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DERIVATIVES AND THE FASB: VISIBILITY AND TRANSPARENCY?
Critical Perspectives on Accounting (2003) 14, 777–789 doi:10.1016/S1045-2354(02)00192-2
DERIVATIVES AND THE FASB: VISIBILITY AND TRANSPARENCY? FRANCISCO GABRIEL HERNÁNDEZ HERNÁNDEZ Department of Finance and Accounting, University of La Laguna, La Laguna, Spain
In June 1998, the Financial Accounting Standards Board issued its Statement No. 133 addressing the accounting for derivative instruments and for hedging activities. This Statement addresses old issues regarding the way companies report their activities in derivatives and how those instruments are used to hedge some types of risks. However, the impact of this standard could be very negative, and it could be not useful for investors and creditors for making good decisions. In fact, SFAS 133 presents serious problems and the Board doesn’t appear to have obtained its goals of increased financial statements transparency and comparability. The problems of implementing this standard are commented in this article. At the same time, an alternative is offered to improve the issue of comparability among different companies using derivatives to hedging purposes. © 2003 Elsevier Science Ltd. All rights reserved.
Introduction The dynamic nature of financial markets and the increasingly widespread use of financial instruments, including derivative instruments, raised the need for new standards addressing issues concerning accounting for financial instruments and the way companies disclose information regarding those instruments. In 1986, the FASB began a broad project to address the accounting for financial instruments and hedging activities. This project was divided into phases: (a) The FASB initially focused on disclosures. In 1990 it issued Statement No. 105, regarding financial instruments with off-balance-sheet risk and concentrations of credit risk (FASB, 1990), and, in 1991, it issued Statement No. 107, concerning disclosure about fair value of financial instruments (FASB, 1991). In this phase, and related to derivative instruments, in 1994 the Board published Statement No. 119 addressing the disclosure of derivative financial instruments and fair value of financial instruments (FASB, 1994). Address for correspondence: Francisco Gabriel Hernández Hernández, Facultad de Ciencias Económicas y Empresariales, Campus de Guajara s/n, 38071 La Laguna (Tenerife), Spain. E-mail: [email protected] Received 15 June 2002; revised 26 September 2002; accepted 22 October 2002
777 1045-2354/$ – see front matter
© 2003 Elsevier Science Ltd. All rights reserved.
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(b) The second phase of the project was to consider the issues of recognition, measurement, and hedge accounting. This phase result in the issuance in 1993 of Statement No. 115, related to the accounting for some investments in debt and equity securities (FASB, 1993), and in 1998, Statement No. 133, regarding to the accounting for derivative instruments and hedging activities (FASB, 1998). In the first phase, the Board’s main goal was disclosed information about the fair value of all financial instruments, including the derivative instruments, both for assets and for liabilities. With respect to financial instruments, the second phase ended when the Board issued in 1993 Statement No. 115. Under SFAS 115 all the investments in debt securities and certain investments in equity securities (those that have readily determinable fair values) should be classified into one of three categories: (a) Held-to-Maturity Securities. This category consists of debt securities the entity has the positive intent and ability to hold to maturity. Investments in this category are measured at amortized cost and changes in their market values are not reported. (b) Trading Securities. This category includes debt securities not to be held to maturity and equity securities that are bought for the purpose of selling them in the near term. Securities in this category are carried at fair value, with changes in these values (unrealized gain and losses) recognized in income. (c) Available-for-Sale Securities. This category is used for debt and equity securities not classified as either held-to-maturity or trading securities. These securities are carried at fair value, with changes in these values recorded as a separate component of shareholder’s equity. This Statement is intended to eliminate the opportunities to influence the numbers that are reported in the financial statements. However, SFAS 115 does not reduce the opportunities for selectively managing earnings (Parks, 1993; Ponemon & Raghunandan, 1993; Clark & Li, 1994; Beatty, 1995). Furthermore, the requirement that unrealized holding gains and losses must be recognized in earnings when there are transfers between categories gives the opportunity for the earnings manipulation by the management. With respect to derivative instruments, the large losses reported by some companies by operating in derivatives had raised issues on the need for improving the information about the way those instruments were used, and the purpose for the entities to operate with them1 . Although those losses were substantial, derivatives do not introduce risks that are fundamentally different from the risks already present in the financial markets (Hentschel & Smith, 1994). Nonetheless, derivative instruments rose questions about off-balance-sheet financing, unjustifiable deferrals of losses, premature recognition of gains, and inadequate disclosure of information in financial statements about risks, fair values, and other attributes of these instruments.
Derivatives and the FASB
779
In this sense, the Securities and Exchange Commission (SEC) and the Association for Investment Management and Research (AIMR) had urged the FASB to adopt a standard that established accounting and reporting standards for derivative instruments and for hedging activities. This pressure had as a result in the issuance of SFAS No. 133 that addressed the accounting for derivatives and hedging activities. In this article, I describe the main issues arising from the SFAS 133, especially the accounting for hedges stated in this standard. In second place, I propose an alternative approach to this question, which would simplify the accounting treatment of hedge relationships.
The Long Way Towards the Statement 133 The FASB began deliberating issues relating to derivatives and hedging activities in January 1992. However, it wasn’t until 1998 when the final standard was issued. Once the FASB ended the first phase on derivatives with the issuance of FASB Statement 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments, the next step was to address questions regarding to accounting for derivative instruments and hedging activities. In 1996, the FASB issued an Exposure Draft on this subject and a comment letter process was opened. In light of the comment received, certain changes to the proposals in the Exposure Draft were made by the FASB, and a new draft was issued. The main decisions made by the FASB could be summarized as follows: (a) Derivative instruments represent rights or obligations that meet the definitions of assets or liabilities and should be reported in financial statements. (b) Derivative instruments should be measured at fair value, with changes in their values recognized currently in earnings, unless they qualify as part of certain kinds of hedging relationship (a cash flow hedge or a hedge of the foreign currency exposure of a net investment in a foreign operation). Before the final issuance of SFAS 133, there were numerous criticisms about the FASB’s proposal to set up the standard on the issue of the accounting for derivative instruments. For instance, the Federal Reserve Board suggested leaving the historical cost based accounting model intact, and supplementing the historical cost based statements by disclosing a separate set of financial statements based wholly on fair value accounting (Phillips, 1997). However, the FASB finally rejected the approach of the Federal Reserve Board. The main concern arising from the FASB’s proposal was that those new rules would make earnings and shareholders’ equity appear more volatile (Osterland, 2000), since changes in the fair value of some items would be reported directly in earnings or in Other Comprehensive Income (OCI). Since only few derivatives could qualify for hedge treatment, their gains or losses would be reflected in current income, whereas changes in the value of the hedge item could continue to be carried at book value if that item doesn’t have to be marked to
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F. G. Hern´andez Hern´andez
market (Ashley & Bliss, 1999). Furthermore, even if a derivative qualifies for hedge accounting, there will be income statement volatility if the change in fair value of that derivative differs from that of the underlying hedged item. That volatility could be artificial due to the piecemeal approach of marking certain risk positions to fair value, but no all positions contributing to the risk. Anyway, and despite the opposition of the Federal Reserve Board and of the most important banks in the USA, as stated in Mayer (1997), the FASB finally approved and issued its standard on derivatives in June 1998. However, after nearly becoming effective for fiscal years beginning after June 15, 1999, SFAS 133 was delayed by FASB Statement No. 137, so it was not effective until June 15, 2000 (FASB, 1999).
