Some comments about available for sale securities and other complications John Woods Audio WOODS40.WAV SFAS 133 is not necessarily neutral in the economy as hoped by SFAS 133 (¶ 241)
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SFAS 133 Overview (WAV
Audio Version)
Bob Jensen at Trinity University
Table of Contents
Some Helpers |
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For a FAS 133 flow chart, go to http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm |
Controversial Issues
| Jim Leisingring from the FASB in 1998 (see Appendix A for the full text) from Tape 37 I think the REAL issue with the banks is that they're derivatives dealers, and they really didn't want the transactions scrutinized at the level that's necessary to account for them. --- particularly account for them at the way that we wanted them accounted for. I don't think it has much to do with bank accounting frankly, but I will leave that for others to decide. Russ Mallett from PwC on April 23, 1999 at a PwC Educators Conference in Dallas
SFAS 133 is not necessarily neutral in the economy as hoped by SFAS 133 (¶ 241)
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DIG Examples
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Overview of SFAS 133
For a FAS 133 flow chart, go to http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm |
A derivative requires either:
Net settlement requires one of the following:
Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm
If the embedded derivative cannot be reliably identified and measured, you must abide by the following rules:
For a FAS 133 flow chart, go to http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm |
A fair value derivative hedge is a hedge of the exposure
to a change in fair value of a recognized asset or liability or
of an unrecognized firm commitment attributable to a
particular risk. Key aspects:
See the following SFAS 133 Examples:
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For a FAS 133 flow chart, go to http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm |
A cash flow hedge is a hedging relationship where the
variability of the hedged item's cash flows is offset by the cash flows of the
hedging instrument.
Changes in value of a cash flow hedge derivative may sometimes have to be partitioned between earnings and OCI
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Limited eligibility of written options
Swaps that are written options
In sum, any swap combined with a written option |
The Board intended to increase the consistency of hedge
accounting guidance by broadening the scope of eligible foreign currency hedges.
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Derivatives or nonderivatives may be designated as hedges
of foreign currency risks if:
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Some comments about available for sale securities and other complications John Woods Audio WOODS40.WAV SFAS 133 is not necessarily neutral in the economy as hoped by SFAS 133 (¶ 241)
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Bob Jensen is not the person to ask about mortgage banking hedging! For a FAS 133 flow chart, go to http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm |
| Workshop 37, American Accounting Association Annual
Meetings New Orleans, Louisiana, August 16, 1998 Caveat from Bob Jensen: The transcriptions of the speakers in this session have never been edited by those professors or modified from a transcript of a presentation that I videotaped at a conference. The audio tape was transcribed by my secretary, Debbie Bowling. The transcription was modified by me only when Debbie failed to understand certain terminology. I prefer to minimize changes in the transcription so that what is read remains as close as possible to what the audience listened to at the conference. None of us speak with the formalized vocabulary and grammar used in our writing. Also we cannot edit what we said in the same manner that we can edit what we wrote. Hence, transcriptions should not be judged as writing. Panelist: James J. Leisenring, FASB Thank you. I apologize to all of you in advance for my voice. I have lost it. It's an infliction that many in the banking community hope is permanent, so I hope it isn't. At the FASB, as you have been told, we have had a lot of controversy over the years about derivatives accounting. We have had a lot of controversy over financial instruments accounting in general. But most importantly, I think, the peak key issues have been derivatives, and that they are sort of a magic or a black box aspect to derivatives that accountants in particular perhaps didn't understand. And sort of shedding any light on that seems to be something that some people didn't think we needed to be doing. Much of the controversy, that was talked about by or was just suggested by Tom in my personal opinion has absolutely nothing to do with accounting. Much like any of the other debates we've had like stock compensation, I think the REAL issue with the banks is that they're derivatives dealers, and they really didn't want the transactions scrutinized at the level that's necessary to account for them. --- particularly account for them at the way that we wanted them accounted for. I don't think it has much to do with bank accounting frankly, but I will leave that for others to decide. What have we done in the process? Well, we looked at some of what we thought were the shortcomings and accepted that in a mixed attribute model which we have, we do not mark everything to market as you well know. --- and probably are not going to at least in the lifetime of my grandchildren. Given that circumstance, people are going to want to engage in instruments that allow for offsetting changes in fair values and allow for offsetting changes in future cash flows. They consider that to be their legitimate risk taking, risk selecting, risk management activity --- whatever you want to call it. And we immediately said we were going to incorporate in any a standard a possibility of doing that. But we reached four fundamental conclusions; one of them is slightly misstated here --- the first one being derivatives are not assets and liabilities, but derivatives are contractual contracts that create contractual rights and contractual obligations that do meet the definitions of assets and liabilities. And because they meet those definitions, there isn't any reason why they shouldn't be recorded the same as any other contractual writing obligations that meets the definition of an asset