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.
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.
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.”
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.
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.
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.