Measurement of Derivatives Under SFAS 133 Under FASB Statement No. 133, all derivatives are measured at fair value, and the way the entities report changes in those values depends on whether the derivatives have been designated and qualify as part of a hedging relationship and, if so, on the reason for holding them. This way of measurement could be used for derivatives traded on an organized exchange that provides quoted prices, since there would be reliable fair values for those derivative instruments. However, the fair value of an over-the-counter (OTC) derivative has to be estimated based on some assumptions that can vary from an entity to another one. For example, for OTC derivatives without quoted market prices, the estimate of fair value may be based on valuation techniques such as the present value of estimated future cash flows or option pricing models. All present value calculations are based in a set of expected cash flows and in an appropriate discount rate. In most of cases, the cash flows used in a present value measurement are estimates, rather than known amounts, especially when the periodic amounts to pay (or to receive) are based on a floating interest rate. Furthermore, the appropriate interest rate may be difficult to determine, and the selection of the appropriate risk premium can be complex and time-consuming. The use of entity’s own assumptions about expected cash flows and the appropriate interest rate can have as a result that different entities determine a different fair value for the same derivative instrument. In this way, entities holding identical derivative instruments can appear very different depending on the assumptions they use for measuring those derivatives. Furthermore, it would be very difficult and costly for independent public accountants to question managers’ assertions that future cash flows of a particular amount are expected, and that such amounts should be discounted by a specified interest rate (Benston, 1997). Option pricing models use complicated formulas based on various assumptions and can produce widely divergent results. Using option pricing models, the value of an option depends on five key factors: the current price of the asset to which the option refers, the strike or exercise price of the option, the time remaining to expiry of the option, a risk-free interest rate and the future volatility of the underlying asset price. Different assumptions regarding those factors would alter the fair value result,
Derivatives and the FASB
781
so at any time there might be many views held simultaneously on what the fair value of a particular option is.
Hedge Accounting in the SFAS 133 FASB Statement No. 133 provides the following three types of hedging relationships, depending upon the risk being hedged: (a) Fair value hedge. It is hedge of the exposure to changes in the fair value of an asset or a liability, or an identified portion of thereof, as well as a firm commitment, attributable to a particular risk. (b) Cash flow hedge. It represents the hedge of the exposure to variability in expected future cash flows that is attributable to a particular risk. That exposure may be associated with an existing recognized asset or liability or a forecasted transaction. (c) Hedge of the foreign currency exposure of a net investment in a foreign operation. It is the hedge of the exposure to changes in the foreign exchange rates of a net investment in a foreign operation2 . Under SFAS 133, in a fair value hedge, the gain or loss on a derivative instrument designated and qualifying as a hedging instrument should be recognized currently in earnings. At the same time, the loss or gain on the hedged item should adjust the carrying amount of the hedge item and be recognized currently in earnings. This treatment is applied even if that hedged item is otherwise measured at fair value with changes in fair value reported in other comprehensive income, or that item is not otherwise measured at fair value. This way of accounting for fair value hedges presents certain problems of application. In this sense, changes in the fair value of a hedging derivative are reported currently in earnings, in the same way as if it were a freestanding derivative. Given that the effect on earnings is the same, whether the derivative is designated and qualifies as a fair value hedging instrument or not, it would be illogical to designate that derivative as a fair value hedging instrument. The reason for this affirmation is that it must be provided with greater volume of information for a hedging derivative than for a freestanding one. On the other hand, and except for certain financial instruments, the change in the fair values of an asset or liability is only recognized if such asset or liability is a part of a hedging relationship. However, it is indeed the change in the fair value of a certain item which is tried to hedge with the derivative instrument, so if that change in its fair value is not going to be recognized in any way in the financial statements, it shouldn’t be logical to hedge that item. To illustrate the accounting for a fair value hedge under SFAS 133, assume that Company A borrows $1,000,000 on a 3-year 6% note on January 2, 2001. Company A also has $1,000,000 in 3-year, variable rate bonds. The variable rate on these bonds is determined annually at London Interbank Offer Rate (LIBOR) each
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F. G. Hern´andez Hern´andez
December 31. On January 2, 2001, Company A enters into a 3-year interest rate swap on $1,000,000 notional amount. The swap is settled annually at the net amount of the difference between the rate exchange and the rate received. Company A is to receive 6% (which is the LIBOR on January 2, 2001) and pay LIBOR. Assume LIBOR is 6.5% on December 31, 2002 and 5.5% on December 31, 2003. Since the fixed and variable rate was the same for 2001, no cash is exchanged on December 31. However, at the end of 2001, LIBOR has risen to 6.5%. If Company A expects to pay $5,000 for the next 2 years [$1,000,000 × (6.5%−6%)] on December 31 the swap would be recorded as a liability at its present value of $9,103 (the expected cash flows discounted at 6.5%). Assume that Company A decides to designate the interest rate swap as a hedge of the changes in the fair value of the note payable attributable to changes in market interest rates. Since the hedged item and the hedging instrument terms exactly match, there will not be any ineffectiveness in the hedging relationship. Subsequently, all changes in the fair value of the note payable and the interest rate swap will be reporting in earnings. Table 1 summarizes the effects of this hedge for each year. With respect to cash flow hedges, the SFAS 133 states that the effective portion of the gain or loss on a hedging derivative shall be reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings. FASB abandoned the criterion that had stated in Statement 80 for hedging of forecasted transactions3 (FASB, 1984). Under this criterion, if the forecasted transaction results in the recognition of an asset or a liability, then at the time the asset
Table 1 Effects of the fair value hedge Note payable January 2, 2001 Interest accrued Payments (receipts) Effect of change in rates December 31, 2001 Interest accrued Payments (receipts) Amortization of basis adjustments Effect of change in rates
$(1,000,000)
Interest rate swap
Expense
$0
(60,000) 60,000 9,103
$(60,000) (9,103)
(990,897)
(9,103)
$(60,000)
(60,000) 60,000 (4,408)
(592) 5,000
$(60,592)
(9,434)
9,434
