SPE threads are at http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm 

Bob Jensen's free online cases are at http://www.trinity.edu/rjensen/caseans/000index.htm  

Introduction

The earliest records of transactions that had features of derivative securities occur around 2000 BC in the Middle East.  (Page 338)
Geoffrey Poitras, The Early History of Financial Economics 1478-1776 (Chelten, UK:  Edward Elgar)
http://www.trinity.edu/rjensen/book01q3.htm#Poitras  

During the Greek and Roman civilizations, transactions involving elements of derivative securities contracts had evolved considerably from the sale for consignment process.  Markets had been formalized to the point of having a fixed time and place for trading together with common barter rules and currency systems.  These early markets did exhibit a practice of contracting for future delivery. (Page 338)
Ibid

Like forward contracts, the use of options contracts or "privileges" has a long history. (Page 339)
Ibid

The heuristics of an options transaction involves the payment of a premium to acquire a right to complete a specific trade at a later date.  These types of transactions appear not only in early commercial activity but also in other areas.  For example, an interesting ancient reference to (sic) options-like transactions can be found in Genesis 29 of the Bible where Laban offers Jacob an option to marry his youngest daughter Rachel in exchange for seven years labour.  (Page 339)

What is surprising is that it took over 4000 years (Until FAS 133 in June of 1998)  to finally requiring the booking of derivatives into the ledger.  However, Laban's contract falls outside the scope of FAS 133 if Rachel cannot readily be  converted into cash.

It may be best to take a look at a flowchart just to know that it is always there and can be viewed at any time.  The link is at http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm.  
Or the relative link is133flow.htm.

In 1998, the Financial Accounting Standards Board (FASB) issued Financial Accounting Standard 133 (FAS 133) on Accounting for Derivative Financial Instruments and Hedging Activities.  This was followed in 1999 by International Accounting Standard 39 (IAS 39) from the International Accounting Standards Committee (IASC).  Although less detailed and complex than FAS 133, IAS 39 accounting rules are virtually in accordance with FAS 133.  Differences are noted (in green) in Bob Jensen's Glossary at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm.  Paul Pacter itemized the major differences at http://www.iasc.org.uk/news/cen8_142.htm 

Why There Are New Rules for 
Accounting for Derivative Financial Instruments

What is the thinking behind the need for FAS 133? 
What was the problem with hedge accounting prior to FAS 133?

The new FAS 133 standard entitled Accounting for Derivative Financial Instruments and Hedging Activities was released in 1998 after an Exposure Draft 162-B circulated for two years around the U.S. and a temporary FAS 119 standard required disclosures in footnotes while FAS 133 was being written.  It was followed soon thereafter by IAS 39 that imposed similar requirements for international reporting and CICA 39 for Canadian reporting of the same types of derivative instruments.  These and the similar new standards in some other nations differ only in minor ways.  

What was new in all of these standards was that derivative financial instruments have to be booked initially at fair value and then adjusted to fair value on all reporting dates, especially for quarterly and annual audited financial statements released to the public.  Most derivatives, other than options and futures contracts covered by FAS 80, were not booked or even disclosed in financial reports prior to these newer standards.  The really problematic derivatives were forward contracts and swaps.  Swaps were not even invented until the early 1980s, and firms were not reporting enormous risks and off-balance-sheet-financing as swaps and forward contracts exploded in popularity in the late 1980s and early 1990s.  For example, companies that formerly managed cash with Treasury Bills, shifted to interest rate swaps for managing interest rate risk on trillions of dollars.  

Futures contracts were accounted for pretty well under FAS 80 since these contracts settle in cash frequently (usually daily) prior to expiration.  Options contracts were not accounted for well at all since only the initial cost (premium) was booked and amortized over the life of each option.  The problem was that the booked value of the option was generally small and irrelevant relative to the much larger fair value of the option.

In the early 1990s, enormous frauds using derivative financial instruments were coming to light.  Both governmental (e.g., Orange County) and corporate (e.g., Proctor and Gamble) scandals revealed how investment banks were writing misleading and immensely complicated derivative contracts to dupe organizations out of billions of dollars.  Many of the scandals are in derivative financial instruments are documented at http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds 
In particular, note Frank Partnoy's truly sickening revelations of intentional frauds perpetrated by virtually all the world's leading investment banks.

Paragraphs 212 and 213 of FAS 133 read as follows at http://www.fasb.org/st/index.shtml#fas150

212. Concern has grown about the accounting and disclosure requirements for derivatives and hedging activities as the extent of use and the complexity of derivatives and hedging activities have rapidly increased in recent years. Changes in global financial markets and related financial innovations have led to the development of new derivatives used to manage exposures to risk, including interest rate, foreign exchange, price, and credit risks. Many believe that accounting standards have not kept pace with those changes. Derivatives can be useful risk management tools, and some believe that the inadequacy of financial reporting may have discouraged their use by contributing to an atmosphere of uncertainty. Concern about inadequate financial reporting also was heightened by the publicity surrounding large derivative losses at a few companies. As a result, the Securities and Exchange Commission, members of Congress, and others urged the Board to deal expeditiously with reporting problems in this area. For example, a report of the General Accounting Office prepared for Congress in 1994 recommended, among other things, that the FASB "proceed expeditiously to develop and issue an exposure draft that provides comprehensive, consistent accounting rules for derivative products. . . ." \30/ In addition, some users of financial statements asked for improved disclosures and accounting for derivatives and hedging. For example, one of the recommendations in the December 1994 report published by the AICPA Special Committee on Financial Reporting, Improving Business Reporting-A Customer Focus, was to address the disclosures and accounting for innovative financial instruments.

213. Because of the urgency of improved financial information about derivatives and related activities, the Board decided, in December 1993, to redirect some of its efforts toward enhanced disclosures
and, in October 1994, issued FASB Statement No. 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments. This Statement supersedes Statement 119.

Even when the derivative contracts are used for economic hedges, the risk exposures prior to expiration of the hedge can be huge since many hedges are highly ineffective prior to expiration of the derivative contracts.  What makes derivative financial instruments unique relative to other financial instruments is that derivatives customarily have either zero initial cost (e.g., for forwards, futures and swap contracts) or exceedingly small initial premiums for options.  Hence the traditional historical cost accounting standards were meaningless for derivative instruments.  For FAS 133, the Financial Accounting Standards Board (FASB) decided to require continuous fair market value booking and adjustments (commonly called Mark-To-Market (MTM) adjustments.  

What the FASB wanted was to simply adjust derivatives to fair value as assets or liabilities and to charge current earnings with the incremental unrealized gains or losses.  All hell broke loose, however, when this was proposed to the business community, because such adjustments sometimes resulted in enormous fluctuations of reported earnings.  These fluctuations were especially troublesome in theory and in practice for firms who were only using derivatives to hedge risk.  Unless there was some way to adjust hedging derivatives to fair value without impacting current earnings, firms who hedged were actually going to look more risky than if they were not hedging risk.

This forced the FASB, the IASB, and other standard setters to adopt hedge accounting relief in the newer standards that require that derivative financial instruments be carried at fair value.  What might have been a relatively simple FAS 133 thus exploded to way over 500 paragraphs of technical jargon and complex accounting rules like the world as ever known.  At the time I am writing this in February 2004, most European nations have agreed to implement all IAS standards in January of 2005 except for IAS 39 which business firms in Europe refuse to accept at this juncture.  FAS 133 has been in effect in the U.S. since Year 2000 and has caused enormous confusion and reporting errors, most notable of which is Freddie Mac --- http://www.trinity.edu/rjensen/caseans/000index.htm#FreddieMac 

The new standards also create immense problems for auditors, some of which are dealt with in SAS 92.

Auditing Derivative Instruments, Hedging Activities, and Investments in Securities
http://www.aicpa.org/members/div/auditstd/riasai/sas92.htm 

Hedge accounting affords companies opportunities to book and adjust derivative financial instruments to fair value at all times.  However, many business firms are upset because the required hedge effectiveness tests cause them to lose part or all their hedge accounting.

Fair Value Exposure Draft
FAS 133 is arguably the most complex, controversial, and tentative standard ever issued by the FASB.  It is not tentative in terms of required implementation, but it may fade in prominence if and when the FASB issues its proposed fair value standard for all financial instruments.  The first exposure draft on this even more controversial proposal is given in Exposure Draft 204-B entitled Reporting Financial Instruments and Certain Related Assets and Liabilities at Fair Value. See updated information on this at http://www.fasb.org/project/fv_measurement.shtml 

The DIG
In the meantime, the FASB formed the FAS 133 Derivatives Implementation Group (DIG) to help resolve particular implementation questions, especially in areas where the standard is not clear or allegedly onerous.  The FASB's DIG website (that contains its mission and pronouncements) is at http://www.fasb.org/derivatives/  DIG issues are also summarized (in red borders) at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#0000Begin.

The international equivalent of the DIG arose when the International Accounting Standards Committee issued  proposed Questions and Answers about IAS 39 on accounting derivative financial instruments recognition, measurement, and hedging activities --- http://www.iasc.org.uk/docs/0005qa39.pdf 

 FAS 138 Amendments to FAS 133
A number of important issues that surfaced in the DIG have resulted in a new standard FAS 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities an amendment of FASB Statement No. 133, Released June 15, 2000 --- http://www.rutgers.edu/Accounting/raw/fasb/public/index.html 

The FASB provides some new examples illustrating the FAS 138 Amendments to FAS 133 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/examplespg.html

I have created a summary document called "FAS 133 As Amended and DIGed:
Introduction to FAS 138 Amendments and Some Key DIG Issues" at 
http://www.cs.trinity.edu/~rjensen/000overview/mp3/138intro.htm 

The amendments and DIG resolutions help, but do not eliminate controversies over FAS 133.    FAS 133 requires that all derivative financial instruments (with only a few defined exceptions) be booked and adjusted to fair value at least quarterly.  This is a huge departure from earlier standards and accounting traditions.  Financial instruments, except in a few defined exceptions, are accounted for at historical (amortized) cost.  Hence there is now a distinction between derivative financial instruments (at fair value) versus financial instruments (amortized cost). 

In May 3003, Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The Statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133 --- http://www.fasb.org/news/nr043003.shtml 

Norwalk, CT, April 30, 2003—Today the Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The Statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133.

The new guidance amends Statement 133 for decisions made:

• as part of the Derivatives Implementation Group process that effectively required amendments to Statement 133,
• in connection with other Board projects dealing with financial instruments, and
• regarding implementation issues raised in relation to the application of the definition of a derivative, particularly regarding the meaning of an “underlying” and the characteristics of a derivative that contains financing components.

The amendments set forth in Statement 149 improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. In particular, this Statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative as discussed in Statement 133. In addition, it clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. Statement 149 amends certain other existing pronouncements. Those changes will result in more consistent reporting of contracts that are derivatives in their entirety or that contain embedded derivatives that warrant separate accounting.

Effective Dates and Order Information

This Statement is effective for contracts entered into or modified after June 30, 2003, except as stated below and for hedging relationships designated after June 30, 2003. The guidance should be applied prospectively.

The provisions of this Statement that relate to Statement 133 Implementation Issues that have been effective for fiscal quarters that began prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates. In addition, certain provisions relating to forward purchases or sales of when-issued securities or other securities that do not yet exist, should be applied to existing contracts as well as new contracts entered into after June 30, 2003.

Copies of Statement 149 may be obtained through the FASB Order Department at 800-748-0659 or by placing an order on-line at the FASB website.

Resources

The Financial Executives Institute (FEI) has some PowerPoint presentations available (from Arthur Andersen experts) on FAS 133.  Faculty and practitioners may find these useful --- http://www.fei.org/download/fas133.cfm 

Exit value accounting is required under GAAP for personal financial statements and companies that are deemed no longer going concerns.  Some theorists advocate exit value accounting for going concerns as well as non-going concerns.  Both nationally (under FAS 133) and internationally (under IAS 39),  fair value accounting is presently required for derivative financial instruments.  Both the FASB and the IASC have exposure drafts advocating fair value accounting for all financial instruments.