or a liability. The second fundamental conclusion that we reached is perhaps stated poorly, and we learned these things as we go along. We said that fair value is the only relevant measure for derivatives. As I said to the group yesterday, in many respects that sounded like the first shot in a religious war. And that wasn't our intention. We are not trying to get into the fair value debate, it was really just sort of a statement of fact. Indeed, most derivatives and if you think about what we are talking about here, which are forwards, options, swaps, by in large, and futures' contracts which of course are formal exchange [credit forward--unsure of phrase]. The only one of those contracts in almost every circumstance, with any historical cost, is an option. And why, because an option obligates one party and allows rights to go to another party. And if you are going to gain a right and somebody else is going to be obligated you are going to have to pay them for that. Since the writer of an option wants a premium, the holder of the option is going to have to pay a premium. But forwards, futures, swaps and the like are all contracts that by and large, for all practical purposes, are going to be entered into at the money. And there isn't anything to measure at the point you enter into the contract. Because I agree to buy something from Tom, and he agrees to sell something to me six months hence, and we fix the price today of that forward. Tomorrow we know whether Tom is better off or I'm better off when the prices change. So we only really meant that the only relevant thing to be captured, the only measurement attribute that you can even capture and measure was fair value, and therefore it lead us to saying derivatives had to be of fair value. The third point is that only assets and liabilities should be reported as such. Now you'd say, and that's a really dog bites man story there, that's not particularly exciting. Except that, that's not the existing model. Through the magic of designation today, losses become assets and gains become liabilities. We will show you examples of how that could be if you don't believe it, but under the defer and match notion of hedge accounting that's grown up in practice --- not much in the standards except for Statement 80 in futures contracts. By and large if you'd say that you are hedging some future event and you occur a loss of $10 million on that, where are you going to put it? Future events haven't happened yet; it's coming next year. Certainly wouldn't want that $10 million loss in an income statement now would we, just because we had a loss. So you hang it up in a balance sheet, call it an asset. Same thing is true if it's a liability and a gain. Now we just don't think that any models have to be understandable that allows losses to be called assets. --- realized losses even in the case of futures contracts, and realized gains to be called liabilities, just doesn't make any sense. And finally, to the extent we are going to allow some deferral accounting, which we do, and by deferral I mean delaying the period in which a gain or a loss is recognized in earnings beyond the period in which it was incurred. If we are going to allow that special accounting, we are going to set some qualifying characteristics of the transactions; and one of those qualifying characteristics is you have to address the effectiveness of the strategy that you've entered into. Now having taken those four conclusions, we can examine to what extent they were accepted in practice in their implications. And by and large people objected to all four of those conclusions. They objected derivatives or assets and liabilities, because it results in accounting or recognizing swaps. Most people weren't so adamant about forward contracts, but swaps are a multi-million dollar market (at least in notional principle amount). And the swaps are, for all practical purposes, accounted for in what they call the accrual basis which, by and large, is the cash basis. --- nothing is recognized when they are in and out of the money. This conclusion puts swaps on a balance sheet. Second one; fair value is the only relevant measure, again results in recording swaps but also forwards and any volatility in options and futures. Now futures contracts have always been recorded, but volatility and the value of options and that volatility people want mitigated in some fashion, which we, as we always are, were fairly accommodating. Saying only assets and liabilities should be reported as such is absolutely a fundamental change in the hedge accounting model that we've used in this country. And it, you know, just isn't something that some people wanted to do, and they particularly didn't want to do it with respect to forecasted transactions. And believe it or not that special accounting only for qualifying transactions some people disagreed with the qualifications, but we actually got letters from some fairly significant organizations, that it was inappropriate to be put in an ineffectiveness of a hedge into earnings. If, after all, hedges were going to be ineffective, then why should I have to account for them in earnings when it would be so much better to defer the gain or loss until the period they wanted to recognize it? So all four fundamental conclusions were objected to for those reasons. And we ended up implementing those four conclusions with a standard that could be summarized at 50,000 feet very easily. Remember all the way through this when Steve gives you some really good examples here--- all derivatives at fair value. There is no exception to that --- OK! All derivatives are mark to market at fair value. Designated hedges of existing assets and liabilities for forecasted transactions are permitted you can do hedge accounting. When you do hedge accounting, there are certain rules in the way that that hedge accounting is applied. For existing assets and liabilities, and actually also for firm commitments which is a sort of an unrecorded asset or liability, for existing assets and liabilities the change in the fair value---the hedged item---attributable to the risk being hedged is included in earnings. Now remember, I already told you, and you accepted that the derivatives mark to market in earnings. Derivatives mark to market, derivatives mark to market in earnings for a fair value hedge to the extent it is 100% effective; your offset from the change in the fair value of the hedged item will also be in earnings. And the so-called volatility really isn't present except for the