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Table of Contents
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
Introduction
In the end, derivatives are like antibiotics. It's dangerous to live
with them, but the world is better off because of them. The same can be
said about FAS 133 and its many implementation guides and amendments.
Booking derivatives at fair value is dangerous, but the economy would be worse
off without it. What we have to do is to strive night and day to improve
upon reporting of value and risk in a world that relies more and more on
derivative financial instruments to manage risks. A major problem is that
they are often traded in unfair and fraudulent markets --- http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
One of the main reasons Bob Jensen chose to specialize in
accounting for derivatives
Derivatives: Potential Benefits and Risk-Management
Challenges
Perhaps the clearest evidence of the perceived
benefits that derivatives have provided is their continued spectacular growth.
As a consequence of the increasing demand for these products, the size of the
global OTC derivatives markets, according to the Bank for International
Settlements (BIS), reached a notional principal value of $220 trillion in June
2004. Indeed, the growth rate of the OTC markets was more rapid in 2001-04 than
over the previous three years. At the same time, the growth rate of
exchange-traded derivatives exceeded the growth rate of OTC derivatives over
2001-04. Throughout the 1990s, the Chicago futures and options exchanges debated
whether the growth of the OTC markets was good or bad for their markets. The
data seem to have resolved that debate. In the United States, the Commodity
Futures Modernization Act of 2000 has permitted healthy competition between the
exchanges and the OTC markets, and both sets of markets are reaping the
benefits. The benefits are not limited to those that use derivatives. The use of
a growing array of derivatives and the related application of more-sophisticated
approaches to measuring and managing risk are key factors underpinning the
greater resilience of our largest financial institutions, which was so evident
during the credit cycle of 2001-02 and which seems to have persisted.
Derivatives have permitted the unbundling of financial risks. Because risks can
be unbundled, individual financial instruments now can be analyzed in terms of
their common underlying risk factors, and risks can be managed on a portfolio
basis. Partly because of the proposed Basel II capital requirements, the
sophisticated risk-management approaches that derivatives have facilitated are
being employed more widely and systematically in the banking and financial
services industries.
"Remarks by Chairman Alan Greenspan Risk Transfer and Financial Stability To the
Federal Reserve Bank of Chicago's Forty-first Annual Conference on Bank
Structure, Chicago, Illinois," May 5, 2005 ---
http://www.federalreserve.gov/boarddocs/speeches/2005/20050505/
Question
FAS 133 and its international equivalent IAS 39 are arguably the most
complex and difficult financial accounting standards ever written. These
are important because they deal with newer types of contracts (interest rate
swaps were only invented in 1984 and soared to over $100 trillion in
contracting) and contracts that have become the primary means by which firms
manage cash and manage financial risk. They are also speculation
contracts in the soaring number of hedge funds across the world. In the
1990s a disturbing number of billion dollar and even trillion dollar frauds in
derivative financial instruments caused the SEC to force the FASB to write FAS
133. Many of these frauds are summarized at
http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
It is clear that neither the financial world nor the accounting
world is yet prepared to deal with FAS 133. For example, failures of
meeting FAS 133 got KPMG fired from the Fannie Mae audit and is causing Fannie
to spend $140 million to make over one million correcting journal entries and
issue restated annual reports. The new auditing firm, PwC, has had to send
hundreds of auditors to Washington DC to take on Fannie's audit and to hire over
1,500 consultants in derivative financial instrument contracting.
The are many finance professors who understand derivative
contracts. But it is extremely rare to find one who knows FAS 133.
It is extremely rare to find an accounting professor who understands
derivatives, let alone FAS 133 and IAS 39.
So my question is, where do you as an
accounting professor or student begin to master FAS 133 and IAS 39?
Answer
I get many email messages asking some form of the above question. My
answer is shown below:
I first recommend that you purchase two books that I use in my
ACCT 5341 accounting theory course ---
http://www.trinity.edu/rjensen/acct5341/acct5341.htm
The first book is one of the best and most concise textbooks
I've ever seen in my professional career. It is a finance text and has no
FAS 133 accounting. However, before you tackle FAS 133, you must
understand the types of contracts covered in FAS 133. Robert Strong at the
University of Maine wrote a wonderful textbook for this purpose.
