May 1, 2004
LOG OUT
Derivatives Accounting (FAS 133/IAS 39)
Key Disclosure Lessons From FAS 133 Q1
July 6, 2001

By Nilly Essaides

A review of 40 10Qs reveals a great diversity in reporting for Q1/01 as well as some lessons on what constitutes a useful disclosure.

Second quarter 10Q reports will soon begin to hit the SEC. With them will come Q2/FAS 133 disclosures for most companies. This next wave of 10Qs will certainly offer insight into the quarter-by-quarter effects of FAS 133. But judging from the first bunch, they may leave as much unsaid, as said.

A review of Q1 disclosures in 40 companies’ 10Qs reveals great diversity in reporting depth and quality. But perhaps the clearest revelation is that FAS 133 does not necessarily offer a clearer picture of a company’s derivatives strategy.

Perhaps the quality of disclosures depends on whether the company intends to conceal more than it reveals; perhaps, too, it indicates that MNCs are only at the start of their FAS 133 learning curve. Over time, best practices will hopefully emerge creating more readable 10Qs.

Patterns in the sand

FAS 133 was designed to create uniformity in hedge accounting practices and transparency in reporting. So far, it’s not clear whether it has achieved either. There are certainly “items” in every 10Q reports, but that’s where uniformity stops and diversity begins.

Some 10Qs contain only general language about the mandates of FAS 133, while others contain detailed descriptions of the company’s risk management policy; its hedges, including tables highlighting derivatives holdings and impact in OCI and income; as well as strike prices for options not held as hedges.

So far, it appears that companies with non-compliant derivatives provide more context and information about the actual strike prices and market risk exposures than companies with only FAS 133-compliant derivatives. 

In the case of the latter, often a boilerplate statement provides information about the sort of derivatives held (swaps, options, forwards). This is perhaps ironic, if not surprising, since companies with non-FAS 133 derivatives often end up disclosing more so that gains and losses are not misread.

The presentation and organization of related information also varies substantially. Nearly every 10Q contained an adoption graph, and a sentence “qualifying” the impact (non-material, in most cases) on earnings. All 10Qs contained some general reference to where the impact of hedge gains/losses can be found (in income or OCI, depending on the hedge).

That said, some companies provided multiple paragraphs explaining hedge relationships under FAS 133, and how their actual hedges fell into those categories, while others did not.

Further, some companies provided very useful summary tables of all derivatives-related gains/losses and impact in income or OCI, plus a cumulative derivatives’ effect number. This was further enhanced by 10Qs with market risk disclosures, noting how a 10 percent shift in rates would affect hedge positions.

Meanwhile, other MNCs provided nearly no fair value information in their disclosures making it harder (or impossible) to decipher the numbers in the income statement. Still others provided some fair value information in the disclosures, but bunched all hedges together, making it very difficult to figure out which ones were effective, and which were fair value vs. cash flow.

What is/isn’t revealed

This diversity obviously makes it hard to analyze 10Qs. (Difficult perhaps, but not impossible: FAS133.com is working on a matrix that would track, on a quarterly basis, various disclosures and impact on EPS/OCI for large MNCs).

Some trend observations do rise above the disclosure clutter:

Effectiveness method. Only one registrant alluded to the critical terms methodology. No one else provided information about what effectiveness measures were being used.

Time value. G20 will make a big difference for some companies, while having no effect at all for others. Many pre-G20 10Qs indicate that there is no time value being recorded in income. Even in cases where some time value was marked to market in income, the effect was minor.

There are exceptions, however. Microsoft’s said the following: “...the reduction to income was mostly attributable to a loss of approximately $300 million reclassified from OCI for the time value of options and a loss of approximately $250 million reclassified from OCI for derivatives not designated as hedging instruments.”

Industry differences: Financial companies seem to be providing more information about their derivatives than non-financial MNCs., perhaps because they have more experience with fair values, have the necessary systems, and tend to have more non-compliant derivatives. Ditto for commodity companies, which must now account for many previously “non-derivatives” as derivatives.

Qualified vs. non-qualified derivatives. The majority of 10Qs do not list substantial non-compliant derivatives, but there are some notable exceptions, including some written calls and non-qualified cross currency swaps or derivatives that hedge other derivatives.

Embeddeds. Of all the 10Qs reviewed, only Lucent mentioned the existence of embeddeds (other than equity options in convertible bonds). “Lucent’s foreign currency embedded derivatives consist of sales and purchase contracts with cash flows indexed to changes in or denominated in a currency that neither party to the contract uses as [its] functional currency. Changes in the fair value of these embedded derivatives are recorded in earnings.”

Emerging best practices

Of course, what constitutes good disclosure depends on one's perspective. Good from the point of view of the investor/analyst means in context and consistent with some forward-looking information.

Good from the company's standpoint may mean one of two things:

(1)   Clearly communicate the intent and value of hedges so that gains and losses are understood and not misread; or

(2)   Effectively conceals gains and losses on derivatives so that investors cannot figure out the effect of derivatives on income.

Perhaps, too, what makes good disclosure will take time to figure out, as for many of these companies are reporting FAS 133 info for the first time.

A checklist

Still, from the 40 10Qs reviewed for this article, the following useful hints emerged:

Divide hedge disclosu3 categories: Fair value, cash flow and net investment, with a discussion of strategy, fair values and ineffectiveness total for each category.

Provide a chart or table summarizing all derivatives gain/loss, impact on income or OCI

Include pointers as to where in the income statement particular derivatives numbers appear, in income and OCI.

Listing how market risk exposures would affect derivatives positions.

Sources of volatility

Finally, the Q1s reveal three sources of OCI/income volatility:

(1)   Time value of options (this will presumably disappear for any hedging options that fall under G20).

(2)   Gains/loss on non-qualified derivatives, either derivatives that do not meet the effectiveness standards or derivatives that hedge other derivatives. Of course, this does not mean the derivatives are speculative. There may be as many qualified derivatives as there are speculative, since those that are non-qualified ones may be true economic hedges.

(3) Finally, gains/losses on derivatives that were not accounted for previously as derivatives such as commercial contracts.

 


All rights reserved. Copyright © 1999-2004 The NeuGroup, publisher of TreasuryCompliance.com
Privacy policy | Agreement for web access | Contact us


  Top