From The Wall Street Journal Accounting Educators' Review on April 3, 2003

TITLE: Lending Less, "Protecting" More: Desperate for Better Returns, Banks Turn to Credit-Default Swaps 
REPORTER: Henny Sender and Marcus Walker 
DATE: Apr 01, 2003 
PAGE: C13 
LINK: http://online.wsj.com/article/0,,SB104924410648100900,00.html  
TOPICS: Advanced Financial Accounting, Banking, Fair Value Accounting, Financial Analysis, Insurance Industry

SUMMARY: This article describes the implications of banks selling credit-default swap derivatives. Firtch Ratings has concluded in a recent report that banks are adding to their own risk as they use these derivatives to sell insurance agains default by their borrower clients.

QUESTIONS: 1.) Define the term "derivative security" and describe the particular derivative, credit-default swaps, that are discussed in this article.

2.) Why are banks entering into derivatives known as credit-default swaps? Who is buying these derivatives that the bank is selling?

3.) In general, how should these derivative securities be accounted for in the banks' financial statements? What finanicial statement disclosures are required? How have these disclosures provided evidence about the general trends in the banking industry that are discussed in this article?

4.) Explain the following quote from Frank Accetta, an executive director at Morgan Stanley: "Banks are realizing that you can take on the same risk [as the risk associated with making a loan] at more attractive prices by selling protection."

5.) Why do you think the article equates the sale of credit-default swaps with the business of selling insurance? What do you think are the likely pitfalls of a bank undertaking such a transaction as opposed to an insurance company doing so?

6.) What impact have these derivatives had on loan pricing at Deutsche Bank AG? What is a term that is used to describe the types of costs Deutsche Bank is now considering when it decides on a lending rate for a particular borrower?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

"Banks' Increasing Use of Swaps May Boost Credit-Risk Exposure, by Henny Sender and Marcus Walker, The Wall Street Journal, April 1, 2003 --- http://online.wsj.com/article/0,,SB104924410648100900,00.html 

When companies default on their debt, banks in the U.S. and Europe increasingly will have to pick up the tab.

That is the conclusion of Fitch Ratings, the credit-rating concern. Desperate for better returns, more banks are turning to the "credit default" markets, a sphere once dominated by insurers. In a recent report, Fitch says the banks -- as they use these derivatives to sell insurance against default by their borrowers -- are adding to their credit risk.

The trend toward selling protection, rather than lending, could well raise borrowing costs for many companies. It also may mean greater risk for banks that increasingly are attracted to the business of selling protection, potentially weakening the financial system as a whole if credit quality remains troubled. One Canadian bank, for example, lent a large sum to WorldCom Inc., which filed for Chapter 11 bankruptcy protection last year. Rather than hedging its loan to the distressed telecom company by buying protection, it increased its exposure by selling protection. The premium it earned by selling insurance, though, fell far short of what it both lost on the loan and had to pay out to the bank on the other side of the credit default swap.

"The whole DNA of banks is changing. The act of lending used to be part of the organic face of the bank," says Frank Accetta, an executive director at Morgan Stanley who works in the loan-portfolio management department. "Nobody used to sit down and calculate the cost of lending. Now banks are realizing that you can take on the same risk at more attractive prices by selling protection."

Despite its youth, the unregulated, informal credit-default swap market has grown sharply to total almost $2 trillion in face value of outstanding contracts, according to estimates from the British Bankers Association, which does the most comprehensive global study of the market. That is up from less than $900 billion just two years ago. (The BBA says the estimate contains a good amount of double counting, but it uses the same method over time and thus its estimates are considered a good measuring stick of relative change in the credit-default swap market.) Usually, banks have primarily bought protection to hedge their lending exposure, while insurers have sold protection. But Fitch's study, as well as banks' own financial statements and anecdotal evidence, shows that banks are becoming more active sellers of protection, thereby altering their risk profiles.

The shift toward selling more protection comes as European and American banks trumpet their reduced credit risk. And it is true that such banks have cut the size of their loan exposures, either by taking smaller slices of loans or selling such loans to other banks. They also have diversified their sources of profit by trying to snare more lucrative investment-banking business and other fee-based activity.

Whether banks lend money or sell insurance protection, the downside is generally similar: The bank takes a hit if a company defaults, cushioned by whatever amount can eventually be recovered. (Though lenders are first in line in bankruptcy court; sellers of such protection are further back in the queue.)

But the upside differs substantially between lenders and sellers of protection. Banks don't generally charge their corporate borrowers much when they make a loan because they hope to get other, more lucrative assignments from the relationship. So if a bank extends $100 million to an industrial client, the bank may pocket $100,000 annually over the life of the loan. By contrast, the credit-default swap market prices corporate risk far more systematically, devoid of relationship issues. So if banks sell $100 million of insurance to protect another party against a default by that same company, the bank can receive, say, $3 million annually in the equivalent of insurance premiums (depending on the company's creditworthiness).

All this comes as the traditional lending business is becoming less lucrative. The credit-derivatives market highlights the degree to which bankers underprice corporate loans, and, as a result, bankers expect the price of such loans to rise.

"We see a change over time in the way loans are priced and structured," says Michael Pohly, head of credit derivatives at Morgan Stanley. "The lending market is becoming more aligned with the rest of the capital markets." In one possible sign of the trend away from traditional lending, the average bank syndicate has dropped from 30 lenders in 1995 to about 17 now, according to data from Loan Pricing Corp.

Some of the biggest players in the market, such as J.P. Morgan Chase & Co., are net sellers of such insurance, according to J.P. Morgan's financial statements. In its annual report, J.P. Morgan notes that the mismatch between its bought and sold positions can be explained by the fact that, while it doesn't always hedge, "the risk positions are largely matched." A spokesman declined to comment.

But smaller German banks, some of them backed by regional governments, are also active sellers, according to Fitch. "Low margins in the domestic market have compelled many German state-guaranteed banks to search for alternative sources of higher yielding assets, such as credit derivatives," the report notes. These include the regional banks Westdeutsche Landesbank, Bayerische Landesbank, Bankgesellschaft Berlin and Landesbank Hessen-Thueringen, according to market participants. The state-owned Landesbanken in particular have been searching for ways to improve their meager profits in time for 2005, when they are due to lose their government support under pressure from the European Union.

Deutsche Bank AG is one of biggest players in the market. It is also among the furthest along in introducing more-rational pricing to reflect the implicit subsidy in making loans. At Deutsche Bank, "loan approvals now are scrutinized for economic shortfall" between what the bank could earn selling protection and what it makes on the loan, says Rajeev Misra, the London-based head of global credit trading.

More on credit derivatives --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#CreditDerivatives 

An Interview With Nobel Economist Kenneth Arrow

Questions
Why is blame squarely on corporate accounting for a lot of the mess that we are into now in health care insurance?
Why have derivative financial instruments become so popular in the international world of business?
Why are derivatives possibly under-used or misused by business firms?
How does insurance differ from hedging?

Answers (Note my new videos that are linked at the bottom of this message.)
I highly recommend Nina Mehta's FEN interview with Nobel economist Kenneth Arrow --- http://fenews.com/fet_aug2003/one_on_one_interview/one_on_one_arrow.html 
Arrow does not get into the FAS 133-type accountancy mess, but he does make a good case for use of derivatives in managing risk.

Arrow's comments indicting corporate accounting for much of the health care mess comes at near the end of the interview, so be patient and read the article to the bitter end.

In his closing comment (last sentence), Arrow states:  "It’s a general problem of accounting."

FEN: There’s been tremendous innovation in financial products in the last few decades and more risks are being transferred to those willing to shoulder them. What are the biggest economic risks that are not being transferred?

Arrow: It’s a surprise to me that ordinary business risks are not transferred to the extent one might have supposed, despite the existence of financial derivatives. Companies are engaged in all sorts of transactions that aren’t really hedged. A company will acquire another company, sometimes a competitor, sometimes a supplier or downstream business, and every now and then it turns out sour. Or a company will come out with new products and some will work and some won’t. There are good reasons why one can’t hedge everything—there are incentive effects and things like moral hazard and adverse selection. The result is that companies have rollercoaster rides on their earnings.  The other problem is that derivatives and securities that offer methods of reducing risks are not necessarily used for that purpose. They are neutral and can be used to reduce risks, but people gamble on them.

FEN: On your last point, what about the argument that without speculators risk-transfer markets wouldn’t be large or deep enough?

Arrow: With derivatives, whether the risk-reducing aspects are predominant or the risk-enhancing aspects are predominant, they can be used for gambling. That means speculators are adding to the swings rather than reducing them. What you said is 100 percent correct: from a social point of view it’s important to have the speculators—they’re the ones who provide the liquidity that keeps the markets operating. But it doesn’t automatically follow that derivatives are risk-reducing.

FEN: Okay. So what risks should businesses or investors be able to hedge that they currently can’t?

Arrow: Consider, for example, mergers or acquisitions. These are risky from the point of view of all the stockholders involved. There’s room for risk-reducing products, not for the firms going through a merger but for stockholders. Firms should have inside information—that’s what you buy the services of a CEO for. If he can lay off the bets, you can see his incentives reduced. So you’d be a little leery of that. But stockholders in a merger should be able to acquire some kind of instrument for insurance purposes.

FEN: Would these products come from actual insurance companies or from other entities?

Arrow: I’m using the word “insurance” metaphorically. Insurance traditionally deals with a set of risks that are fairly well defined. It would have to be not a traditional insurance company. As a theorist, I’d think there’s room for third parties.

FEN: A lot of attention is now focused on the use of options in executive compensation and on how the options might influence the decisions executives make. Given your early, seminal work on moral hazard, what do you think of this issue?

Arrow: Options have a legitimate place as one part of a package. When they become dominant, lots of problems arise. If the financial structure of a company were completely transparent, it wouldn’t matter. The market would know what the situation is. But there’s a lot of judgment in financial projections and even in the actual items on the balance sheet, so a CEO has incentives to put the most favorable—from his point of view—structure forward. However, I think the incentive effects have been greatly exaggerated. Aligning the interest of an executive or CEO with the company—well, the officers have a big stake in the success of the company even if they’re paid salaries, because of their reputation. Tax-handling is a big part of why CEOs have been shifting toward options. Plus, from a company’s point of view, stock options are not regarded as costing anything—which is absurd. People buy stock on the idea that it might go up, so part of their gain is being diluted if there are more options out there. The result is that it is a potential, uncertain hit to stockholders. It changes the terms on which they’re speculating, yet it doesn’t appear as a cost to the company.

Continued in the article

And a quote from the end of the article places the blame squarely on corporate accounting for a lot of the mess that we are into now in health care insurance.

FEN: In an interview a few years back with Ellen McGrattan at the Minneapolis Federal Reserve Bank, you made the point that there’s no natural or logical relationship between employment and health insurance. Can you expand on that?

Arrow: The need for economies of scale is why many small companies don’t elect to have insurance. Something like one-sixth of the country is uninsured. We have a peculiar, hybrid system of going through an employer for coverage. It’s an easy way to reach people, but why should a wife be covered on her husband’s policy? Why should she not have her own policy? If married people are covered, why not two people living together, or a homosexual couple? The issue shouldn’t arise at all. If we take a purely individualistic point of view, each person is responsible for his or her own insurance. One extreme is universal coverage. Most of the advanced world has this. By virtue of being a citizen of the United States, you’d be covered—this is the case in Great Britain, France, Canada and elsewhere. That would separate the accident of whether you’re employed from whether you are insured.

FEN: Many people in the insurance industry say the HMO system is not working now because prices are getting out of control and that this problem needs to be addressed.

Arrow: Where should a country spend its money? We’re a rich country. Fifteen percent of GNP [gross national product] goes to healthcare, and it’s rising. But what better to spend your money on? The problem is how it’s arranged. If this were something each individual bought on his or her own, it wouldn’t be a social problem. It would be handled through the price system or through contractual arrangements with corporations.

It’s not easy to see why corporations should be troubled right now. They knew they were taking on this obligation. They could calculate actuarially what the costs would be. The costs should have already been accounted for. When you hire a worker, part of the worker’s compensation is wages, another part is health benefits, a third part is retirement benefits, and a fourth part is retirement health benefits. So the compensation wasn’t $10 per hour but $15 per hour. The money should have been set aside as part of a worker’s compensation. For various accounting reasons companies didn’t do it. They resisted the idea that retirement health benefits should be taken as an expenditure when they hired the worker. Since it didn’t appear on their balance sheets, their profits looked bigger—but fictitiously, because there were these obligations. Now there are losses. FASB was looking into this 10 or 15 years ago and had hearings on this question. It’s a general problem of accounting.

