Focus On Hedging: FAS 133, IAS 39 and the Movement Toward International Accounting Standards
John Bird, Vice President and Senior Risk Analyst, Global Risk Analysis, Bank of America, 23 Dec 1999
An overview of hedge accounting standards applied in a number of major countries, a description of the major principles and likely outcome of the new US hedge accounting Standard: FAS 133; and a discussion on the current status of the creation of an international accounting standard
Before we get started, I should state that I am not an accountant by training. However, during the past couple of years I have spent a large amount of time studying accounting standards and analyzing their impact on the hedging activities of corporations, as well as working with companies on their response to the new hedge standards.

Prior to this work, I spent most of the last 20 years in a variety of derivative trading, analytic and consulting positions; all relating to the management of risk. I should also say that I won't be getting into all of the details of the hedge accounting standards. At BofA we have been holding a number of one day FAS 133 seminars during the past year, with the intricacies of the new accounting standards a lot to handle even with an entire day.

But I will try to provide you with the bottom line relating to what the new accounting standards will mean to companies. These new accounting standards are likely to cause a major change in the way that companies evaluate exposures, hedge them, and disclose the results.

My presentation will be divided into three parts: an overview of hedge accounting standards applied in a number of major countries, a description of the major principals and likely outcome of the new US hedge accounting Standard: FAS 133, and a discussion on the current status of the creation of an international accounting standard.

Domestic accounting standards are set through different processes around the globe, but similar parties seem to be involved regardless of where the process is occurring. Accounting practitioners, industry experts, and government representatives all generally have input into the process. However, the relative power of these different entities seems to vary substantially from country to country with a singular interest dominating the process in some instances while other standards are arrived at through a more democratic process. Additionally, evidence during the past couple of years shows that the growing movement towards an international accounting standard also shows a process dominating by these groups.

Today, we will be focusing on two bodies setting accounting standards: the International Accounting Standards Committee (IASC) which is in the process of setting a common international standard, and the Financial Accounting Standards Board (FASB), with review by the Securities and Exchange Committee (SEC), which sets accounting standards in the U.S. (GAAP).

Different countries set accounting standards through various groups with the focus varying as well. Most of Euroland and Switzerland either have adopted or are adopting IAS. The U.K. is in the process of studying IAS and will adopt them if UK requirements for robustness etc. are met. In Japan, the Ministry of Finance sets accounting standards, with the dictates of the economy sometimes affecting policies in the past - more on this later. And in the U.S., the SEC is responsible for setting accounting standards that they exert through FASB. Investor interests are the major focus for standards in the U.S.

A reading of a number of articles and speeches shows current opinion to be in general agreement relating to the standards. The IASC standards are an attempt to harmonize the various standards used around the world, with an early focus on core themes, as opposed to some of the minutia. By contrast, U.S. GAAP tends to be very detailed and rule driven with many industry-specific rules. With regards to the comparison of the standards, FASB has identified 255 differences between IASC standards and U.S. GAAP with opinion varying about the meaningfulness of these differences.

The past couple of years have seen major activity with respect to hedge accounting standards. FAS 133, Accounting for Derivative Instruments and Hedging Activities, was released in the U.S. in June '98 with required implementation delayed in May '99 to calendar 2001 for most companies. IAS 39, Financial Instruments: Recognition and Measurement, was released in December '98 for implementation in January 2001 for most companies.

A comparison of the two shows that core principals between the two are essentially the same: with derivatives deemed to be assets/liabilities and carried at fair value. Also, the use of special "hedge" accounting (deferral of gains/losses on valuation changes) is to be restricted. As will all accounting standards, however, the specific implementation of themes/rules will be the key to understanding what the rules will mean for companies.

I should also take a moment to describe the "DIG" process. While the FAS Standard was issued nearly 18 months ago and is unlikely to change, details remain uncertain with regards to specific application of the Standard. The Derivatives Implementation Group meets bimonthly to review and discuss specific application issues with FASB agreement required. The process of deciding on specific applications has been a lengthy and involved one to date with FASB over-ruling a DIG opinion in one case and FASB reversing itself in another.

Analysis of FAS 133 by ourselves and others has shown that its implementation may lead to P&L and balance sheet volatility. By placing derivatives on the balance sheet, and revaluing quarterly, hedge valuation changes that do not exactly match changes in the value of the underlying risk will cause P&L swings.

Research shows this to be a minor problem for FX forwards but a much more significant problem for options. Even well structured "cash flow" hedges (where the underlying risk is not on the balance sheet) may also result in equity balance volatility. During the final comment period for FAS 133, Federal Reserve Chairman Greenspan voiced these concerns when he stated that adoption of 133 would reduce the reliability of financial statements and create artificial volatility.