$60,000
$65,000
1,004,739
4,739
$(65,000)
Interest accrued Payments (receipts) Amortization of basis adjustments
(60,000) 1,060,000 4,739
261 (5,000)
$(59,739)
$0
$60,000
(4,408)
December 31, 2002
December 31, 2003
Net payment
$65,000 $1,055,000
4,739 $0
$55,000
$1,055,000
783
Derivatives and the FASB Table 2 Effects of the cash value hedge Swap debit (credit) January 2, 2001
0
OCI debit (credit)
(9,103)
9,103
December 31, 2001
(9,103)
9,103
5,000 8,842
December 31, 2002
4,739
Payments (receipts) Changes in fair value of swap Reclassification to earnings December 31, 2003
(5,000) 261 $0
Cash debit (credit)
$(60,000)
$60,000
$(60,000)
$60,000
$(65,000)
$60,000
0
Payments (receipts) Changes in fair value of swap Payments (receipts) Changes in fair value of swap Reclassification to earnings
Earnings debit (credit)
(8,842) (5,000)
$5,000
(4,739)
$(60,000)
$60,000
$(55,000)
$60,000
(261) 5,000 $0
$(5,000) $(60,000)
$60,000
or liability is recognized the associated gains or losses that were reported into other comprehensive income should be removed from equity and should enter into the initial measurement of the acquisition cost or other carrying amount of the asset or liability. This way of accounting for hedges of forecasted transaction simplifies to a great extent the control of the amount reported in other comprehensive income. Under SFAS 133, for every period it should have to be verified the portion of other comprehensive income that should have to be reclassified into earnings as the extent the hedged item had affected earnings. On the contrary, if the gain or loss on the hedging derivative is included in the initial measurement of the hedged item, as mentioned earlier, this gain or loss will be recognized in earnings when the hedged item affects earnings without a need of verifying the amount being reclassified. That is, the gain or loss on hedging derivative should affect earnings when the hedged item was sold, amortized or settled. An example can help to illustrate the accounting for cash flow hedges under SFAS 133. With the same data of the previous example, assume on January 2, 2001 Company A designates the interest rate swap as a cash flow hedge of the variable-rate interest receipts on the bonds. The risk designated as being hedged is the risk of changes in cash flows attributable to changes in market interest rates. Again, since the hedged item and the hedging instrument terms exactly match, it is assumed that there will not be any ineffectiveness in the hedging relationship. Table 2 shows the effects of this cash flow hedge for each year.
The Impact of SFAS 133 As stated in the Journal of Accountancy (1977), financial accounting standards can affect the behavior of the users of financial reports and also the behavior of the reporting company.
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F. G. Hern´andez Hern´andez
Financial statements should provide information that is useful to users of financial reports in making economic decisions. In this sense, investment and credit decisions use to rely on comparisons, and the quality of comparisons is elevated to the extent that financial accounting standards produce financial statements that are consistent from period to period and comparable from company to company. Consequently, it is particularly important for both internal and external users of financial reports that adoption of any standard leads to the disclosure of genuinely comparable financial information. Moreover, comparability is desirable as it allows users to compare the financial information of different companies in order to evaluate their relative financial performance and financial position. Nonetheless, as I have already stated earlier, the application of the provisions of SFAS 133 can lead to comparability problems. Firstly, derivatives can be accounted for in different ways, depending on whether they have been designated as hedging instruments and, if so, the type of hedge they have been designated for. On the other hand, once an asset or liability has been recorded, it can be measured in many different ways depending on whether that asset or liability is a part of a hedging relationship or not, so it represents just another comparison problem. Therefore, even though different companies had acquired the same assets or issued the same liabilities, they could appear very different in terms of financial statements. As far as fair value measurement is concerned, without a sufficient detailed guidance on valuation of OTC derivatives, SFAS 133 will not generate comparable financial statements, but could lead users of financial reports to believe presentations are comparable when, in reality, they are not. Comparability requires that like transactions be accounted for uniformly among companies and applied consistently over time, so that investors, creditors and other users of financial reports can make meaningful comparisons of investment or credit opportunities. However, under SFAS 133, comparability between and among enterprises could be obstructed by the application of alternative accounting treatments to the same derivative or hedge. With regard to the reporting company, financial accounting standards can also affect its behavior. In this respect, the company might choose to alter its economic behavior in anticipation of potentially adverse feedback arising from its reporting according to required measurement and disclosure standards (Journal of Accountancy, 1977). DeMarzo and Duffie (1995) state that managers are concerned with the accounting consequences of their hedging decisions, so these consequences may influence their choice of hedging instrument, or whether they hedge at all. They demonstrate that risk minimization (full hedging) is an equilibrium policy for managers if the hedging activity is not disclosed. On the contrary, if full disclosure of hedging positions is required, the most natural equilibrium is for managers not to engage in hedging at all. Barton (2001) asserts that, since earnings volatility is costly to both managers and their firms, the imposition of SFAS 133 could reduce hedging and increase earnings management. Phillips and Lierley (1999) argue that, since SFAS 133 allows companies to hedge anticipated transactions with foreign currency forwards, more companies may
Derivatives and the FASB
785
increase their use of forwards. They also affirm that the hedging requirements of SFAS 133 may fuel the growth of securitization activities at financial institution. The Association for Financial Professionals (AFP) conducted a survey to assess the degree to which end users of derivatives have modified their behavior in response to SFAS 133 (AFP, 2001). The survey revealed that approximately two-thirds of survey respondents believed that SFAS 133 imposed an excessive corporate reporting burden. As a result, a significant portion of these respondents reduced their use of derivatives. In addition, approximately a quarter of the surveyed companies said they elected to mark a significant portion of derivatives to market through earnings, rather than devoting time and expense to the process of qualifying for special hedge accounting. An Alternative Approach to Hedge Accounting As mentioned earlier, the implementing of hedge accounting approach as stated in SFAS 133 would result in problems of comparability among firms, even though those firms hold identical investment securities, and had acquired or issued identical derivative instruments. For example, as Wilson et al. (1998) affirm, “a company whose strategy is to establish