Bob Jensen's threads on derivatives and accounting for derivative financial instruments and hedging activity can be found at http://www.trinity.edu/rjensen/caseans/000index.htm 
New video helpers on this topic will soon be available.  Some of the preliminary videos are already posted at http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/ 

Definitions

The FASB's FAS 133 and IASC's IAS 39 were badly needed standards in spite of strong opposition from the corporate world, especially from the banking community.  Many types of contracts included in the scope of these standards (e.g. swaps and forwards contracts) had no prior rules for accounting measurement or disclosure.  Settlement accounting failed to disclose or measure assets, liabilities, and risks of these contracts.  Some contracts had prior standards (e.g., FAS 80 covered futures contracts on commodities but not derivative financial instruments) that were inconsistent and incomplete.  Some corporations had enormous financial risks in derivative instruments that were not disclosed.

Initially the FASB and the IASC wanted very simple (apart from difficulties in measuring fair value) accounting standards that required all derivative instruments to be maintained at fair value with gains and losses due to changes in value being posted to current earnings.  Due to immense political pressures (that came down largely from financial institutions and their friends in government), special exceptions were granted for certain types of contracts.  As a result, the hoped-for simple fair value accounting standards turned into the most complex nightmares ever issued by either the FASB or the IASC.  Read about and listen to the experts complaining in http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm.

A FAS 133 and IAS 39 Glossary is available at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm.  Complaints about both standards may be overshadowed by complaints about more recent movements by the FASB and the IASC to require fair value accounting for all financial instruments rather than just derivative instruments.  You can read about this and find links to the current exposure drafts for new standards requiring such fair value accounting.  Look up "Fair Value" at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms.  If those new fair value standards are enacted, both FAS 133 and IAS 39 fade in importance.  Until then, however, implementation of FAS 133 and IAS 39 has become the most difficult and costly implementation of any accounting standards in history.  There are many complex and controversial issues with discovery of embedded derivatives, value estimation, and effectiveness testing of hedges being the most problematic issues.

Note especially that Appendix A beginning in Paragraph 57 of FAS 133 provides implementation guidance.  Section 2 of Appendix A beginning with Paragraph 62 deals with assessment of hedge effectiveness.

Derivative Financial Instrument

a financial instrument that by its terms, at inception or upon the occurrence of a specified event, provides the holder (or writer) with the right (or obligation) to participate in some or all of the price changes of an underlying (that is, one or more referenced financial instruments, commodities, or other assets, or other specific items to which a rate, an index of prices, or another market indicator is applied) and does not require that the holder or writer own or deliver the underlying.  A contract that requires ownership or delivery of the underlying is a derivative financial instrument if (a) the underlying is another derivative, (b) a mechanism exists in the market (such as an organized exchange) to enter into a closing contract with only a net cash settlement, or (c) the contract is customarily settled with only a net cash payment based on changes in the price of the underlying.  What is most noteworthy about derivative financial instruments is that in the past two decades, the global use of derivatives has exploded exponentially to where the trading in notional amounts is in trillions of dollars.  Unlike FAS 133, IAS 39 makes explicit reference also to an insurance index or catastrophe loss index and a climatic or geological condition.  

Tutorial:  Financial Derivatives in Plain English --- 
http://www.iol.ie/~aibtreas/derivs-pe/ 

Also see http://www.adtrading.com/adt3/begin3.htm 

There are some good examples of hedging and speculating strategies.  I did not, however, see anything on accounting for derivatives under FAS 133 or IAS 39.

A nonderivative financial instrument fails one or more of the above tests to qualify as a derivative in FAS 133.  Nonderivatives do not necessarily have to be adjusted to fair value like derivative instruments.  However, they may be used for economic hedges even though they do not qualify for special hedge accounting under FAS 133.  Exceptions in FAS 133 that afford special hedge accounting treatment for nonderivative instruments include hedges of foreign currency fair value and/or hedge foreign currency exposures of net investment in a foreign operation.  See FAS Paragraphs 6c, 17d, 18d, 20c, 28d, 37, 39, 40, 42, 44, 45, 246, 247, 255, 264, 293-304, 476, 477, and 479.  Also see foreign currency hedge.

It is important to note that all derivatives in finance may not fall under the FAS 133 definition.  In FAS 133, a derivative must have a notional, an underlying, and net settlement.  There are other requirements such as a zero or minimal initial investment as specified in Paragraph 6b and Appendix A Paragraph 57b of FAS 133 and Paragraph 10b of IAS 39.  Examples of derivatives that are explicitly excluded are discussed in Paragraph 252 on Page 134 of FAS 133.  Paragraph 10c of IAS 39 also addresses net settlement.  IASC does not require a net settlement provision in the definition of a derivative.  To meet the criteria for being a derivative under FAS 133, there must be a net settlement provision.  

For a FAS 133 flow chart, go to http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

There must also be zero or small net investment to meet the definition of a derivative financial instrument  (FAS 133 Paragraphs 6b and Appendix A Paragraph 57b.  Also see IAS 39 IAS 39: Paragraph 10b).

Key to this definition are the concepts of "underlying," "notional amount," and "payment provision."  An "underlying" in a derivative is a specified interest rate, security price, commodity price, foreign-exchange rate, or some other variable.  An underlying may be a price or rate of an asset or liability but is not the asset or liability itself.  Accordingly, the underlying generally will be the referenced index that determines whether or not the derivative has a positive or negative value.

A "notional amount" is a number of currency units, shares, bushels, pounds, or other units specified in the contract.  The notional amount represents the second half of the equation that goes into determining the settlement amount or amounts under the derivative contract.  Accordingly, the settlement of a derivative is determined by the interaction of the notional amount with the underlying.  This interaction may consist of simple multiplication or it may involve a more complex formula.  A "payment provision" specifies a fixed or determinable settlement that is to be made if the underlying behaves in a specified manner (e.g., if the rainfall in San Francisco exceeds five inches in a given month, a payment of $1,000,000 would be made).

Most futures, forwards, swaps, and options will meet the FAS 133 definition of a derivative.  As a general matter, one's intuition of what is or is not a derivative will probably align with the Standard most of the time.  Regarding intuition, however, it would be prudent to follow the motto:  Trust, but verify.

Like most man-made things, the FAS 133 definition is not perfect.  It includes some things that the FASB wanted to exclude and excludes some things that the FASB wanted to include.  So there are some exclusions and add-ons to the Standard.  Among the more important exclusions are

• "regular-way" securities trades (e.g., the purchase of an equity security traded on the New York Stock Exchange, which is technically a forward contract on the trade date);
  

• "normal" purchases and sales of inventory items;
  

• contingent consideration from a business combination;
  

• certain insurance contacts (such as traditional life and property/casualty insurance contracts) and financial guarantees;
  

• employee compensation arrangements; and
  

• contracts that are indexed to an entity's own stock and classified as part of stockholders' equity.

The exclusion of "normal" purchases and sales of inventory items may have the most relevance for some companies.  Simply stated, if a forward contract for the purchase or sale of inventory or other goods that are not financial instruments cannot be settled net and represents a purchase or sale that occurs in the entity's normal course of business, it is not accounted for under FAS 133, even though technically it might meet the definition of a derivative.

One of the things that concerns accounting standard-setters when they are considering a new standard is the possibility that people might find a way around the rules.  In the case of derivatives, the FASB realized that it may not be all that difficult for financial engineers to "embed" derivatives into contracts that clearly are not derivatives.  In so doing, these so-called "embedded derivatives" could escape the new accounting rules that are intended for them.  This concern led to the inclusion of certain "embedded derivatives" in the Standard's scope.

The DIG has an entire section of releases dealing with complexities of defining a derivative.  See Section A Issues at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuindex.html.

Hedge Accounting

Business firms using derivatives for hedging are mainly interested in qualifying for hedge accounting that will offset booked changes in derivative fair values to something other than current earnings.  This prevents volatility in reported earnings that will otherwise arise when derivatives are adjusted for fair values at least every 90 days under FAS 133 requirements.

Embedded Derivatives 

Embedded derivatives are portions of contracts that meet the definition of a derivative when the entire nonderivative contract cannot be considered a financial instruments derivative. Types of embedded derivative  instruments are often indexed debt and investment contracts such as commodity indexed interest or principal payments, convertible debt, credit indexed contracts, equity indexed contracts, and inflation indexed contracts.  Embedded derivatives are discussed in FAS 133, pp. 7-9, Paragraphs 12-16.  Embedded derivatives such as commodity indexed and equity indexed contracts and convertible debt require separation of the derivative from the host contract in FAS 133 accounting.  In contrast, credit indexed and inflation indexed embedded derivatives are not separable from the host contract.   Also see FAS 133 Paragraphs 51, 60, 61, 176-178, and 293-311. The overall contract is sometimes referred to as a "hybrid" that contains one or more embedded derivatives.  Embedded derivatives within embedded derivatives generally meet the closely-and-clearly related test and cannot be accounted for as separate derivatives.  The concept of "closely related is also discussed in IAS 39  Paragraph 23a.  Rules for accounting for the host contract after an embedded derivative has be bifurcated are discussed in FAS 133 Paragraph 16.  If an embedded derivative should bifurcated but the firm cannot do so for some reason, FAS 133 Paragraph 16 requires that the entire contract be treated as a trading security that is adjusted to fair value at least quarterly with changes and fair value being charged to current earnings rather than OCI.  See FAS 133 Paragraph 16 and IAS 39 Paragraph 26.

For more details on embedded derivatives, go to the expanded definition at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#EmbeddedDerivatives 

Appendix E in FAS 133 beginning in Paragraph 539 provides a flowchart for detecting embedded derivatives that must be bifurcated and accounted for separately.

A FAS 133 flowchart developed by Ira Kawaller and John J. Ensminger is reproduced at http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

The DIG has an entire section dealing with the complexities of embedded derivatives.  See Section B at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuindex.html.

The site below referred to by Mr. Fanzini is at http://www.trinity.edu/rjensen/caseans/000index.htm 

However, the important update news is in his message below.

Bob Jensen

-----Original Message----- 
From: Fanzini, Louis [mailto:louis.fanzini@csfb.com]  
Sent: Thursday, May 31, 2001 3:01 PM 
To: 'rjensen@trinity.edu' Subject: Bob Jensen's FAS 133, 138, IAS 39 site

Bob,

Kudos on a great site that I have visited often!

One item re embedded derivatives that you may want to include when you next update the site; the SEC has come out and said a bifurcated derivative and its host can be shown on the balance sheet net. The theory being that bifurcation is an accounting concept and that, in reality, only one contract exists between the counterparties. So, there will no longer be a difference between 133 and IAS 39.

Best regards,

Lou

> Louis Fanzini > Accounting & Regulatory Policy & Research > CREDIT l FIRST > SUISSE l BOSTON > Tel: (212) 325-7365 > Fax: (212) 325-8539 > E-Mail: louis.fanzini@csfb.com  >

Recognition and Measurement of Derivatives

After searching for all derivative contracts, including embedded derivatives in other contracts, all derivatives covered under FAS 133 are subject to disclosure and fair value adjustment rules according to Paragraph 17 of FAS 133.

Many derivatives must be booked and adjusted at least every quarter to fair value even if they do not qualify as hedges.

Unlike financial instruments in general, derivative financial instruments must be measured at fair value on the balance sheet.  For example, fixed-rate bonds are measured at amortized historical cost, but a swap of that bond interest is a derivative financial instrument that must be maintained at fair value.  Or a forward contact intended to hedge the value of the bond must be maintained at fair value.  By definition, most derivatives (e.g., futures, forwards, and swaps) have no value at inception or a relatively low value (e.g., option contract premiums).  Since many such contracts are hedges of hedged items, the hedge contracts (unlike the hedged items) must be revalued at least quarterly.

Two major problems in adjusting to fair value (marking to market) are as follows:

• How to measure custom contract fair value such as forwards and swaps that are not traded in active markets.  The main guidance is given in FAS 107, but the guidance is very limited.  Also, FAS 107 has a "practicality exception" that does not extend to FAS 133.  It is impossible to measure hedge effectiveness without some estimate of fair value.  
  