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Derivatives: An Introduction by Robert A Strong, Edition 2 (Thomson
South-Western, 2005, ISBN 0-324-27302-9)
Jensen Comment
For those of you who are interested in an overview of both
derivatives contracting and FAS 133/IAS 39, I prepared a CD that I
sometimes distribute to my audiences. The first time I prepared this
CD was for some commodities traders in Calgary. I update the CD
every now and then. You may download all the CD files from the link
below.
You can see an
overview of my connection of derivatives contracts with FAS 133 in
some PowerPoint files that I prepared for a presentation for
commodities traders. Simply click on the PowerPoint link at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/
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Next you must study FAS 133 and its amendments and "DIGs". I recommend
the following:
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It is possible to
download FAS 133, 138, and 149 for free from
http://www.fasb.org/st/
This is a good idea for word searching and compact storage.
However, it gets somewhat expensive to print the downloaded
versions.
For the print
version, I require that you purchase FASB book called FASB
Derivatives Codification ---
http://stores.yahoo.com/fasbpubs/dc133-3.html
This not only has the printed version of FAS 133, 138, and 149 it
has most of the relevant DIG commentaries as well. Since some exams
and quizzes are open book, you will want this book.
The above book will not be available in the Trinity Bookstore. You
must order it directly from the FASB.
To order:
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After you learn the basics of FAS 133, you can then study some
of the differences between the U.S. FAS 133 and the international IAS 39.
At conception, the IASB considered simply photocopying FAS 133 and calling it
IAS 39. However, that was deemed neither politically correct nor suitable
for the politics of Europe where putting some derivatives on balance sheets at
current (fair) values is vehemently opposed. Thus the IASB generated its
own IAS 39 which is very similar to FAS 133, but differs on some key points.
You can read about the differences, along with the differences in the Canadian
Guideline 13 (AcG-13), at
http://www.trinity.edu/rjensen/caseans/canada.htm
Along the way you can seek help from my multimedia tutorials
and an enormous glossary:
The question that I am asked most frequently by investment
bankers, CPA practitioners, and corporate accountants is how to value interest
rate swaps. I guide them to the following links and files:
Swap valuation helpers ---
http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
Swap valuation video --- Click on 133ex05a.wmv at
http://www.cs.trinity.edu/~rjensen/video/acct5341/
Swap valuation Excel illustration --- Click on 133Ex05a.xls at
http://www.cs.trinity.edu/~rjensen/
Lastly I have a very old and still popular given at 133sp.htm
and 133spans.xls at
http://www.cs.trinity.edu/~rjensen/
Enron collapsed mainly due to derivative financial
insturments ---
http://www.trinity.edu/rjensen/FraudEnronQuiz.htm
Financial Derivatives & Scandals Explode
in the Early 1990's
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Derivative Financial Instruments Frauds --- http://www.trinity.edu/rjensen/fraud.htm
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Warnings to Users of Financial
Accounting Textbooks
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For this Spring 2002 Semester, I
naively adopted, as a supplementary textbook, the following book:
Business Analysis & Valuation:
Using Financial Statements by Krishna G. Palepu, Paul M. Healy, and Victor
L. Bernard, (South-Western, Second Edition, 2000)
Note that there are two versions of this book: One version is a short
paperback version without cases and the other is a long hard copy version with
cases. The paperback version's identification number is
ISBN 0-324-01565-8.