an asset-liability match can account for a hedging instrument differently depending on whether it designates the instrument as hedging the investment or the debt”. A way to avoid this kind of problem would be to use the same accounting criteria for any type of hedging relationship. In other words, it does not matter what kind of hedge is being used by the company, the really important thing would be whether there is such a hedging relationship or not. In this way, when a company uses a derivative instrument for a hedging purpose, the accounting for this derivative will be the same as the one used by another company using the same derivative for the same purpose, independently of the type of risk being hedged. I will illustrate this approach by using the same example previously commented. With the same data, assume that Company A designates the interest rate swap as a hedge of the changes in the fair value of the note payable attributable to changes in market interest rates. Table 3 shows the effects of this alternative approach on the accounting for this hedging relationship. As you can verify by comparing Table 1 with Table 3, the effects on earnings of this approach are the same as those of the fair value hedge under SFAS 133 provisions. That is, the swap converts the debt from a fixed rate to a variable rate. However, the alternative approach does not change the carrying amount of the debt, so such a debt is accounted for in the same way as if Company A had designated the swap as a cash flow hedge of the variable rate interest receipts on the investment. Following this approach, the debt, the investment and the swap are accounted for in the same way, regardless of the type of hedging relationship involved. Consequently, there would be no comparability problems arising from applying this approach. Therefore, and to sum up, the effective portion of a gain or loss on a hedging derivative instrument should be recognized as a component of other comprehensive
786
F. G. Hern´andez Hern´andez Table 3 Effects of the alternative approach on fair value hedge Swap debit (credit)
January 2, 2001
0
OCI debit (credit)
(9,103)
9,103
December 31, 2001
(9,103)
9,103
5,000 8,842
December 31, 2002
4,739
Payments (receipts) Changes in fair value of swap Reclassification to earnings December 31, 2003
(5,000) 261 $0
Cash debit (credit)
$60,000
$(60,000)
$60,000
$(60,000)
$60,000
$(65,000)
0
Payments (receipts) Changes in fair value of swap Payments (receipts) Changes in fair value of swap Reclassification to earnings
Earnings debit (credit)
(8,842) (5,000)
$5,000
(4,739)
$65,000
$(65,000)
$60,000
$(55,000)
(261) 5,000 $0
$(5,000) $55,000
$(55,000)
income. It should be this way whatever is the derivative instrument or the risk being hedged. The gain or loss recognized in accumulated other comprehensive income should be reclassified into earnings in the same period or periods during which the hedged item affects earnings. If the hedged item is a recognized asset, the gain or loss previously included in other comprehensive income should be reported in earnings in the period or periods in which the asset is sold, the expense of depreciation or interest is recorded, or the interest income is recognized. In the case that the hedged item is a recognized liability, the gain or loss on the hedging derivative should be reclassified into earnings in the period or periods in which that liability is settled, or a interest expense is registered. If the derivative instrument is used to hedge a forecasted acquisition of an asset, the gain or loss recognized in other comprehensive income should be included in the initial measurement of that asset. In this way, the deferred gain or loss should affect earnings at the same period as the asset is sold or depreciated, and there should be no need of verifying in each period which amount should be reclassified. Finally, if the derivative instrument hedges the forecasted incurrence of a liability, the gain or loss should be recognized in earnings when the liability affects earnings, in the way stated previously for the hedge of an existing liability. With respect to fair value measurement, if the derivative instrument is traded on an organized exchange, there will usually be reliable quoted prices, so the gain or loss on that instrument could be recorded daily. Moreover, the amount of such a gain or loss will be the same for any company holding that derivative. As stated earlier, if the derivative instrument is not traded on an organized exchange, its fair value should be determined by using some valuation technique. As Schuetze (2001) suggests, the FASB would have to develop standardized valuation techniques for use by reporting companies when estimating the cash sales price of an asset if there is no liquid market for that kind of an asset. However, in paragraph 56 of SFAS 107 (FASB, 1991), the FASB stated that it preferred general rather than
Derivatives and the FASB
787
detailed guidance even though general guidance may result in disclosures that are less comparable from entity to entity. In spite of the FASB’s preference for a general guidance on how to estimate fair values, it would be necessary to develop a detailed guidance or standard methods or assumptions for valuation purposes, in order to achieve that financial statements are comparable from company to company. Conclusions Despite the FASB states that SFAS 133 increases the visibility, comparability, and understandability of the risks associated with derivatives, implementing that Statement give as a result serious problems of comparability among financial statements from different companies. Under SFAS 133, the accounting treatment of derivatives and hedging activities can be very different among companies, so it has as a result in problems to compare the financial information from several entities since they can use several alternatives to report the same instruments or hedging activities. The way to avoid this kind of problem should be to use the same accounting treatment for all the derivatives and for all hedging activities. In this sense, the effective portion of the gain or loss on a derivative instrument used in a hedging relationship should have to be recognized in other comprehensive income and reclassified into earnings in the same period or periods during which the hedged item affects earnings. This approach of hedge accounting should avoid the problems of comparability arising from the application of FASB Statement No. 133, as the gains or losses on derivative instruments designated and qualified as part of a hedging relationship should be accounted for in the same way, regardless of the type of derivative instrument used and of the kind of risk being hedged. Although I have illustrated some of the problems of applying the SFAS 133 provisions, insufficient time has elapsed for proper analysis of the impact of SFAS 133. Future research could consider the effect on the companies’ securities price of the application of SFAS 133. Studies in the future could also investigate the changes in use of different types of derivatives, and how the managers have adjusted their hedging strategies. Acknowledgements I would like to thank George Benston for many helpful comments and Tony Tinker (The Editor) and two anonymous reviewers for constructive suggestions. Notes 1. You’ve read about large losses associated with the use of derivatives by firms such as Procter & Gamble ($137 million), Metallgesellschaft ($1 billion), Barings PLC ($1.3 billion) or Orange County, California ($1.7 billion).