  

• Whether to record changes in fair value as current earnings or as other comprehensive income (OCI) that came into being with FAS 133.  Outside the U.S., many nations do not define an OCI alternative.  However, in the international standard IAS 39, the International Accounting Standards Committee allows for a similar accounting using some equity account other than retained earnings.

The income-statement recognition of changes in the fair value of a derivative will depend on the intended use of the derivative.  If the derivative does not qualify as a hedging instrument or is not designated as such, the gain or loss on the derivative must be recognized currently in earnings.  If the derivative qualifies for special hedge accounting, the gain or loss on the derivative will either (1) also be recognized in income, along with an offsetting adjustment that is made to the basis of the item being hedged, or (2) be deferred in other comprehensive income (i.e., in equity).  To qualify for special hedge accounting, the derivative must qualify either as a "fair value hedge," "cash flow hedge," or "foreign currency hedge."   

It should be stressed that many derivative contracts are not hedges, especially all speculative derivative instruments.  Also some economic hedges cannot receive special hedge accounting treatment.  For example, a recall option embedded in a fixed-rate note payable is an economic hedge that allows the debtor to recall the bonds if interest rates plunge.  This is a hedge in the sense that it becomes possible to refinance at lower interest rates.  However, since the embedded recall provision does not have to be bifurcated and accounted for separately if it is considered "clearly-and-closely related," there is no special accounting provision for this economic hedge.

Hedge Accounting

In a hedging strategy, a choice must be made as to whether to hedge fair value or cash flow.  It is impossible to hedge both at the same time.  For example, if a company enters into a "firm commitment" (with a fixed quantity and fixed price) to purchase inventory at a future date, it is possible to hedge fair value but not cash flow.  If it is instead a "forecasted transaction (with a fixed quantity and an unknown price) it is possible to hedge the cash flow uncertainty due to the unknown price.  

As a second example, suppose a company owns a $1,000, 10% bond currently selling at a discount of $900 because new buyers are currently demanding more than a 10% return on the bond.  With some type of derivative instrument, the holder of such a bond may hedge against future value declines below $900, but the combined cash flow (from the bond and the hedge) must be variable such that the investor has given up cash flow certainty for value protection.  In the inverse situation, an investor in a variable rate bond has no fair value risk (by definition of a variable rate bond that moves up and down with market interest rate changes).  Such an investor can enter into a hedge of unknown cash flows, but to do so requires giving up the certainty that fair value is not at risk.

Fair Value Hedges

A fair value hedge represents the hedge of an exposure to changes in the fair value of an asset, liability, or an unrecognized firm commitment that is attributable to a particular risk.  Some common examples of fair value hedges include:

• the use of an interest-rate swap to change-fixed rate debt into floating-rate debt;
  

• the use of futures contracts to hedge the fair value of copper or other types of inventory; and
  

• the use of a derivative to hedge the fair value of a firm commitment (e.g., to sell crude oil at a fixed price).

Flow Chart for Fair Value Hedge Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

Several criteria must be met for a hedging relationship to qualify as a fair value hedge.  These criteria pertain to both the hedging instrument and the hedged item and are very prescriptive.  The excruciating level of detail in some of them illustrates quite well what many people believe to be a rather unfortunate state of affairs in U.S. generally accepted accounting principles today -- we seem to need a specific rule for every conceivable situation, plus a few extra rules to boot.  The more important (general) criteria that must be met if a hedging relationship is to qualify as a fair value hedge are as follows:

1. At the inception of the hedge, there is formal documentation of the hedging relationship and the entity's risk-management objective and strategy for undertaking the hedge.  This should include identification of the hedging instrument, the hedged item, the nature of the risk that is being hedged, and how the hedging instrument's effectiveness will be assessed.  There must be a reasonable basis for how the entity plans to assess the hedging instrument's effectiveness.  In short, the entity must clearly state what it is doing.
   

2. Both at the inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in achieving the offset of changes in fair value that are attributable to the hedged risk during the period that the hedge is designated.  An assessment of effectiveness is required whenever financial statements or earnings are reported, and at least every three months.  In short, the entity must believe and regularly assess that its strategy will be effective.
   

3. The hedged item is a single asset, liability, or firm commitment, or is a specific portion thereof, or is a portfolio of similar items.  The FASB's interpretation of "similar" assets or liabilities in FAS 133 if very narrow -- when it says "similar," it means very similar.
   

4. The hedged item presents an exposure to changes in fair value that are attributable to a hedged risk that could affect reported earnings.  For example, this criterion precludes hedge accounting for transactions related to an entity's equity accounts (e.g., treasury stock), since earnings would not be affected.
   

5. If the hedged item is a nonfinancial asset or liability, the designated risk that is being hedged is the risk of changes in the fair value of the entire hedged asset or liability (reflecting its actual location, if it's a physical asset).  That is, the price risk of a similar asset in a different location or of a major ingredient may not be the hedged risk.  For example, if a derivative were used to hedge the exposure to changes in the fair value of tires held in inventory, the entity could not designate the market price of rubber as the hedged risk, even though rubber is a major component of the tires.
   

6. If the hedged item is a financial asset or liability, the designated risk that is being hedged can be the risk of (a) changes in the overall fair value of the entire hedged item or (b) changes that are attributable to changes in market interest rates, foreign currency exchange rates, or the obligor's creditworthiness.
   

7. The hedging instrument must be a derivative.  A nonderivative instrument, such as a treasury note, cannot be designated as a hedging instrument.

For a qualifying fair value hedge, the gain or loss on the hedging instrument (i.e., the derivative) is recognized currently in earnings.  The gain or loss (i.e., the change in fair value) on the hedged item attributable to the hedged risk also is recognized currently in earnings and adjusts the carrying amount (or "basis") of the hedged item.  This means that an asset or liability related to a firm commitment will appear on the balance sheet if the commitment is the subject of a fair value hedge.  Where the hedge is highly effective, the gains and losses generally will be equal and offsetting.  Earnings will be affected only to the extent that the hedge is not 100-percent effective.  The adjustment of the carrying amount of the hedged asset or liability is accounted for in the same manner as the other components of the carrying amount of the asset or liability.  For example, adjustments to hedged gasoline inventory would remain part of the gasoline inventory balance until the inventory is sold.  With respect to interest-bearing financial instruments, the adjustment is amortized to earnings beginning no later than when the hedged item ceases to be adjusted for changes in its fair value that are attributable to the risk that is being hedged.

One of the best documents the FASB generated for FAS 133 implementation is called "summary of Derivative Types."  This document also explains how to value certain types.  It can be downloaded free from at http://www.rutgers.edu/Accounting/raw/fasb/derivsum.exe

Cash Flow Hedges

When observing the hedging strategies of different entities, the FASB noticed that risk to some entities is the risk of a change in fair value, whereas to other entities it is the risk of a change in cash flows.  For example, fixed-rate debt issued by an entity subjects the entity to a potential change in the fair value of the debt, but the interest cash flows are not subject to variation.  Floating-rate debt, on the other hand, is not subject to changes in its fair value as market interest rates change, but the interest cash flows may vary.  Thus was born the notion of a cash flow hedge.

Flow Chart for Cash Flow Hedge Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

A cash flow hedge is a hedge of an exposure to variability in cash flows that is attributable to a particular risk.  That exposure may be associated with an existing recognized asset or liability or a forecasted transaction (such as a forecasted purchase or sale).  Some common examples include

• the hedge of a forecasted sale or purchase of natural gas (or another commodity) with futures contracts; or
  

• the hedge of variable interest payments using an interest-rate swap to convert the variable payments into fixed payments.

As with fair value hedges, there are numerous prescriptive criteria that must be met in order for a hedging relationship to qualify as a cash flow hedge.  They are similar to the qualifying criteria for fair value hedges, the more important of which are as follows.

1. At the inception of the hedge, there is formal documentation of the hedging relationship and the entity's risk-management objective and strategy for undertaking the hedge, including identification of the hedging instrument, the hedged cash flow transaction, the nature of the risk that is being hedged, and how the hedging instrument's effectiveness will be assessed.  There must be a reasonable basis for how the entity plans to assess the hedging instrument's effectiveness.
   

2. Both at the inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in offsetting the variability of cash flows that are attributable to the hedged risk during the term of the hedge.  An assessment of effectiveness is required whenever financial statements or earnings are reported, and at least every three months.
   

3. The forecasted transaction is specifically identified as a single transaction or a series of individual transactions.  If aggregated, the individual transactions must share the same risk exposure for which they are designated as being hedged.
   

4. The occurrence of the forecasted transaction is probable.
   

5. The forecasted transaction presents an exposure to variations in cash flow for the hedged risk, which could affect reported earnings.
   

6. If the hedged transaction is the forecasted purchase or sale of a nonfinancial asset, the designated risk that is being hedged is the risk of changes in the cash flows relating to all changes in the purchase price or sales price of the asset (reflecting its actual location, if it's a physical asset), not the risk of changes in the cash flows relating to the purchase or sale of a similar asset in a different location or of a major ingredient.
   

7. If the hedged transaction is the forecasted purchase or sale of a financial asset or liability, or, the variable cash flows of an existing financial asset or liability, the designated risk that is being hedged can be the risk of changes in the cash flows of the entire asset or liability, or, those changes in cash flows that are attributable to changes in market interest rates, foreign currency exchange rates, or the obligor's creditworthiness (or default).
   

8. The hedging instrument must be a derivative.

One of the legacies of double-entry bookkeeping (articulated by Luca Pacioli in the 15th Century)  is that debits must equal credits.  Generally, this means that the balance sheet articulates the income statement.  Sometimes, though, there is a tension between what is perceived as good for the balance sheet versus what is perceived as good for the income statement.  (For example, the LIFO method of inventory costing is usually viewed as meaningful for the income statement but of dubious merit for the balance sheet.)  The FASB admits to a balance sheet priority in setting many of its standards in the past two decades.  One of the main reasons is concern over understated liabilities and off-balance-sheet financing.  FAS 133 is one of the many standards where improved balance sheets result in volatile and confusing income statements.  In fact, earnings volatility resulting from FAS 133 and IAS 39 is the main reason for complaints raised by financial institutions and other corporations.

From time to time, accounting standard-setters have resolved this tension by allowing changes in balance-sheet assets and liabilities to bypass the income statement and go directly to equity.  As recently required by the FASB, such items are now included in other comprehensive income.  Prior to FAS 133, U.S. GAAP provided for three such items: foreign currency translation adjustments, unrealized gains and losses on available-for-sale debt and equity securities, and minimum pension liabilities.  The FASB has now added a fourth item resulting from cash flow hedge accounting.

Accounting for cash flow hedges involves the notion of other comprehensive income (OCI).  The effective portion of a hedging instrument's gain or loss is initially reported as a component of other comprehensive income (outside of earnings) and reclassified as earnings in the same period or periods during which the hedged forecasted transaction affects earnings (for example, when a forecasted sale actually occurs).  If the hedged transaction were to result in the acquisition of an asset or the incurrence of a liability, the gains and losses that had accumulated in other comprehensive income would be reclassified as earnings in the same period or periods during which the asset acquired or the liability incurred affects earnings (such as in the periods in which depreciation expense, interest expense, or cost of sales are recognized).  This procedure ensures that the "earnings impact" in future periods is equal to the price or cost that the entity "fixed" or "locked in" by entering into the cash flow hedge.

Foreign Currency Hedges

A foreign currency hedge can be a hedge of the foreign currency exposure of

• an unrecognized firm commitment (a fair value hedge),
  

• an available-for-sale security (a fair value hedge),
  

• a foreign currency-denominated transaction.  Prior to the FAS 138 amendments, the hedge could only be a cash flow hedge.  FAS 133 extended this to cross-currency fair value hedge such as a hedge of the value of variable rate note denominated in a foreign currency.  Note that cross-currency hedges banned in Paragraph 425 are no longer banned due to a FASB change of heart in FAS 138.
  

• a net investment in a foreign operation.