ineffective portion. So that is sort of fundamental to the fair value hedge accounting. I want to get back to attributable risk being hedged very briefly. But you do have to say how you are going to test for effectiveness, and if in fact as you describe it, the hedge is not effective, the ineffective portion has to be separate in earnings --- and it falls out in there anyway --- which is the more important conclusion when you get to cash flow hedging. This attributable to the risk being hedged is kind of something you want to watch out for, and I don't know whether you really have that Steve (No). But let's look at a very quick example... You've got a receivable that's a fixed rate, 8%, receivable denominated in a foreign currency. You've got really three pretty significant distinct risks going on there. You've got the affects risk, you've got the credit risk, and you've got interest rate risk. You have to decide which you're hedging. If you're hedging the credit risk, you've got a credit derivative, you would only market to market to the extent the credit risks change. If you've got an interest rate exposure, you would only market to market a portion attributable to the change in value from interest rates. Now prorationing is extraordinarily complicated. Why is it done? (It wasn't done in the exposure draft.) Because it mitigates volatility in earnings that would otherwise be there for changes in value other than from the risk being hedged. For forecasted transactions --- a fundamentally different model. For forecasted transactions, the change in the fair value of the derivative you mark to market the derivative, but the change in that fair value does not go to the earnings statement. It goes to comprehensive income, other comprehensive income --- in other words, that part of comprehensive income not in earnings. --- those things that are sort of a dangling debits and credits --- mysteriously we don't know what they are. But it is reported as a component of comprehensive income to the extent of hedge effectiveness. Ineffectiveness now has to go to earnings, all right. But the effective portion of that hedge will go to comprehensive income. They magically emerge from other comprehensive income into earnings when the forecasted transaction occurs. Very simple example, you can't mark to market next to your sales. If you are hedging next year's sales with some instrument, you mark the hedging instrument to market. You put it in other comprehensive income, and the sales that you have identified as being hedged occur next year--- pull it out of comprehensive income the gain or loss and have it offset in the income statement. Now, we actually got done with those conclusions about 27 years ago. And have spent the last few months, actually, debating two things. And you are going to have to watch out for both of mine. Actually I think the most complicated aspect of the document is in the definition of derivative. And what constitutes an embedded derivative and what would otherwise be a cash instrument? Many of you are going to say well, gees why did you bother? Let me tell you a little anecdotal point that you may not realize. The ink was not dry on our exposure draft, it would have required marking to market derivatives for hedging when a certain big investment bank and an insurance company came out with a product that would insure you against changes in foreign exchange rates. Not a derivative, wasn't hedging changes in exchange rates, wasn't a derivative product. It was an insurance policy designed to pay off for changes in exchange rates. Sort of was an eye opener to us and everyone else that's been involved with the project, that if you don't get at what's an embedded derivative, all you got to do is have a one dollar cash payment going back and forth and you'd eliminate every derivative. Now you have just put a one-dollar loan on the top of any forward contract or anything else. So we spent a long time looking at embedded derivatives, and you have got to take an embedded derivative if it would have met the definition standing alone and underlying the change in price that you are worried about is not directly related to the host contract. You have to separate that derivative in market to market. If you assert that you cannot separate the embedded derivative, mark the whole damn instrument to market. I think people will find their ability to separate is greatly enhanced by that learning that little thing, all right? Now, the last thing is again scope in a way, through the definition of derivatives is certainly a scope question, and it was a difficult one. But the other thing you have got to worry about is just that there are some exclusions. We weren't trying to capture some things, regular way securities, for example. This is where I pick on Tom because he's, I'll switch to Dick because he's in the front row. Dick goes and buys a hundred shares of IBM from his broker. He has to settle in three business days, right? Between today and three business days from now, he's got a forward contract. It clearly meets the definition of a derivative. He may pay off his broker three days hence and find out that he's several dollars better off or worse off, but he still owes that price. That's a derivative, but we are not going to make people separate regular way securities trades. Now if you don't do it regular way, which is the three days settlement, and you decide that you are going to do it ninety days, that is a different story. We also have some exceptions for normal purchases and sales of inventory, forward contracts to buy inventory and the like. We are not going to force, or allow actually, the separation of derivative contracts hedging future business combinations. And we also have some exclusion for insurance contacts. Those exclusions involve the more--by and large--morbidity and mortality risk. Do not go to insurance contracts that is essentially financial insurance and financial reinsurance, which may very well be derivatives. Now we are going to come back, as Tom suggested, and analyze the impact of this after Steve shows you some examples of practice transactions and look forward to your questions. The above is only a portion of the transcriptions. For the full transcriptions, go to the Tape 31 transcription at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
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Dear Professor Jensen,
You can get news or free e-mail about FAS 133 from Global Treasury News at http://www.gtnews.com/risk/
Thank you,
Rudi Handoko