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2. SFAS 133 really states a foreign currency hedge, but this type of hedge are actually divided into the following: (a) Hedge of a foreign-currency-denominated firm commitment, accounted for as a fair value hedge. (b) Hedge of an available-for-sale security, accounted for as a fair value hedge. (c) Hedge of a forecasted foreign-currency-denominated transaction, accounted for as a cash flow hedge. (d) Hedge of a net investment in a foreign operation. In this hedge, the gain or loss on the hedging derivative or nonderivative instrument is reported in other comprehensive income as part of the cumulative translation adjustment. 3. FASB Statement 80 stated that a change in the market value of a futures contract that hedged the price or interest rate of an anticipated transaction should be included in the measurement of the subsequent transaction.
References Ashley, L. & Bliss, R., “Financial Accounting Standard No. 133—The Reprieve”, Chicago Fed Letter, No. 143, July 1999. Association for Financial Professionals (AFP), 2001, “The Impact of FAS 133 on the Risk Management Practices of End Users of Derivatives”, available online at [pdf-non/research/fas1330601.pdf] [accessed August 19, 2002]. Barton, J., “Does the Use of Financial Derivatives Affect Earnings Management Decisions?”, The Accounting Review, Vol. 76, No. 1, 2001, pp. 1–26. Beatty, A., “The Effects of Fair Value Accounting on Investment Portfolio Management: How Fair Is It?”, Review (Federal Reserve Bank of Saint Louis), Vol. 77, No. 1, 1995, pp. 3–17. Benston, G. J., “Accounting for Derivatives: Back to Basics”, Journal of Applied Corporate Finance, Vol. 10, No. 3, 1997, pp. 46–58. Clark, M. W. & Li, J. F., “SFAS No. 115: New Accounting Rules for Investments in Debt and Equity Securities”, The Ohio CPA Journal, Vol. 53, No. 1, 1994, pp. 29–33. DeMarzo, P. M. & Duffie, D., “Corporate Incentives for Hedging and Hedge Accounting”, The Review of Financial Studies, Vol. 8, No. 3, 1995, pp. 743–771. Financial Accounting Standards Board (FASB), “Statement of Financial Accounting Standards No. 80”, Accounting for Futures Contract (Stamford, CT: FASB, 1984). Financial Accounting Standards Board (FASB), “Statement of Financial Accounting Standards No. 105”, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentration of Credit Risk (Norwalk, CT: FASB, 1990). Financial Accounting Standards Board (FASB), “Statement of Financial Accounting Standards No. 107”, Disclosures about Fair Value of Financial Instruments (Norwalk, CT: FASB, 1991). Financial Accounting Standards Board (FASB), “Statement of Financial Accounting Standards No. 115”, Accounting for Certain Investments in Debt and Equity Securities (Norwalk, CT: FASB, 1993). Financial Accounting Standards Board (FASB), “Statement of Financial Accounting Standards No. 119”, Disclosure About Derivative Financial Instruments and Fair Value of Financial Instruments (Norwalk, CT: FASB, 1994). Financial Accounting Standards Board (FASB), “Statement of Financial Accounting Standards No. 133”, Accounting for Derivative Instruments and Hedging Activities (Norwalk, CT: FASB, 1998). Financial Accounting Standards Board (FASB), “Statement of Financial Accounting Standards No. 137”, Accounting for Derivative Instruments and Hedging Activities—Deferral of the Effective Date of FASB Statement No. 133—An Amendment of FASB Statement No. 133 (Norwalk, CT: FASB, 1999). Hentschel, L. & Smith, C. W., “Risk and Regulation in Derivatives Markets”, Journal of Applied Corporate Finance, Vol. 7, No. 3, 1994, pp. 8–21. Journal of Accountancy, “Economic Impact of Accounting Standards—Implications for the FASB”, Journal of Accountancy, Vol. 143, No. 5, 1977, pp. 89–99.
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Mayer, M., “FASB on Trial”, Institutional Investor, Vol. 31, No. 11, 1997, pp. 78–90. Osterland, A., “Derivatives: Good Morning Volatility”, CFO, Vol. 16, July 2000, pp. 129–133. Parks, J. T., “FASB 115: It’s Back to the Future for Market Value Accounting”, Journal of Accountancy, Vol. 176, No. 3, 1993, pp. 49–56. Phillips, L. J. & Lierley, D. G., “The Impact of FASB Statement No. 133 on Financial Institutions”, Bank Accounting & Finance, Vol. 13, No. 1, 1999, pp. 51–62. Phillips, S. M., “Testimony Before the Subcommittee on Capital Markets, Securities and Government Sponsored Enterprises of the Committee on Banking and Financial Services, U.S. House of Representatives, October 1”, Federal Reserve Bulletin, Vol. 83, No. 12, December 1997, pp. 957–961. Ponemon, S. M. & Raghunandan, K., “Accounting for Investments in Debt and Equity Securities”, The CPA Journal, Vol. 63, No. 8, 1993, pp. 34–40. Schuetze, W. P., “What are Assets and Liabilities? Where is True North? (Accounting That My Sister Would Understand)”, Abacus, Vol. 37, No. 1, 2001, pp. 1–25. Wilson, A. C., Waters, G. & Bryan, B. J., “The Decision on Derivatives”, Journal of Accountancy, Vol. 186, No. 5, 1998, pp. 24–29.
DERIVATIVES AND THE FASB: VISIBILITY AND TRANSPARENCY? FRANCISCO GABRIEL HERNÁNDEZ HERNÁNDEZ Department of Finance and Accounting, University of La Laguna, La Laguna, Spain
In June 1998, the Financial Accounting Standards Board issued its Statement No. 133 addressing the accounting for derivative instruments and for hedging activities. This Statement addresses old issues regarding the way companies report their activities in derivatives and how those instruments are used to hedge some types of risks. However, the impact of this standard could be very negative, and it could be not useful for investors and creditors for making good decisions. In fact, SFAS 133 presents serious problems and the Board doesn’t appear to have obtained its goals of increased financial statements transparency and comparability. The problems of implementing this standard are commented in this article. At the same time, an alternative is offered to improve the issue of comparability among different companies using derivatives to hedging purposes. © 2003 Elsevier Science Ltd. All rights reserved.
