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 

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

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).