Flow Chart for FX Hedge Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

Although an available-for-sale security cannot have a fair value hedge (since the hedged item is adjusted for value changes in its own currency), it can be hedged for foreign currency risk whether it is an inter-company investment or with a third party provided the following conditions are met:

• the security is not traded on an exchange based upon the investor's functional currency,
  
  

• dividends and sale proceeds are denominated in the same foreign currency.

The accounting for a foreign currency fair value hedge and a foreign currency cash flow hedge follows the same principles as those that apply to the accounting for non-foreign currency hedges.  In a hedge of a net investment in a foreign operation, the gain or loss on the hedging instrument is reported in other comprehensive income (outside of earnings) as part of the cumulative translation adjustment (as provided for in FAS 52, Foreign Currency Translation).

Except for available-for-sale securities, FAS 133 precludes a recognized foreign currency-denominated asset or liability from being a hedged item, because such an asset or liability is remeasured with the changes in carrying value (attributable to what would be the hedged risk -- i.e., an exchange-rate change) reported currently in earnings.  The FASB's rationale for prohibiting a foreign currency-denominated asset or liability from being a hedged item is that the transaction gains and losses on the asset or liability arising from changes in exchange rates would naturally be, to a great extent, offset in the income statement by the changes in the fair value of the derivative.

Generally, FAS 133 retains the hedge-accounting provisions currently in practice for foreign currency hedges.  To accommodate this, the Standard makes a couple of exceptions to its overall hedge-accounting model.  The two exceptions relate to permitting (1) hedge accounting for a net investment in a foreign operation and (2) the designation of nonderivative financial instruments denominated in a foreign currency (such as foreign currency debt) as part of a hedge of a firm commitment or of a net investment.  Both are continuations of practices permitted prior to FAS 133.

Two aspects of FAS 133 that mark a notable departure from previous practice in the foreign currency area are (1) an entity's ability to hedge forecasted transactions with foreign currency forward contracts or combination options and (2) an entity's ability to hedge with a tandem currency (provided that effectiveness can be demonstrated).

Assessing Hedge Effectiveness

Qualifying as a hedge under FAS 133/138 and/or IAS 39 generally reduces both balance sheet and income statement volatility caused by booking and adjusting derivative instruments to fair value.  Perhaps the key qualifying criterion for hedge accounting under FAS 133 is that the hedging relationship between the hedging instrument and the hedged item be highly effective in achieving the offset of changes in those fair values or cash flows that are attributable to the hedged risk, both at the inception of the hedge and on an ongoing basis.  An assessment of this effectiveness is required at least every three months and whenever financial statements or earnings are reported by the entity.  This requirement is meant to have the same meaning and application as the "high correlation" assessment required by current accounting rules.  It does not mean that there must be a "reduction of risk," as was required under the pre-FAS 133 hedge model.

FAS 133 requires that an entity, as part of the designation of a hedging relationship, define up front how it will assess a hedge's effectiveness in achieving the offset of changes in fair value or the offset of cash flows that are attributable to the risk that is being hedged.  In this regard, FAS 133 requires that, throughout the hedge period, an entity consistently use a defined method to (1) assess whether it expects the hedging relationship to be highly effective in achieving offset and (2) measure the ineffective part of the hedge.  The Standard does not limit an entity to specifying a single method for assessing effectiveness and provides entities with a reasonable amount of flexibility.  Generally, however, it would be expected than an entity would assess effectiveness for similar hedges in a similar manner.  Any changes that an entity might make to its method of assessing effectiveness would have to be justified and would be applied prospectively by there being a discontinuation of the existing hedging relationship and a new designation of the relationship through the use of the improved method.

Statistical techniques, such as regression analysis, and expectations about future changes based on various pricing models may often be used at the hedge's inception to assess the probable future effectiveness of a hedging relationship.  The test of actual past effectiveness (i.e., the ongoing effectiveness during the hedge period) should be measured based on the actual results of the hedge.  A common way of measuring the degree of ongoing effectiveness is to divide the cumulative price (or cash flows) change for the hedging instrument by the cumulative price (or cash flows) change of the hedged item that is attributable to the risk that is being hedged.  Although there is not precise guidelines, in order for a hedging relationship to qualify for ongoing "high effectiveness," the changes in the fair value or cash flows of the hedging instrument must, at a minimum, be between 80 percent and 125 percent on the inverse changes in the fair value or cash flows of the hedged item.  FAS 133 requires the termination of hedge accounting for hedging relationships that are no longer "highly effective."

Ineffectiveness is the degree ex ante to which a hedge fails to meet its goals in protecting against risk (i.e., degree to which the hedge fails to correlate perfectly with the underlying value changes or forecasted transaction prices.  According to Paragraphs 20 on Page 11 and 30 on Page 21 of FAS 133, ineffectiveness is to be defined ex ante at the time the hedge is undertaken.  Hedging strategy and ineffectiveness definition with respect to a given hedge defines the extent to which interim adjustments affect interim earnings.   Hedge effectiveness requirements and accounting are summarized in Paragraphs 62-103 beginning on Page 44 of FAS 133.  An illustration of intrinsic value versus time value accounting is given in Example 9 of  FAS 133, Pages 84-86, Paragraphs 162-164.  In Example 9, the definition of ineffectiveness in terms of changes in intrinsic value of a call option results in changes in intrinsic value each period being posted to other comprehensive income rather than earnings.  In Examples 1-8 in Paragraphs 104-161, designations as to fair value versus cash flow hedging affects the journal entries.  

One means of documenting hedge effectiveness is to compare the cumulative dollar offset defined as the cumulative value over a succession of periods (e.g., quarters) in which the cumulative gains and losses of the derivative instrument are compared with the cumulative gains and losses in value of the hedged item.  When assessing the effectiveness of a hedge, an enterprise will generally need to consider the time value of money according to FAS 133 Paragraph 64 and IAS 39 Paragraph 152.

Neither the FASB nor the IASC specify a single method for either assessing whether a hedge is expected to be highly effective or measuring hedge ineffectiveness.   Tests of hedge effectiveness should be conducted at least quarterly and on financial statement dates.  The appropriateness of a given method can depend on the nature of the risk being hedged and the type of hedging instrument used.  See FAS 133 Appendix A, Paragraph 62 and IAS 39 Paragraph 151.  

Paragraph 63 of FAS 133 reads as follows:

In defining how hedge effectiveness will be assessed, an entity must specify whether it will include in that assessment all of the gain or loss on a hedging instrument. This Statement permits (but does not require) an entity to exclude all or a part of the hedging instrument's time value from the assessment of hedge effectiveness, as follows:

a. If the effectiveness of a hedge with an option contract is assessed based on changes in the option's intrinsic value, the change in the time value of the contract would be excluded from the assessment of hedge effectiveness.

b. If the effectiveness of a hedge with an option contract is assessed based on changes in the option's minimum value, that is, its intrinsic value plus the effect of discounting, the change in the volatility value of the contract would be excluded from the assessment of hedge effectiveness.

c. If the effectiveness of a hedge with a forward or futures contract is assessed based on changes in fair value attributable to changes in spot prices, the change in the fair value of the contract related to the changes in the difference between the spot price and the forward or futures price would be excluded from the assessment of hedge effectiveness.

Paragraph 69 of FAS 133 reads as follows [also see (IAS 39 Paragraph 152)]:

The fixed rate on a hedged item need not exactly match the fixed rate on a swap designated as a fair value hedge. Nor does the variable rate on an interest-bearing asset or liability need to be the same as the variable rate on a swap designated as a cash flow hedge. A swap's fair value comes from its net settlements. The fixed and variable rates on a swap can be changed without affecting the net settlement if both are changed by the same amount. That is, a swap with a payment based on LIBOR and a receipt based on a fixed rate of 5 percent has the same net settlements and fair value as a swap with a payment based on LIBOR plus 1 percent and a receipt based on a fixed rate of 6 percent.

Paragraph 10c of IAS 39 also addresses net settlement.  IASC does not require a net settlement provision in the definition of a derivative.  To meet the criteria for being a derivative under FAS 133, there must be a net settlement provision.  

A Great Article!
"A Consistent Approach to Measuring Hedge Effectiveness," by Bernard Lee, Financial Engineering News --- http://www.fenews.com/fen14/hedge.html

A number of common effectiveness testing criteria used when implementing FAS 133 include the following from Quantitative Risk Management, Inc. --- http://www.qrm.com/products/mb/Rmbupdate.htm

FAS Effectiveness Testing --- http://www.qrm.com/products/mb/Rmbupdate.htm To provide the maximum flexibility in testing hedge effectiveness, we now offer the following methods:   Dollar Offset (DO) calculates the ratio of dollar change in profit/loss for hedge and hedged item   Relative Dollar Offset (RDO) calculates the ratio of dollar change in net position to the initial MTM value of hedged item   Variability Reduction Measure (VarRM) calculates the ratio of the squared dollar changes in net position to the squared dollar changes in hedged item   Ordinary Least Square (OLS) measures the linear relationship between the dollar changes in hedged item and hedge. OLS calculates the coefficient of determination (R2) and the slope coefficient (ß) for effectiveness measure and accounts for the historical performance   Least Absolute Deviation (LAD) is similar to OLS, but employs median regression analysis to calculate R2 and ß.

 

The following Section c in Paragraph 65 on Page 45 is of interest with respect to a premium paid for a forward or futures contract:

c. Either the change in the discount or premium on the forward contract is excluded from the assessment of effectiveness and included directly in earnings pursuant to Paragraph 63 or the change in expected cash flows on the forecasted transaction is based on the forward price for the commodity.

Delta ratio D = (D option value)/ D hedged item value)
range [.80 < D < 1.25] or [80% < D% < 125%]      (FAS 133 Paragraph 85)
Delta-neutral strategies are discussed at various points (e.g., FAS 133 Paragraphs 85, 86, 87, and 89)

A hedge is normally regarded as highly effective if, at inception and throughout the life of the hedge, the enterprise can expect changes in the fair value or cash flows of the hedged item to be almost fully offset by the changes in the fair value or cash flows of the hedging instrument, and actual results are within a range of 80-125% (SFAS 39 Paragraph 146).  The FASB requires that an entity define at the time it designates a hedging relationship the method it will use to assess the hedge's effectiveness in achieving offsetting changes in fair value or offsetting cash flows attributable to the risk being hedged (FAS 133 Paragraph 62).  In defining how hedge effectiveness will be assessed, an entity must specify whether it will include in that assessment all of the gain or loss on a hedging instrument.  The Statement permits (but does not require) an entity to exclude all or a part of the hedging instrument's time value from the assessment of hedge effectiveness. (FAS 133 Paragraph 63).

Hedge ineffectiveness would result from the following circumstances, among others:

a) difference between the basis of the hedging instrument and the hedged item or hedged transaction, to the extent that those bases do not move in tandem.

b) differences in critical terms of the hedging instrument and hedged item or hedged transaction, such as differences in notional amounts, maturities, quantity, location, or delivery dates.

c) part of the change in the fair value of a derivative is attributable to a change in the counterparty's creditworthiness (FAS 133 Paragraph 66).

The method an enterprise adopts for assessing hedge effectiveness will depend on its risk management strategy.  In some cases, an enterprise will adopt different methods for different types of hedges.  For instance, an interest rate swap is likely to be an effective hedge if the notional and principal amounts, term, repricing dates, dates of interest and principal receipts and payments, and basis for measuring interest rates are the same for the hedging instrument and the hedge item (IAS 39 Paragraph 147).  Sometimes the hedging instrument will offset the hedged risk only partially.  For instance, a hedge would not be fully effective if the hedging instrument and hedged item are denominated in different currencies and the two do not move in tandem.
(IAS 39 Paragraph 148).

Especially note the section of Short-Cut Method for Interest Rate Swaps.