Introduction The dynamic nature of financial markets and the increasingly widespread use of financial instruments, including derivative instruments, raised the need for new standards addressing issues concerning accounting for financial instruments and the way companies disclose information regarding those instruments. In 1986, the FASB began a broad project to address the accounting for financial instruments and hedging activities. This project was divided into phases: (a) The FASB initially focused on disclosures. In 1990 it issued Statement No. 105, regarding financial instruments with off-balance-sheet risk and concentrations of credit risk (FASB, 1990), and, in 1991, it issued Statement No. 107, concerning disclosure about fair value of financial instruments (FASB, 1991). In this phase, and related to derivative instruments, in 1994 the Board published Statement No. 119 addressing the disclosure of derivative financial instruments and fair value of financial instruments (FASB, 1994). Address for correspondence: Francisco Gabriel Hernández Hernández, Facultad de Ciencias Económicas y Empresariales, Campus de Guajara s/n, 38071 La Laguna (Tenerife), Spain. E-mail: [email protected] Received 15 June 2002; revised 26 September 2002; accepted 22 October 2002
777 1045-2354/$ – see front matter
© 2003 Elsevier Science Ltd. All rights reserved.
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(b) The second phase of the project was to consider the issues of recognition, measurement, and hedge accounting. This phase result in the issuance in 1993 of Statement No. 115, related to the accounting for some investments in debt and equity securities (FASB, 1993), and in 1998, Statement No. 133, regarding to the accounting for derivative instruments and hedging activities (FASB, 1998). In the first phase, the Board’s main goal was disclosed information about the fair value of all financial instruments, including the derivative instruments, both for assets and for liabilities. With respect to financial instruments, the second phase ended when the Board issued in 1993 Statement No. 115. Under SFAS 115 all the investments in debt securities and certain investments in equity securities (those that have readily determinable fair values) should be classified into one of three categories: (a) Held-to-Maturity Securities. This category consists of debt securities the entity has the positive intent and ability to hold to maturity. Investments in this category are measured at amortized cost and changes in their market values are not reported. (b) Trading Securities. This category includes debt securities not to be held to maturity and equity securities that are bought for the purpose of selling them in the near term. Securities in this category are carried at fair value, with changes in these values (unrealized gain and losses) recognized in income. (c) Available-for-Sale Securities. This category is used for debt and equity securities not classified as either held-to-maturity or trading securities. These securities are carried at fair value, with changes in these values recorded as a separate component of shareholder’s equity. This Statement is intended to eliminate the opportunities to influence the numbers that are reported in the financial statements. However, SFAS 115 does not reduce the opportunities for selectively managing earnings (Parks, 1993; Ponemon & Raghunandan, 1993; Clark & Li, 1994; Beatty, 1995). Furthermore, the requirement that unrealized holding gains and losses must be recognized in earnings when there are transfers between categories gives the opportunity for the earnings manipulation by the management. With respect to derivative instruments, the large losses reported by some companies by operating in derivatives had raised issues on the need for improving the information about the way those instruments were used, and the purpose for the entities to operate with them1 . Although those losses were substantial, derivatives do not introduce risks that are fundamentally different from the risks already present in the financial markets (Hentschel & Smith, 1994). Nonetheless, derivative instruments rose questions about off-balance-sheet financing, unjustifiable deferrals of losses, premature recognition of gains, and inadequate disclosure of information in financial statements about risks, fair values, and other attributes of these instruments.
Derivatives and the FASB
779
In this sense, the Securities and Exchange Commission (SEC) and the Association for Investment Management and Research (AIMR) had urged the FASB to adopt a standard that established accounting and reporting standards for derivative instruments and for hedging activities. This pressure had as a result in the issuance of SFAS No. 133 that addressed the accounting for derivatives and hedging activities. In this article, I describe the main issues arising from the SFAS 133, especially the accounting for hedges stated in this standard. In second place, I propose an alternative approach to this question, which would simplify the accounting treatment of hedge relationships.
The Long Way Towards the Statement 133 The FASB began deliberating issues relating to derivatives and hedging activities in January 1992. However, it wasn’t until 1998 when the final standard was issued. Once the FASB ended the first phase on derivatives with the issuance of FASB Statement 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments, the next step was to address questions regarding to accounting for derivative instruments and hedging activities. In 1996, the FASB issued an Exposure Draft on this subject and a comment letter process was opened. In light of the comment received, certain changes to the proposals in the Exposure Draft were made by the FASB, and a new draft was issued. The main decisions made by the FASB could be summarized as follows: (a) Derivative instruments represent rights or obligations that meet the definitions of assets or liabilities and should be reported in financial statements. (b) Derivative instruments should be measured at fair value, with changes in their values recognized currently in earnings, unless they qualify as part of certain kinds of hedging relationship (a cash flow hedge or a hedge of the foreign currency exposure of a net investment in a foreign operation). Before the final issuance of SFAS 133, there were numerous criticisms about the FASB’s proposal to set up the standard on the issue of the accounting for derivative instruments. For instance, the Federal Reserve Board suggested leaving the historical cost based accounting model intact, and supplementing the historical cost based statements by disclosing a separate set of financial statements based wholly on fair value accounting (Phillips, 1997). However, the FASB finally rejected the approach of the Federal Reserve Board. The main concern arising from the FASB’s proposal was that those new rules would make earnings and shareholders’ equity appear more volatile (Osterland, 2000), since changes in the fair value of some items would be reported directly in earnings or in Other Comprehensive Income (OCI). Since only few derivatives could qualify for hedge treatment, their gains or losses would be reflected in current income, whereas changes in the value of the hedge item could continue to be carried at book value if that item doesn’t have to be marked to
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F. G. Hern´andez Hern´andez
market (Ashley & Bliss, 1999). Furthermore, even if a derivative qualifies for hedge accounting, there will be income statement volatility if the change in fair value of that derivative differs from that of the underlying hedged item. That volatility could be artificial due to the piecemeal approach of marking certain risk positions to fair value, but no all positions contributing to the risk. Anyway, and despite the opposition of the Federal Reserve Board and of the most important banks in the USA, as stated in Mayer (1997), the FASB finally approved and issued its standard on derivatives in June 1998. However, after nearly becoming effective for fiscal years beginning after June 15, 1999, SFAS 133 was delayed by FASB Statement No. 137, so it was not effective until June 15, 2000 (FASB, 1999).
