By Nilly Essaides

Looking for a “big” system to solve your FAS 133 and risk management needs? You may be looking in the wrong place, depending on your definition of “big.”

The term “big” and “small” have been commonly used in describing software applications. But what does it really mean?  Does big mean complex or fully integrated? Does small mean cheap or simple?

It used to be that “big” meant expensive systems requiring an army of on site consultants to help implement and configure. The bigger the price tag, it seemed, the bigger the system. But is price tag still the determining factor? With new web technologies and risk management accounting requirements, the definition of size may be irrelevant or at least in a state of flux.

As the dust settles on the vendor universe in our FAS 133 System Survey it appears that some expensive systems, and some very inexpensive ones may both fall into the “big” category. The key: Being able to track the hedge through the FAS 133 hedge accounting process, dynamically and with a clear audit trail.

The compliance process

Compliance with FAS 133 is an ongoing process, with four distinct elements:

(1)   Calculating fair value. Step one in the compliance process is valuation of hedges and underlying exposures. While some companies have had their own pricing capability for some time, many others have relied on banks and other providers for that information. With FAS 133 now a reality, companies with anything more than a handful of derivatives are better off having their own fair value (hence system and pricing feed) capacity. (Although the FASB has not prescribed a particular fair-value model—leaving that up to the market and auditors’ discretion. That means that some companies may be able to continue relying on the values provided by the banks’ monthly swap ticket, for example.)

(2)   Performing effectiveness testing. For companies deciding to go for special accounting, the core of FAS 133 is the effectiveness test. It’s important to remember hedge accounting is an option that some companies may choose to forego. “Quite a few of our large European clients have opted not to do hedge accounting,” reports Ritta Kuusela, accounting product manager with software vendor Trema. “They just decided that it’s too much hassle.”  The same is true with some large US MNCs as well.

However, that said, companies that want special accounting will need to run the hedge and underlying through some rigorous testing. FAS 133 not prescribe exactly what sort of test companies must use. The standard (and consequent DIG/FASB guidance) requires two types of tests: One for measuring prospective effectiveness or the likelihood of highly effective offset of fair value, and the other, an ongoing measure of actual, dollar offset. Our survey shows a certain common threat among the various tests offered by compliant systems, but the jury is still out on the “best” test. Some outsiders, like fixed income specialist Andrew Kalotay of Andrew Kalotay Associates Inc., maintain that it’s critical that companies identify a test that works for risk management and accounting purposes. Some of the accounting-focused testing, he cautions, may result in non-effective hedges and hits to the income statement.

(3)   Making the accounting entries – Finally, there’s the need to make the actual G/L entries that correspond to the results of the effectiveness test and fair value models. These entries are tedious and confusing and a challenge that perhaps can be only alleviated using an integrated system approach. We’ve addressed these issues at length with our FAS 133 System Readiness Survey.

(4)   Documentation, documentation, documentation.  However, underlying all three compliance process elements is the constant need for documentation. Companies need to document compliance from day 1 of the hedge, through effectiveness testing as well as any changes in the risk management activity.

“Documentation does not mean a long and verbose document about your hedge policy,” explains Elie Zabal, CEO of software vendor Inssinc, whose product Futrak 2000 provided perhaps the most extensive “documentation” back up among our early-bird respondents to the FAS 133 system survey. Rather, he says, “it’s the ability to dynamically track your hedges.”

For example, what happens when treasury decides to terminate a hedge, unexpectedly? The system needs to know to generate a memo, noting the hedge was terminated, while keeping OCI gain/loss in OCI until the underlying exposure is recognized, which could be months later. “The real issue is being able to prove what you did, that what you are doing is correct and that you are not manipulating earnings.”

While FAS 133 has no restrictions on terminating hedges, it is sensitive to any attempts to manipulate income numbers. In addition, notes Brian Ferguson of Open Link Financial, systems must be able to track component hedges or components of a hedged portfolio and make the necessary entries to OCI and income, and produce the reports.

Indeed, this latter phase of the compliance process may be the most taxing. “Effectiveness and mark-to-market are the simplest components,” argues Mr. Zabal. He notes that mark-to-market values for hedgers need only be derived once a quarter under FAS 133. Plus, there are no precise requirements as to the “quality” of that number and its precision (i.e., the type of fair value methodology/model hedgers should use).

“Fair value for traders operating with razor-thin margins is one thing; fair value for periodic accounting evaluations is another. Companies with a handful of hedges may simply rely on their banks for this quarterly valuation,” he says. “I would not trade on this value, but it’s sufficient for fair valuing..” However, you would still need a system to track and document effectiveness, generate journal entries and recognize AOCI at the right time. “That,” says Mr. Zabal, “no bank can do for you.” As to more active hedgers – they probably already have ways to price their instruments, and if they don’t they should.

Meeting the process challenges

So how can you tell a big system from a small one? As far as FAS 133 is concerned, big systems are the ones that truly allow you to continue your hedging business undisturbethe system creates the audit trail that the auditors and the SEC will need to see. That means being able to terminate hedges, hedge portfolios, etc., while the system keeps track of OCI values and entries, and generates the necessary memos regarding hedge activity.

In addition, look for a system that gives you more than just compliance, but allows you to improve the risk management culture, for example one that includes an effectiveness test that offers real insight into the chances that your hedge will remain effective throughout its life.