See http://www.swcollege.com/acct/palepu/palepu.html
Now I greatly regret my naive
assumption that the above Edition 2, with a copyright date of Year 2000, incorporated
the immensely important FAS 133 issued in June 1998 and followed by an extended
standard FAS 138. Sadly, the PHB book makes no mention that, for the first
time in history, derivative financial instruments must be booked and adjusted to
fair values at least every 90 days. Unbooked derivatives caused the
collapse of Enron,
Long
Term Capital, and Orange
County. Huge dangers in derivatives
investing are sensationalized in a 1993 CBS (Sixty Minutes)
video at
http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm#Introduction
My introduction and cases on derivative financial instruments
accounting are at http://www.trinity.edu/rjensen/caseans/000index.htm
What is even more complicated is
that long-standing historical cost rules are changed for booking of traditional assets
(e.g., inventories and equipment) and liabilities (e.g., bonds and capital leases)
under FAS 133/138 fair values if they are being hedged in certain ways by derivative instruments.
This includes fair value adjustments at least every 90 days for positive and
negative changes in value of accounts normally maintained at historical
cost. The fact that the Year 1998 FAS 133 is completely ignored in the
Year 2000 PHB Edition 2 gives rise
to serious errors and misleading analyses of value and risk.
I will return to the PHB textbook in a
moment. In fairness, I should note that virtually all authors of financial
accounting textbooks have most likely failed to appreciate how the frustrating
FAS 133/138 rules impact in so many unsuspecting and complicated ways upon other
standards and GAAP in general. Textbook authors, like accounting educators
in general, became confronted with the most complex and
convoluted new standard ever issued in accountancy.
I suspect that authors, especially
authors of new editions of intermediate accounting textbooks, did not fully
comprehend the immense complexities of FAS 133/138 when they inserted a module
or complete chapter on FAS 133/138. What is required is to also
incorporate the implications of FAS 133/138 on all other chapters of the
book. As a user of such a book, you need to provide red flags for your
students on errors in this regard. Two illustrative red flags are noted
below:
Red Flag 1
You should check the asset and liability modules in the book and verify that
the authors incorporated the changes described under the "Basis
Adjustment" in the glossary at http://www.trinity.edu/rjensen/acct5341/speakers/glossf.htm#B-Terms
What is even more confusing is that the international IAS 39 kissing-kin to the United
States FAS 133 takes a different position on basis adjustment.
Red Flag 2
You should check to see if FAS 133 is incorporated into the modules dealing
with FAS 115 on valuation of financial instruments and FAS 52 on foreign
currency.
There are too many other red flags to
document in this message. A quick and dirty check on author due care and
diligence entails looking up FAS 133 in the book's index. If citations are not
listed for multiple chapters, chances are the book is misleading. I
provide some examples below.
Let me return to the PHB textbook that
will be frustrating me and my students this semester. Several warnings are
given below as examples:
Illustrative Warnings for PHB
Textbook Users
WARNING
1
Any item impacted by
FAS 133/138 may be highly misleading and cause students to make errors
in the CPA examination and in their jobs. For example, on Page
5-14 of the PHB textbook you will find the following:
Convertible
debt is a hybrid security. Typically it commands a lower rate of
interest than a straight debenture, since the seller also receives the
option to convert the debt into common shares. The value of the
conversion right depends on the conversion price, the firm's current
stock price, the government bond rate, and the estimated variance on
the firm's stock returns. A good case can be made for separating
the debt and equity components of a convertible issue, since the value
of each can be separately estimated. The value of the debt claim
will vary over time with interest rates. The value of the option
will vary with the firm's stock price.
However,
accounting rules do not recognize any value attached to the conversion
right. The convertible debenture is therefore reported as if it
were nonconvertible debt (See APB 14).
The above quotation is just plain wrong and out of date in terms of
newer embedded derivative rules. Paragraph 61(k) of FAS 133 reads
as follows:
Convertible debt.
The changes in fair value of an equity interest and the interest rates
on a debt instrument are not clearly and closely related. Thus, for a
debt security that is convertible into a specified number of shares of
the debtor's common stock or another entity's common stock, the
embedded derivative (that is, the conversion option) must be separated
from the debt host contract and accounted for as a derivative
instrument provided that the conversion option would, as a
freestanding instrument, be a derivative instrument subject to the
requirements of this Statement.