See further paragraphs 73-103 for illustrations of assessing effectiveness and measuring ineffectiveness:

Example 1: Fair Value Hedge of Natural Gas Inventory with Futures Contracts (FAS 133 Paragraphs 73-77)

Example 2: Fair Value Hedge of Tire Inventory with a Forward Contract
(FAS 133 Paragraphs 78-80)

Example 3: Fair Value Hedge of Growing Wheat with Futures Contracts
(FAS 133 Paragraphs 81-84)

Example 4: Fair Value Hedge of Equity Securities with Option Contracts
(FAS 133 Paragraphs 85-87)

Example 5: Fair Value Hedge of a Treasury Bond with a Put Option Contract
(FAS 133 Paragraphs 88-90)

Example 6: Fair Value Hedge of an Embedded Purchased Option with a Written Option
(FAS 133 Paragraphs 91-92)

Example 7: Cash Flow Hedge of a Forecasted Purchase of Inventory with a Forward Contract
(FAS 133 Paragraphs 93-97)

Example 8: Cash Flow Hedge with a Basis Swap
(FAS 133 Paragraphs 98-99)

Example 9: Cash Flow Hedge of Forecasted Sale with a Forward Contract
(FAS 133 Paragraphs 100-101)

Example 10: Attempted Hedge of a Forecasted Sale with a Written Call Option
(FAS 133 Paragraphs 102-103)

Note especially DIG Issue E7 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuee7.html 

One of the best documents the FASB generated for FAS 133 implementation is called "summary of Derivative Types."  This document also explains how to value certain types.  It can be downloaded free from at http://www.rutgers.edu/Accounting/raw/fasb/derivsum.exe

Interest Rate Swap Valuation, Forward Rate Derivation,  and Yield Curves
for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments 
See http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

”Testing and Accounting for Hedge Ineffectiveness Under FAS 133, by Angela L.J. Huang and  Robert E. Jensen, Derivatives Report, February 2003, pp. 1-10.  http://www.riahome.com/estore/detail.asp?ID=TDVN
Bob Jensen's documents on hedge accounting are linked at http://www.trinity.edu/rjensen/caseans/000index.htm 

Ira Kawaller has some papers on matters related to FAS 133.

I wanted to let you know that I've posted two newly published articles on my web site. Both pertain to FAS 133 -- the accounting standard that covers derivative instruments and hedging activities.

"The 80/125 Problem," Derivatives Strategy, March 2001 -- This article explains the pitfalls of relying on a commonly cited hedge effectiveness measure.

"FAS 133: System Worries," Bank Asset/Liability Management, May 2001 - This article makes the point that a system solution may be FAS 133-compliant, but not necessarily FAS 133-optimal.

You can download each of these articles by clicking onto the following links: http://www.kawaller.com/pdf/Der_Strategies.pdf  and http://www.kawaller.com/pdf/BALM_System_Worries.pdf. 

Please let me know if have any difficulty accessing either, or if there is anything else I might be able to assist you with.

Best regards,

Ira Kawaller 
Kawaller& Company, LLC 
(718) 694-6270 kawaller@idt.net www.kawaller.co 

Macro (Portfolio Hedging) --- See Macro Hedge at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#M-Terms 

Discontinuance of Hedge Accounting

Under FAS 133, an entity would discontinue hedge accounting if (1) a hedge were to fail to meet any of the qualifying criteria of FAS 133 or (2) the derivative were to expire or be sold, terminated, exercised, or simply dedesignated as a hedging instrument.

The accounting for the discontinuance of a hedge depends on the reason for the discontinuance.  Generally, discontinuance will not have an immediate effect on earnings -- for either fair value hedges or cash flow hedges -- with two exceptions.  In a fair value hedge of a firm commitment, it is possible that the firm commitment will no longer qualify as such.  In this expected-to-be-rare situation, any asset or liability that had been recognized through cumulative mark-to-market adjustments of the firm commitment will be removed from the balance sheet, and a corresponding gain or loss will be recorded in earnings.  In a cash flow hedge of a forecasted transaction, it is possible that an entity may later determine that it is probable that the forecasted transaction will not occur.  In this situation, the gain or loss that had accumulated in other comprehensive income will be recognized immediately in earnings.  Note here a subtle but deliberate use of words by the FASB.  In order to preclude situations in which an entity might manipulate earnings by changing its estimate of probability (i.e., transferring gains deferred in other comprehensive income to earnings due solely to a change in the assessment of probability), the FASB decided to require earnings recognition of amounts accumulated in other comprehensive income only for those cases in which an entity determines that it is probable that the forecasted transaction will not occur, rather than when it is no longer probable, or reasonably possible, that the forecasted transaction will occur.

Disclosures  See http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#Disclosure 

The disclosure requirements of FAS 133 are quite extensive.  The Standard requires certain general disclosures, quantitative disclosures for certain "failed" hedges, and some additional disclosures for cash flow hedges and hedges of a net investment in a foreign operation, as follows:

General disclosures:

• Qualitative information: The entity's objectives and strategies for holding and issuing derivatives, and a description of the items or transactions for which risks are hedged
  

• Quantitative information: The net gain or loss recognized in earnings for the period representing aggregate ineffectiveness for all hedges, and the components of the derivatives' gains or losses excluded from the assessment of hedge effectiveness

Disclosure of certain "failed" hedges: FAS 133 requires an entity to disclose the amount of gains and losses recognized in earnings as a result of (1) a previously hedged firm commitment that becomes no longer firm (for example, the commitment is canceled) or (2) a previously hedged forecasted transaction that becomes not probable of occurring.

     

Additional cash flow hedge disclosures:

• Qualitative information: A description of the forecasted transactions being hedged, the maximum period of time before the transactions are expected to occur, and the transactions or other events that will result in the recognition in earnings of gains and losses that have accumulated in other comprehensive income
  

• Quantitative information: An estimate of the amount of gains and losses included in other comprehensive income that will be recognized in earnings within the next twelve months
  

• Changes in the components of other comprehensive income: FAS 133 requires an entity to display within other comprehensive income the net gain or loss on derivative instruments that are both designated as and qualify as cash flow hedges.  In addition, beginning and ending accumulated derivative gains and losses, the related change associated with current-period transactions, and the amount of any reclassification as earnings are also required to be displayed pursuant to FAS 130, Reporting Comprehensive Income.

Additional net-investment hedge disclosures: FAS 133 requires disclosure of the hedging instrument  foreign currency-transaction gains or losses that are included in the cumulative translation adjustment for the period

Governmental Accounting Disclosure Rules --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#Disclosure 

SEC Market Risk Disclosures http://www.sec.gov/rules/othern/derivfaq.htm 

Effective Date and Transition

FAS 133 implementation deadlines were delayed by the FASB.  It is now effective for all fiscal quarters of fiscal years beginning after June 15, 2000 and January 1, 2001, for calendar-year entities).  The Standard can be implemented early, as of the beginning of any fiscal quarter subsequent to the Standard's issuance (i.e., as early as July 1, 1998), but it cannot be applied retroactively to financial statements of prior periods.

As might be expected, accounting for the transition to such a markedly different approach for derivatives and hedging is rather complex.  Upon adoption of the Standard, all derivatives must be recognized on the balance sheet at their then fair value.  Any stand-alone deferred gains and losses remaining on the balance sheet under previous hedge-accounting rules must be removed from the balance sheet, since the FASB determined that they don't meet the definition of an asset or liability.  All hedging relationships must be designated anew and documented pursuant to the new accounting rules.  In many cases, the designations will be consistent with the hedging purpose that had been previously in place.  However, in some cases, the hedge relationship may not qualify for hedge accounting under FAS 133.  The initial designation upon the adoption of the Standard will serve as the basis for the transition adjustments made in the financial statements (e.g., in a fair value hedge, the hedged item's carrying amount also will be adjusted as part of the transition).  In the period of adoption, the transition adjustments will include (1) a net effect on earnings, if the hedge relationship is designated as a fair value hedge and (2) a net effect on other comprehensive income, if the hedge relationship is designated as a cash flow hedge.

FAS 133's transition provisions permit, at the date of initial application, entities to reclassify any held-to-maturity security as either an "available-for-sale" or "trading" security so that, in the future, they may be able to designate such a security as the hedged item in a fair value hedge or designate its variable interest payments as the hedged item in a cash flow hedge.  Held-to-maturity securities generally cannot otherwise be hedged.  Any reclassification of held-to-maturity securities pursuant to the adoption of FAS 133 will not, however, call into question an entity's intent to hold other debt securities to their maturity in the future.

Public companies that choose not to adopt FAS 133 early must follow the disclosure requirements of SEC Staff Accounting Bulletin No. 74, Disclosure of the Impact That Recently Issued Accounting Standards Will Have on the Financial Statements of the Registrant When Adopted in a Future Period.  Beginning with the first quarterly report issued after June 15, 1998, such disclosures should include

• a brief description of FAS 133, the date that adoption is required, and the date that the entity plans to adopt the Standard, if earlier;
  

• a discussion of the methods of adoption allowed by FAS 133 and the method expected to be utilized by the entity, if one has been determined;
  

• a discussion of the impact that the adoption of FAS 133 is expected to have on the financial statements of the entity, unless this is not known or reasonably estimable (in that case, a statement to that effect should be made); and
  

• disclosure of the potential impact of other significant matters that the entity believes might result from the adoption of FAS 133 (such as technical violations of debt covenant agreements, planned or intended changes in business practices, etc.) is encouraged.

Common Risk-Management Strategies Under FAS 133

Here are a number examples of common strategies and a brief analysis of how FAS 133 affects these strategies.

1. Identify all embedded dervatives and evaluate whether they have to be bifurcated under FAS 133 rules.  This entails an organized effort, sometimes worldwide, to have trained FAS 133 employees examine active financial contracts. It is especially troublesome in Asia where the business culture is one of trust rather than written documentation and contracting on paper.  
   
   

   Roger Pearson at Union Carbide CARBR10.mp3 http://www.cs.trinity.edu/~rjensen/000overview/mp3/CARBR10.mp3

    

   Audio Clip on Costs of Detection and Documentation http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm#Detection

   
   
   

2. Lock in or cap/floor an interest rate for a forecasted future borrowing/investing
   
   Interest rates on forecasted transactions can be hedged in a variety of ways.   Derivatives such as interest-rate options, futures, or forward contracts can accomplish this objective.   Example 9 beginning in Paragraph 153 illustrates use of a swap.   Under FAS 133, such a hedging strategy would constitute a cash flow hedge, provided that all requisite conditions of Paragraphs 28-29 are met.  The effective portion of the hedge is closed to OCI each time the derivative is marked to market (at least quarterly).  My CapIt and FloorIT Bank cases illustrate using Eurodollar options as hedges of interest rates on forecasted transactions.  See 
   http://www.trinity.edu/rjensen/acct5341/133cases/000index.htm .
   
   Note that cash flow hedge gains and losses are not automatically closed to OCI.  Effectiveness must be tested.  The ineffective portion due to over-hedging must be closed to current earnings.
   
   

   Martin Klein from Lehman Brothers http://www.cs.trinity.edu/~rjensen/000overview/mp3/KLEIN10.mp3

   
   

3. Convert variable-rate debt/investment into fixed-rate debt/investments by using an interest-rate swap
   
   This strategy illustrates one of the classic uses of interest-rate swaps as a cash flow hedge.  A company issues variable-rate debt (e.g., commercial paper) and, by entering into an interest-rate swap, it receives a payment based on a variable interest rate and makes a payment based on a fixed interest rate.  Or a company invests at a variable rate and hedges the variability of interest income.  Prior to FAS 133, accounting for these situations followed what became known as "synthetic-instrument accounting."  The effect was that the income statement was the same as if the company actually had issued fixed-rate debt or invested in a fixed rate note.  
   
   Under FAS 133, this technique should qualify as a cash flow hedge, with essentially the same income-statement effect as before.  The balance sheet, of course, will now be grossed up to reflect the swap's fair value and its changes in fair value that are deferred in other comprehensive income.  It is worth noting, however, that FAS 133 requires that a specific swap be designated as hedging a specific debt instrument or instruments (or portions thereof) to qualify for hedge accounting.  Previously, some companies took a broader view of things, designating a portfolio of swaps as being linked to a portfolio of debt instruments.
   
   It is important to note that if an interest rate swap satisfies effectiveness criteria for the shortcut method as illustrated in Paragraph 132 of FAS 133, then it is not necessary to test for effectiveness every quarter of the hedge.  The hedging of a variable interest investment is illustrated in Example 5 of FAS 133 beginning in Paragraph 131.  Jensen and Hubbard make some corrections in this example and elaborate upon how answers are derived at http://www.trinity.edu/rjensen/caseans/133ex05.htm.
   