If there is a single important issue relating to 133, it has to do with hedge "effectiveness". As stated earlier, any change in valuation of a hedge that does not exactly match the change in value of the underlying risk will flow through to earnings. This unmatched valuation change is referred to as an ineffective change, with the matching portion referred to as the effective change.

As the time value portion of an option represents a valuation that is unlikely to mirror any portion of the underlying risk, changes in time value, according to the Standard, are likely to be deemed ineffective. The following slides display some of the possible effects of FAS 133 implementation. The chart below shows the change in time value of a one year option evaluated at the end of the first quarter.

First Qtly Remarking of 1y USD/DEM Option
 

The chart shows that the first quarterly re-marking of the time value of an option lost between 10% and 95% of the total option time value (using USD/DEM data from 1993). The earnings impact of this decrease in time value is both significant and unpredictable. The next chart displays the average loss (as a percentage of total time value) for a range of options with original maturity between 6 months and 2.5 years (these results are for an average of USD/DEM and USD/JPY for the same time period as above).

Original Option Maturity (in years)
 

The significant front-weighting of time value changes is apparent in this chart; where the largest portion of the time value for at-the-money options is lost during the earliest quarters of the option term. A proviso should be made regarding these last two charts, however. These results are for single options relating to single risks. Most companies hedge their exposures through time, and when viewed over the course of time, the earnings volatility results should be less than shown in these single option examples.

In other words, these results exhibit the worst case when analyzing this aspect of FAS 133. In addition, both of these previous results were for at the money forward options. The following chart displays the relative loss in time value for a range of options from at the money forward to 10% out of the money.

Proportional TV Changes for Various Option Strikes
 

This chart shows that the proportional time value loss for purchased at the money forward options is much larger than for options struck out of the money, especially those struck far from the forward. So the good news is that the negative earnings impact that I have been describing can be lessened by moving strikes further from the forwards and by evaluating hedges on a rolling basis (as described above).

However, most companies currently set option strikes at or near the money, which explains some of the rationale for my initial statement about the adoption of FAS 133 altering the way that companies will hedge themselves. 133 is also likely to give rise to more structured hedge vehicles. The chart below shows just one of many structures that provides exposure coverage while minimizing the effect of 133 (we call it a forward extra plus, it is the combination of an option and a forward).


 

The chart displays the net delta of this structure over time and for a range of market levels. The delta tells us how the value of the structure changes in comparison to the underlying market (a proxy for the unhedged exposure). For companies using structures whose deltas closely track the underlying market, and therefore the unhedged risk, the earnings effect caused by 133 will be lessened when compared to vanilla options hedging under current accounting standards.

The final part of my presentation examines the momentum observable towards the creation of a universal international accounting standard. In December of 1998, the IASC completed the last portion of its core standards work. Both the IOSC and the SEC are currently reviewing the core IASC standards with a review, comment, and discussion period underway.

The need for an international standard was clearly seen a number of years ago when Daimler-Benz announced its financial results (I owe this example to a speech by Arthur Levitt, Chairman of the SEC - my complete bibliography is listed at the end of this presentation). In 1993, Daimler-Banz reported a profit of DEM 168MM under German accounting standards while also reporting nearly a USD 1 billion loss under U.S. GAAP.

An important aspect of the drive towards international accounting standards, I believe, should be on the final focus of the standards. In an article in the CPA Journal by Paul Pacter, he describes how the MOF changed bank accounting standards during the early days of the Japanese banking crises.

The net result showed the banks' financial strength more favorably. This example highlights the danger of a governmental agency, which also has responsibility for aspects of the economy, creating accounting standards that may not be the best from an investor perspective. An investor focus, in contrast, seeks a combination of comparability and transparency with consistent implementation. The point that I am leading to is that the choice of task master to determine the focus of international standards will likely have considerable impact on the standards created.

There are a number of alternatives for how the international accounting standards of the future will be determined. One alternative that is being discussed, is to agree on a universal set of accounting principals with the details of implementation determined on a country by country basis. While this alternative sounds attractive in theory, none of the work that I have done on the application of the new U.S. hedge accounting standard for companies has shown much value in core themes in contrast to specific implementation rules. In accounting, details definitely matter.

A more likely case for the creation of an international standard is to allow current accounting standards to merge naturally. There has already been some movement in this direction with U.S. GAAP eliminating the "pooling-of-interests" treatment for acquisitions and IAS contemplating more industry-specific standards.


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