Measurement of Derivatives Under SFAS 133 Under FASB Statement No. 133, all derivatives are measured at fair value, and the way the entities report changes in those values depends on whether the derivatives have been designated and qualify as part of a hedging relationship and, if so, on the reason for holding them. This way of measurement could be used for derivatives traded on an organized exchange that provides quoted prices, since there would be reliable fair values for those derivative instruments. However, the fair value of an over-the-counter (OTC) derivative has to be estimated based on some assumptions that can vary from an entity to another one. For example, for OTC derivatives without quoted market prices, the estimate of fair value may be based on valuation techniques such as the present value of estimated future cash flows or option pricing models. All present value calculations are based in a set of expected cash flows and in an appropriate discount rate. In most of cases, the cash flows used in a present value measurement are estimates, rather than known amounts, especially when the periodic amounts to pay (or to receive) are based on a floating interest rate. Furthermore, the appropriate interest rate may be difficult to determine, and the selection of the appropriate risk premium can be complex and time-consuming. The use of entity’s own assumptions about expected cash flows and the appropriate interest rate can have as a result that different entities determine a different fair value for the same derivative instrument. In this way, entities holding identical derivative instruments can appear very different depending on the assumptions they use for measuring those derivatives. Furthermore, it would be very difficult and costly for independent public accountants to question managers’ assertions that future cash flows of a particular amount are expected, and that such amounts should be discounted by a specified interest rate (Benston, 1997). Option pricing models use complicated formulas based on various assumptions and can produce widely divergent results. Using option pricing models, the value of an option depends on five key factors: the current price of the asset to which the option refers, the strike or exercise price of the option, the time remaining to expiry of the option, a risk-free interest rate and the future volatility of the underlying asset price. Different assumptions regarding those factors would alter the fair value result,
Derivatives and the FASB
781
so at any time there might be many views held simultaneously on what the fair value of a particular option is.
Hedge Accounting in the SFAS 133 FASB Statement No. 133 provides the following three types of hedging relationships, depending upon the risk being hedged: (a) Fair value hedge. It is hedge of the exposure to changes in the fair value of an asset or a liability, or an identified portion of thereof, as well as a firm commitment, attributable to a particular risk. (b) Cash flow hedge. It represents the hedge of the exposure to variability in expected future cash flows that is attributable to a particular risk. That exposure may be associated with an existing recognized asset or liability or a forecasted transaction. (c) Hedge of the foreign currency exposure of a net investment in a foreign operation. It is the hedge of the exposure to changes in the foreign exchange rates of a net investment in a foreign operation2 . Under SFAS 133, in a fair value hedge, the gain or loss on a derivative instrument designated and qualifying as a hedging instrument should be recognized currently in earnings. At the same time, the loss or gain on the hedged item should adjust the carrying amount of the hedge item and be recognized currently in earnings. This treatment is applied even if that hedged item is otherwise measured at fair value with changes in fair value reported in other comprehensive income, or that item is not otherwise measured at fair value. This way of accounting for fair value hedges presents certain problems of application. In this sense, changes in the fair value of a hedging derivative are reported currently in earnings, in the same way as if it were a freestanding derivative. Given that the effect on earnings is the same, whether the derivative is designated and qualifies as a fair value hedging instrument or not, it would be illogical to designate that derivative as a fair value hedging instrument. The reason for this affirmation is that it must be provided with greater volume of information for a hedging derivative than for a freestanding one. On the other hand, and except for certain financial instruments, the change in the fair values of an asset or liability is only recognized if such asset or liability is a part of a hedging relationship. However, it is indeed the change in the fair value of a certain item which is tried to hedge with the derivative instrument, so if that change in its fair value is not going to be recognized in any way in the financial statements, it shouldn’t be logical to hedge that item. To illustrate the accounting for a fair value hedge under SFAS 133, assume that Company A borrows $1,000,000 on a 3-year 6% note on January 2, 2001. Company A also has $1,000,000 in 3-year, variable rate bonds. The variable rate on these bonds is determined annually at London Interbank Offer Rate (LIBOR) each
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F. G. Hern´andez Hern´andez
December 31. On January 2, 2001, Company A enters into a 3-year interest rate swap on $1,000,000 notional amount. The swap is settled annually at the net amount of the difference between the rate exchange and the rate received. Company A is to receive 6% (which is the LIBOR on January 2, 2001) and pay LIBOR. Assume LIBOR is 6.5% on December 31, 2002 and 5.5% on December 31, 2003. Since the fixed and variable rate was the same for 2001, no cash is exchanged on December 31. However, at the end of 2001, LIBOR has risen to 6.5%. If Company A expects to pay $5,000 for the next 2 years [$1,000,000 × (6.5%−6%)] on December 31 the swap would be recorded as a liability at its present value of $9,103 (the expected cash flows discounted at 6.5%). Assume that Company A decides to designate the interest rate swap as a hedge of the changes in the fair value of the note payable attributable to changes in market interest rates. Since the hedged item and the hedging instrument terms exactly match, there will not be any ineffectiveness in the hedging relationship. Subsequently, all changes in the fair value of the note payable and the interest rate swap will be reporting in earnings. Table 1 summarizes the effects of this hedge for each year. With respect to cash flow hedges, the SFAS 133 states that the effective portion of the gain or loss on a hedging derivative shall be reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings. FASB abandoned the criterion that had stated in Statement 80 for hedging of forecasted transactions3 (FASB, 1984). Under this criterion, if the forecasted transaction results in the recognition of an asset or a liability, then at the time the asset
Table 1 Effects of the fair value hedge Note payable January 2, 2001 Interest accrued Payments (receipts) Effect of change in rates December 31, 2001 Interest accrued Payments (receipts) Amortization of basis adjustments Effect of change in rates
$(1,000,000)
Interest rate swap
Expense
$0
(60,000) 60,000 9,103
$(60,000) (9,103)
(990,897)
(9,103)
$(60,000)
(60,000) 60,000 (4,408)
(592) 5,000
$(60,592)
(9,434)
9,434
$60,000
$65,000
1,004,739
4,739
$(65,000)
Interest accrued Payments (receipts) Amortization of basis adjustments
(60,000) 1,060,000 4,739
261 (5,000)
$(59,739)
$0
$60,000
(4,408)
December 31, 2002
December 31, 2003
Net payment
$65,000 $1,055,000
4,739 $0
$55,000
$1,055,000
783
Derivatives and the FASB Table 2 Effects of the cash value hedge Swap debit (credit) January 2, 2001
0