4. Hedge foreign currency risk of debt/investment using an interest-rate swap
   
   This strategy illustrates one of the FAS 133 areas where effectiveness testing can destroy some of the OCI postings.  The problem is that FAS 52 uses spot rates and FAS 133 requires forward rates.  These two rates are often not sufficiently correlated to avoid ineffectiveness.
   
   

   Jin Chang from Lehman Brothers http://www.cs.trinity.edu/~rjensen/000overview/mp3/CHANG30.mp3

    

5. Convert nonprepayable fixed-rate debt into variable-rate debt by using an interest-rate swap
   
   This common technique is the mirror image of the one just described.  However it is a fair value hedge rather than a cash flow hedge.  A company issues fixed-rate debt and, by entering into an interest-rate swap whereby the company receives a payment based on a fixed interest rate and makes a payment based on a variable interest rate, synthetically creates variable-rate debt.  The popularity of both this and the previous technique comes from arbitrage opportunities in the various interest-rate markets, thus creating lower borrowing costs for companies.  Prior to FAS 133, synthetic-instrument accounting was followed, with the effect being that the income statement was the same as if the company actually had issued variable-rate debt.  
   
   Under FAS 133, this technique should qualify as a fair value hedge, with essentially the same income-statement effect as before.  However, unlike previous practice under the rather broad umbrella of synthetic-instrument accounting, hedge accounting for this technique may not be available for a plain-vanilla interest-rate swap if the underlying fixed-rate debt is prepayable or callable, because the changes in the debt's fair value may not be highly effective in offsetting the changes in the swap's fair value that are due to changes in market interest rates.
   
   An illustration of the use of a swap to hedge the fair value of an investment is illustrated in Example 2 of FAS 133 beginning in Paragraph 111.  Jensen and Hubbard elaborate on this illustration in http://www.trinity.edu/rjensen/caseans/133ex2.doc.
   

6. Monetize an embedded call option in existing callable fixed-rate debt
   
   As interest rates declined over the 1990s, companies increasingly entered into various transactions to monetize embedded call options in existing callable fixed-rate debt.  A typical situation involves a company that has outstanding callable fixed-rate debt.  Due to a decline in interest rates, it would be advantageous to the company to call the debt and refinance at lower interest rates.  However, the call provision is not exercisable until some contracted time in the future.  By writing a separate option that effectively neutralizes the purchased call option embedded in the debt, the company receives cash currently.  
   
   Prior to FAS 133, it was somewhat difficult to achieve hedge accounting for such transactions, due to the SEC staff position that hedge accounting was inappropriate for freestanding written options; companies had to resort to more complicated structures.  FAS 133 makes it easier to achieve hedge accounting for call monetizations because, assuming that all the conditions are met, a freestanding written option can qualify as a fair value hedge of an embedded purchased option.
   

7. Protect against the weakening of a foreign currency for anticipated export sales by a U.S. parent company
   
   One of the most common hedging strategies in the foreign currency area is to guarantee the dollar value of a U.S. parent company's expected future export sales that will be denominated in a foreign currency.  FAS 133, which treats such a forecasted transaction as a cash flow hedge, makes this process much easier than it was previously by allowing foreign currency forward contracts to be used and achieve hedge accounting.  Under prior rules and practice, only purchased options (which many companies viewed as too expensive) could qualify for hedge accounting with respect to these forecasted transactions.  Also, FAS 133 is more liberal than the previous rule in permitting a so-called "tandem currency" to be used in foreign currency hedging.  A tandem currency is one that is expected to move in tandem with the currency that represents the actual foreign currency exposure.
   

8. Protect against the strengthening of a foreign currency when the U.S. parent company has a firm commitment to buy a fixed asset and the price is denominated in a foreign currency
   
   This is another classic example of foreign currency hedging.  Assume, for example, that a U.S. company has committed to buy a sophisticated piece of optical equipment from a German company and that the price is fixed in deutsche marks (or, perhaps, euros).  To lock in the dollar cost of the equipment, the U.S. company enters into a foreign currency forward contract to receive marks and pay dollars.  Consistent with current rules, such a transaction would qualify as a fair value hedge under FAS 133 (i.e., a foreign currency hedge of a firm commitment).  The income-statement effects would be largely unchanged from previous accounting practices.
   
   An illustration of this type of hedge is provided in Example 10 beginning in Paragraph 165 of FAS 133.
   

9. Protect against the weakening of a foreign currency for anticipated sales by a foreign subsidiary whose functional currency is not the foreign currency in which the sales will occur
   
   This is a convoluted way of addressing a situation in which, for example, a U.K. subsidiary, whose functional currency (an accounting term) is the pound, expects future sales in France that will be denominated in francs.  It is similar to the export-sale situation described in item (5) above, and the hedging strategy would be similar.
   
   However, FAS 133 introduces a requirement that could have significant practical implications for multinational entities that use centralized treasury centers (TCs) for hedging foreign currency risk.  In such a structure, the TC receives information about foreign currency exposures from a number of foreign subsidiaries.   The TC first attempts to offset these exposures within the consolidated group and then enters into hedging contracts for only the next exposure.  FAS 133 requires that, in order for these structures to qualify for hedge accounting, there must be (1) an intercompany hedging contract between the foreign subsidiary and the parent or TC and (2) another hedging contract between an independent third party and the parent or TC.  Essentially, the parent or TC must act as an intermediary between the foreign subsidiary and a third party, and the hedging gain or loss must be "pushed down" to the subsidiary.  The problem is that the new rules may restrict the ability of the TC to enter into a net contract by requiring that the parent or TC enter into contracts with third parties for "gross" amounts (that is, separate contracts for all long positions and short positions), without internal netting of currency exposures.  Accordingly, entities with centralized treasury operations may now have to incur additional transaction costs and increased counterparty risk.
   
   Relevant paragraphs in FAS 133 include Paragraphs 40 and 483.
   

10. Protect against the weakening of a foreign currency for a net investment in a foreign subsidiary
    
    The hedging strategy seeks to maintain the dollar value of a company's investment in one or more foreign subsidiaries whose functional currency is the local currency.  It sometimes is used as a surrogate for hedging anticipated dividends from a foreign subsidiary.  Foreign currency forward contracts, options, or nonderivative financial instruments, such as foreign currency debt, can all be used as the hedging vehicle.  
    
    This is one of only two areas (the other being the hedge of a foreign currency firm commitment) where FAS 133 permits nonderivatives to qualify as hedges.  The accounting for this hedging strategy is largely unchanged from that of previous practice.
    

11. Lock in the current price of a precious metal, such as gold, for anticipated sales of future production
    
    This hedging strategy often involves the use of forward contracts or option combinations that can be settled net.  Prior to FAS 133, there had been considerable uncertainty as to whether these types of transactions should be accounted for under the hedge-accounting rules or, rather, thought of simply as contracts for the sale of goods.  
    
    The forecasted purchase of lumber inventoried at cost can be a hedged item, but the forecasted purchase of gold or some other "precious" market commodity cannot qualify for OCI deferral as a hedged item.   The reason is that  "precious" items under GAAP are booked at maintained at market value.  For example, suppose a forward contract is entered into on January 1 when commodity's price is $300 per unit.  The "political issue" issue faced by the FASB is merely a matter of when gains and losses on the derivative contract are posted to current earnings.  If the price goes up to $400 per unit on July 1 when the commodity is actually purchased, there is a $100 per unit deferred gain on the forward contract that is transferred from OCI to current earnings if the commodity is lumber.  If the commodity is "precious" gold, however, there is no intervening credit to OCI because of Paragraph 29d on Page 20 of FAS 133. 
    

12. Lock in the current price of a commodity, such as lumber, for anticipated purchases/sales
    
    This strategy is similar to the previous one, except that it relates to qualifying cash flow hedges rather than precious commodities.  It can qualify as a cash flow hedge if it meets all the conditions in Paragraphs  29 and 30.  If the purchase is a firm commitment, however, it cannot be a cash flow hedge.   If it is not net settled it also cannot be a derivative.  FAS 133 clarifies this issue, generally requiring that such forecasted transactions can  be accounted for as derivatives.  The exception is for contracts that, by their terms, (a) require delivery of the asset subject to the contract, (b) are not traded on an exchange, (c) are for quantities that are reasonable in relation to the company's business activities, and (d) cannot be settled net.  Contracts that meet criteria (a) - (d) are considered normal sales and, thus, would be accounted for as such according to Paragraphs 271-272.  A derivative that is used to fix the price of anticipated future sales will be a cash flow hedge under FAS 133 if the derivative does not meet the aforementioned criteria and, thus, the specific exception for normal sales.

A free document on risk management from Ira Kawaller

Dear Bob,

I wanted to alert you to the fact that I've posted a new article to the Kawaller & Company web site – "The Impact of FAS 133 on the Risk Management Practices of End Users of Derivatives." This survey was commissioned by the Association for Financial Professionals. You should be able to access it by clicking on the link below:

http://www.kawaller.com/pdf/Survey_results.pdf

If you have trouble viewing the article, copy the link above and paste it into the address field of your browser, or go to www.kawaller.com and click on the "Articles" link. The survey is the very last article listed in the section titled "Articles Relating to General Derivatives Markets."

I'd welcome your feedback or any questions that you might have. Please feel free to email me or call.

Ira Kawaller Kawaller & Company, LLC (718) 694-6270 kawaller@idt.ne  
www.kawaller.com 

A Decision Flowchart for FAS 133

Appendix E in FAS 133 beginning in Paragraph 539 provides a flowchart for detecting embedded derivatives that must be bifurcated and accounted for separately.

A FAS 133 flowchart developed by ," Ira Kawaller and John J. Ensminger is reproduced at http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

Unfortunate Consequences of FAS 133 and IAS 39

Prior to FAS 133, derivative financial instruments were used for both accounting and economic reasons.  The accounting reasons were largely to obtain off balance sheet financing or to modify financing in a way that would not be reflected on balance sheets (e.g., the conversion of fixed rate debt into variable rate debt with a swap).  Prior to FAS 133 and IAS 39, there were no rules for accounting for certain derivatives such as swaps and forward contracts.  Since 1984, interest rate swaps and FX swaps became enormously popular in global markets.  FAS 133 was needed, because there were no accounting rules in place for trillions of dollars in newer types of transactions involving derivative contracting.

Derivative contracting, however, is used more for economic reasons than accounting reasons.  Several of the main economic reasons are as follows:

• To speculate (e.g., take on leveraged risks and returns).
  

• To modify fair value, cash flow, or FX risk (e.g., convert variable exposures into fixed exposures).  For example, Paragraph 421 of FAS 133 describes how the FX risk component of the value of a foreign asset such as land can be hedged apart from the changes in the economic value as a whole.
  

• To lower costs (e.g., by using a derivative to synthetically refinance debt at lower rates).
  

• To obtain financing in a particular country (e.g., a company with no credit standing in Germany can swap both the interest and principal of a $10 million debt instrument for, say, DM20 million German marks and make the interest payments in marks without having to borrow in Germany). 
  

• To convert interest rate and/or FX Risk to counterparty credit risk   The key paragraphs on this, along with some restrictions, begin in Paragraph 422 of FAS 133.  Note that fair value cross-currency hedges banned in Paragraph 425 are no longer banned due to a FASB change of heart in FAS 138.
  

• To provide greater investment and financing alternatives that have various advantages including ease of contracting, access to deeper and wider global markets, lower transactions costs, arbitraging efficiencies, etc.

One of the major reasons derivatives became so important in the past two decades was to manage risk via financial engineering of portfolios.  Probably the most unfortunate consequence of FAS 133 is that firms that tend to hedge portfolios of financial assets and liabilities rather than individual components of the portfolio now must, except in unlikely circumstances, drill down to each component and link a hedge to each component rather than the portfolio as a whole.  The only exception is when all items in the portfolio are nearly identical in terms of risk and maturity dates.  Very few portfolios meet those conditions.