An
alternative for bifurcating debt instrument value into its component
conversion option value and remainder value are provided in
"Implementation of an Option Pricing-Based Bond Valuation
Model for Corporate Debt and Its Components." by Mary E. Barth, et
al, Accounting Horizons, December 2000.
WARNING 2
Companies with enormous
economic hedges may have hedged items that do not qualify for FAS 133
hedge accounting such that earnings take drastic hits when derivatives
are booked at fair value. Examples include partial-term hedging,
weather hedging, and macro (portfolio) hedging. FAS 138 revisions
do not allow hedge accounting for credit risk spreads above LIBOR
allowed for benchmarking.
My point here is that FAS 133
may be the cause of huge discrepancies between evaluations of
risk and equity value before versus after FAS 133. For more about
such problems and audio clips from financial analysts on Wall Street, go
to http://www.trinity.edu/rjensen/caseans/000index.htm
WARNING 3
Use of more recent
financial statements such as those issued for the Year 2001 may give
rise to confusing patterns of financial ratios and other aspects of
financial statement analysis such as the analysis in Chapter 9 of the
PHB textbook. All U.S. firms had to implement FAS
133 after January 1, 2001. Comparisons between Year 2000 financial
statements that did not book derivatives and did not change other assets
and liabilities under FAS 133 rules. For example, suppose an unbooked
interest rate swap valued at $5 million on December 31, 2000 did not
impact on net assets. The same swap valued at a negative $10
million on December 31, 2001 must be booked as a liability such that
there is a $10 million decrease in net assets. If the swap is a
cash flow hedge, the offsetting $10 million debit goes to Other
Comprehensive Income (OCI) in the equity section of the balance
sheet. Such ratios as ROI and ROE can be greatly impacted since
current earnings numerators of ROI and ROE are not impacted by the huge
fair value booking of this derivative in the denominators.
Since most companies (Enron
being a blatant exception) have policies requiring that derivative
financial instruments for hedging financial risk and not speculation, we
do not expect current earnings to be greatly impacted by the adoption of
FAS 133/138 if their hedges qualify for hedge accounting under FAS
133/138. However, we do expect the total assets and
liabilities to be increased by millions or even billions of dollars to fair value booking of previously unbooked derivatives. This, in
turn, must be taken into account when comparing reported outcomes before
FAS 133/138 went into effect. Major changes may be caused by
implementation of the accounting FAS 133/138 rules rather than
fundamental changes in the economic performances of companies.
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My appeal is that
all users of financial accounting books carefully check to see if FAS 133/138
impacts on all chapters have been cited. If not, please beg those
authors to issue errata sheets for all false or misleading passages that are
impacted by FAS 133 and FAS 138.
It would also help for
all textbook users to share their discovered textbook errors in any accounting book on the
AECM listserv. Please help professors and students in other universities
avoid teaching false or misleading accountancy and finance.
My closing point is that subscribers of the AECM are probably overlooking a
great opportunity to share discovered errors in the published literature.
Have you found errors were noting?
The AECM free subscription site is at http://pacioli.loyola.edu/aecm/
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FAS 133 Impacts on Prior FASB Standards and
EITF Rulings
| Summarized in FAS 133 Appendix B
Paragraphs 525-538
Supersedes:
Audio of James J. Rozsypal, Partner in
Arthur Andersen ROZSY02.mp3
- Statement 80 (futures contracts)
- Statement 105 (disclosures of off-balance-sheet
risk)
- Statement 119 (derivative disclosures)
- Numerous EITF Issues
Amends or Relies Upon:
- Statement 52 (foreign currency)
- Statement 107 (fair value disclosures)
- Statement 115 (accounting for debt and equity
securities)
- Various EITF Issues
Need for FAS 133 and
IAS 39
- Quantity and variety of derivatives are increasing
- Accounting conventions and standards were outdated,
incomplete, and inconsistent
- Effects of derivatives were not transparent
in the financial statements
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