Interest Rate Swap Valuation, Forward Rate Derivation,  and Yield Curves
for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments 
See http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

Hi Greg,

I have not probed into FAS 133 implications for mortgage banking, at least not at a depth of use to you. Some links that might be of interest in FAS 133 accounting in mortgage banking are as follows:

"12 Unintended Consequences of FAS 133," by Barclay T. Leib, DerivativesStrategy.com, March 2001 --- http://www.derivativesstrategy.com/magazine/archive/2001/0301fea3.asp 

1. Corporate options trading volume is dropping.

2. Forward hedging is on the rise.

3. Corporates are hedging smaller notional amounts of their potential total exposures.

4. Financial reporting is still likely to be confusing.

5. Fun and games with P&L reporting are getting funnier and gamier.

6. Accounting for embedded derivatives is turning out to be far more complicated than expected.

7. Asset managers face huge problems with mortgage portfolios, convertibles and other products.

8. Energy hedges are particularly prone to being declared “ineffective.”

9. Multinationals can no longer reap windfall interest savings on cross-currency swaps.

10. Plenty of FAS exceptions and loopholes remain.

11. Many hedge effectiveness tests are conceptually flawed, and parameter risks abound.

12. Salesmen and corporates will both smarten up fast.

 

Item 7 above summarizes many of your problems, although I am sure that you would really rather have a summary of answers rather than questions.

DIG Issue F8—Hedging Mortgage Servicing Right Assets Using Preset Hedge Coverage Ratios (Cleared 3/21/01) 
http://accounting.rutgers.edu/raw/fasb/derivatives/issuef8.html  

MIAC FAS133 Web Forum --- http://www.servicing.com/MIAC/FAS133Forums.htm 

FAS133 web forum is solely dedicated to FAS133 discussions on the very special issues and challenges that FAS133 presents to the mortgage banking industry. The Web Forum is divided into Residential Servicing, Pipeline and Commercial Servicing. This provides a common site where people can post their FAS133 related questions and have an active dialogue with other individuals in the mortgage banking industry on issues related to FAS133

MIAC FAS133 Tools

MIAC ANT FAS125/FAS133 Module

MIAC ANT FAS125/133 Module --- http://www.mbaa.org/resident/lib2000/fasb_0629.html 

Win OAS --- http://www.servicing.com/MIAC/Products/winoas/default.htm 

Vizhedge --- http://www.servicing.com/MIAC/Products/vizhedge/default.htm 

You might check on how Fannie Mae followed up on its promise to develop materials for FAS 133 compliance --- http://fas133.com/search/search_detail.cfm?page=0&areaid=231

Fannie Mae: Using Shadow Processing To Preview FAS 133 Hurdles
http://fas133.com/search/search_article.cfm?page=0&areaid=274 

Mortgage banking issues not covered or delayed by DIG --- http://www.servicing.com/MIAC/Announcements/July31FAS133Update.htm 

Issue 11-4, When a Loan Commitment Meets the Net Settlement Criteria
Issue 12-4, Hedging Mortgage Servicing Right Assets Using Preset Hedge Coverage Ratios
Issue 11-6, Excluded Components of an Option's Time Value
Issue 11-5, Application of the "Regular-Way" Security Trades Exception to When-Issued Securities

June 29, 2000 Update --- http://www.mbaa.org/resident/lib2000/fasb_0629.html 
Item 11-4: "When a Loan Commitment Meets the Net Settlement Criteria"
Item 11-6: "Excluded Components of an Option's Time Value"
Item 12-4: "Hedging Mortgage Servicing Right Assets Using Preset Hedge Coverage Ratios"
Item 12-12: "Definition of a Derivative: Application of Statement 133 to Beneficial Interests Issued in
                    Securitization Transactions"

My main FAS 133 site is at http://www.trinity.edu/rjensen/caseans/000index.htm 

Original Message
May 23, 2001

Greetings

I have reviewed much of the information you have posted on your website regarding FAS133 and found your work to be very informative. However, I am researching the implications of FAS133 on mortgage banking operations, specifically the impact on companies that hedge rate-locked pipelines. Have you performed any analysis in this area? If not, do you know of any other sources available for this subject.

Thank you for your assistance.

Regards, Greg Ellis 

Reply from Dan Thomas regarding the ($50) FAS 133 implementation report from the MBA

Robert,

Yes, You can get a copy by calling 1.800.793.MBAA.

Dan Thomas
Senior Director, Education Products and Services
Mortgage Bankers Association of America 1919 Pennsylvania Avenue, NW Washington, DC 20006 Ph: 202-557-2915 Fx: 202-721-0194 Email: daniel_thoms@mbaa.org  Web site: http://www.campusmba.org

Two references from Ira Kawaller on unwanted consequences of FAS 133 are as follows

• "The Fallout from FAS 133," (With John Ensminger), Regulation (The CATO Review of Business and Government), Vol. 23, No. 4, 2000.  
  
• "FAS 133: System Worries," Bank Asset/Liability Management, May 2001.

The consequence of having to change from portfolio hedging strategies to item hedging is only one of many unfortunate consequences of FAS 133 and IAS 39.

Other unfortunate consequences of FAS 133 and IAS 39 are the reactions of companies, security analysts, and investors to the fact of or efforts to mitigate the fact of earnings volatility and liability reporting.  Purportedly, some of our most prominent companies are sub-optimizing due to fears that better economic decisions (e.g., macro hedges) will adversely affect stock prices and volatility.  If you are reading this online and can play MP3 files, click on the following examples of audio statements by some of the leading experts in the world.

• Wall Street is busily designing new derivative instruments to help customers comply with FAS 133 rules.
• Louis Le Guyader of PwC reports that foreign currency risk managers are changing strategies because of FAS 133.
• FAS 133 is causing some bad economic decisions in order have "better" accounting reports
  
  • Bob Jensen and the Equity Analyst Panel in NYC on December 14  Audio Clip PANEL01.mp3
  • Mike Koegler from Chase Bank Audio Clip KOEGLER80.mp3 
  • Martin Klein from Lehman Brothers Audio Clip KLEIN10.mp3  
  • Jin Chang from Lehman Bothers Audio Clip CHANG30.mp3  
  • Eileen Fahey from Duff & Phelps Audio Clip FAHEY06.mp3  

An unhappy executive at Chase Bank  
    Audio of Mike Koegler of Chase Bank  KOEGLER3.mp3
    Audio of Mike Koegler of Chase Bank  KOEGLER4.mp3

 

• The main issue is increased volatility from fair value adjustments 

• Audio of Mike Koegler of Chase Bank  KOEGLER5.mp3  
• Audio of a senior portfolio manger named Scott McGrossin  MCCROS01.mp3  
• Audio of equity analyst Gerard Cassidy  CASSIDY1.mp3  
• Audio of equity analyst Mark G. Brennan  BRENNAN1.mp3  

• The bottom line is crucial no matter how voluminous are the supplementary disclosures

• Audio from a panel of top financial analysts  PANEL02.mp3
• That unmentioned specter of compensation tied to earnings measures

However, in spite of all you heard above, there are also many, many companies who side with the FASB/IASC and go about implementing the standards with minimal complaints.  One such company is Union Carbide.

• Roger Pearson (Manager of Accounting Research at Union Carbide) CARBR30.mp3 

A message concerning  Normal Purchases and Normal Sales (NPNS)

I received a very long message and received permission to quote the message below regarding the Normal Purchases and Normal Sales (NPNS) amendment in FAS 138::

Hello Professor Jensen,

Great website! However, I have to disagree with your comment regarding the issue of NPNS.

I work for the Bonneville Power Administration (Bonneville), a federal based Electric Wholesale Power Marketer, we sell the output from the 29 federally owned dams on the Columbia and Snake River system in the Pacific Northwest.  I am the project manager for Bonneville responsible for implementing FAS 133.  More on Bonneville at the end of this email - postscript.

 Regarding the NPNS issue:    This issue is of big concern to the Energy industry as it relates to our normal sales and purchases activities.  I am most familiar with the Electric Utility  industry and the sales and delivery practices that are prevalent throughout the industry.  I would argue that Bonneville was much better off under the original statement para 10 (b) because the statement was silent on the practice I describe below referred to as "Bookouts".

Specifically, in the electric utility industry it is necessary and is considered best utility and business practice to perform a type of transaction called a "Bookout" whereby several transactions with the same Counterparty in the same month - a purchase and a sale - are offset and not scheduled for physical delivery.  For example, Bonneville may sell forward 200 MWs for the month of August 2000 in January 2000 based on our most current hydro forecasts and subsequently in May 2000 our most current forecasts now show a deficit and we have to purchase 200 MWs for the same month to cover our obligations.  We may from time to time find ourselves with both purchases and sales with the same counterparty in the same month at the same delivery location.  Just prior to delivery, we look at our schedule and try and match up transactions --- the "Bookout" procedure.

This "Bookout" procedure is common in the electric utility industry as a scheduling convenience when two utilities happen to have offsetting transactions. If this procedure is not used, both counterparties incur transmission costs in order to make deliveries to each other. The Bookout procedure avoids the energy scheduling process (an administrative burden as well) which would trigger payment of transmission costs.  We do not plan for this event or know in advance what we will bookout and we do not "Bookout" to capture a margin.  Rather, we find ourselves in this situation because of our inventory management constraints, maintenance schedules, and dependency on factors outside our control such as the weather and streamflows or environmental constraints placed upon us by other federal agencies or federal courts. 

We  lobbied the FASB and the DIG to clarify and revise the NPNS language to allow for this practice, but the FASB position was very restrictive -- if you do not deliver then it is considered net settled.   It seems to me and other industry participants that bookouts do not fit into the net settlement definition as it was described and intended in FAS 133. Rather it is a utility best practice that results in no physical delivery.  In addition, when we bookout the cash settling is done at the agreed upon contract prices - not at the market pricing.  We would argue that the Board's original intent was to capture net settlement mechanisms that require "market" settlement.   Unfortunately, the FASB made their decision about a practice without doing more homework on the nature of the transaction.  I understand the pressures the FASB was under to get the statement amended and implemented.  Unfortunately, the industry participants and practitioners are left to deal with the Board's end product.   The final 138 was not clear in its guidance either as it relates to these types of transactions and what this meant to our "similar" contracts that we want to qualify for NPNS.  I continue, along with our auditors, to hold discussions with FASB staff. 

What I am afraid may happen is that because of the "One size fits all approach by the FASB",  Bonneville and other regulated utilities will be forced into adopting a FV accounting approach on transactions that are simple sales and purchases.  Applying mark to market treatment to these transactions is more misleading to the financial statement reader not clearer - the original intent of 133.  I believe the interpretation of the final written words by individuals unfamiliar with the Energy industry is driving us into misleading and confusing presentation.

Any advice or encouragement you can provide would be appreciated.  We adopt October 1 and I have a deadline to meet and I still do not have final clear and convincing guidance.  I am ahead of most folks on this issue since we do have an earlier adoption date than most utilities.  Thanks for your time.  This is a complex issue and I apologize for the length of this email and I imagine I still have not described the issues in the most succinct and clear fashion.

Regards,

Sanford Menashe
Project Manager, FAS 133
Bonneville Power Administration
phone:  503-230-3570
email:  smmenashe@bpa.gov

Postscript:

About Bonneville Power Administration:

Bonneville is a federal agency under the Department of Energy, which was established over 60 years ago to market power from 29 federal dams and one non-federal nuclear plant in the Pacific Northwest. BPA’s energy sales are governed by federal legislation (e.g. the Northwest Power Act) and other regional mandates to maintain the benefits of power sales for the Pacific Northwest region and to manage its environmental and safety obligations relative to operating the federal hydroelectric system. Its primary objective is to provide low-cost electricity to the region by offering cost-based rates for its power and transmission services to eligible publicly owned and investor-owned utilities in the Pacific Northwest (including Oregon, Washington, Idaho, western Montana and small parts of Wyoming, Nevada, Utah, California and eastern Montana).

Sanford Menashe, Manager, FAS 133 Project.
Project Manager, FAS 133
Bonneville Power Administration
phone:  503-230-3570
email:  smmenashe@bpa.gov

Email: smmenashe@bpa.gov

Update in September 2001:
The DIG addressed Mr. Menasche's concerns, especially in Dig Issue C16.  See the term "Net Settlement" at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm 

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Derivative Financial Instruments Frauds --- http://www.trinity.edu/rjensen/fraud.htm

A Condensed Multimedia Overview With Video and Audio from Experts --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm 

Bob Jensen's Home page is at http://www.trinity.edu/rjensen/