OCI debit (credit)
(9,103)
9,103
December 31, 2001
(9,103)
9,103
5,000 8,842
December 31, 2002
4,739
Payments (receipts) Changes in fair value of swap Reclassification to earnings December 31, 2003
(5,000) 261 $0
Cash debit (credit)
$(60,000)
$60,000
$(60,000)
$60,000
$(65,000)
$60,000
0
Payments (receipts) Changes in fair value of swap Payments (receipts) Changes in fair value of swap Reclassification to earnings
Earnings debit (credit)
(8,842) (5,000)
$5,000
(4,739)
$(60,000)
$60,000
$(55,000)
$60,000
(261) 5,000 $0
$(5,000) $(60,000)
$60,000
or liability is recognized the associated gains or losses that were reported into other comprehensive income should be removed from equity and should enter into the initial measurement of the acquisition cost or other carrying amount of the asset or liability. This way of accounting for hedges of forecasted transaction simplifies to a great extent the control of the amount reported in other comprehensive income. Under SFAS 133, for every period it should have to be verified the portion of other comprehensive income that should have to be reclassified into earnings as the extent the hedged item had affected earnings. On the contrary, if the gain or loss on the hedging derivative is included in the initial measurement of the hedged item, as mentioned earlier, this gain or loss will be recognized in earnings when the hedged item affects earnings without a need of verifying the amount being reclassified. That is, the gain or loss on hedging derivative should affect earnings when the hedged item was sold, amortized or settled. An example can help to illustrate the accounting for cash flow hedges under SFAS 133. With the same data of the previous example, assume on January 2, 2001 Company A designates the interest rate swap as a cash flow hedge of the variable-rate interest receipts on the bonds. The risk designated as being hedged is the risk of changes in cash flows attributable to changes in market interest rates. Again, since the hedged item and the hedging instrument terms exactly match, it is assumed that there will not be any ineffectiveness in the hedging relationship. Table 2 shows the effects of this cash flow hedge for each year.
The Impact of SFAS 133 As stated in the Journal of Accountancy (1977), financial accounting standards can affect the behavior of the users of financial reports and also the behavior of the reporting company.
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F. G. Hern´andez Hern´andez
Financial statements should provide information that is useful to users of financial reports in making economic decisions. In this sense, investment and credit decisions use to rely on comparisons, and the quality of comparisons is elevated to the extent that financial accounting standards produce financial statements that are consistent from period to period and comparable from company to company. Consequently, it is particularly important for both internal and external users of financial reports that adoption of any standard leads to the disclosure of genuinely comparable financial information. Moreover, comparability is desirable as it allows users to compare the financial information of different companies in order to evaluate their relative financial performance and financial position. Nonetheless, as I have already stated earlier, the application of the provisions of SFAS 133 can lead to comparability problems. Firstly, derivatives can be accounted for in different ways, depending on whether they have been designated as hedging instruments and, if so, the type of hedge they have been designated for. On the other hand, once an asset or liability has been recorded, it can be measured in many different ways depending on whether that asset or liability is a part of a hedging relationship or not, so it represents just another comparison problem. Therefore, even though different companies had acquired the same assets or issued the same liabilities, they could appear very different in terms of financial statements. As far as fair value measurement is concerned, without a sufficient detailed guidance on valuation of OTC derivatives, SFAS 133 will not generate comparable financial statements, but could lead users of financial reports to believe presentations are comparable when, in reality, they are not. Comparability requires that like transactions be accounted for uniformly among companies and applied consistently over time, so that investors, creditors and other users of financial reports can make meaningful comparisons of investment or credit opportunities. However, under SFAS 133, comparability between and among enterprises could be obstructed by the application of alternative accounting treatments to the same derivative or hedge. With regard to the reporting company, financial accounting standards can also affect its behavior. In this respect, the company might choose to alter its economic behavior in anticipation of potentially adverse feedback arising from its reporting according to required measurement and disclosure standards (Journal of Accountancy, 1977). DeMarzo and Duffie (1995) state that managers are concerned with the accounting consequences of their hedging decisions, so these consequences may influence their choice of hedging instrument, or whether they hedge at all. They demonstrate that risk minimization (full hedging) is an equilibrium policy for managers if the hedging activity is not disclosed. On the contrary, if full disclosure of hedging positions is required, the most natural equilibrium is for managers not to engage in hedging at all. Barton (2001) asserts that, since earnings volatility is costly to both managers and their firms, the imposition of SFAS 133 could reduce hedging and increase earnings management. Phillips and Lierley (1999) argue that, since SFAS 133 allows companies to hedge anticipated transactions with foreign currency forwards, more companies may
Derivatives and the FASB
785
increase their use of forwards. They also affirm that the hedging requirements of SFAS 133 may fuel the growth of securitization activities at financial institution. The Association for Financial Professionals (AFP) conducted a survey to assess the degree to which end users of derivatives have modified their behavior in response to SFAS 133 (AFP, 2001). The survey revealed that approximately two-thirds of survey respondents believed that SFAS 133 imposed an excessive corporate reporting burden. As a result, a significant portion of these respondents reduced their use of derivatives. In addition, approximately a quarter of the surveyed companies said they elected to mark a significant portion of derivatives to market through earnings, rather than devoting time and expense to the process of qualifying for special hedge accounting. An Alternative Approach to Hedge Accounting As mentioned earlier, the implementing of hedge accounting approach as stated in SFAS 133 would result in problems of comparability among firms, even though those firms hold identical investment securities, and had acquired or issued identical derivative instruments. For example, as Wilson et al. (1998) affirm, “a company whose strategy is to establish an asset-liability match can account for a hedging instrument differently depending on whether it designates the instrument as hedging the investment or the debt”. A way to avoid this kind of problem would be to use the same accounting criteria for any type of hedging relationship. In other words, it does not matter what kind of hedge is being used by the company, the really important thing would be whether there is such a hedging relationship or not. In this way, when a company uses a derivative instrument for a hedging purpose, the accounting for this derivative will be the same as the one used by another company using the same derivative for the same purpose, independently of the type of risk being hedged. I will illustrate this approach by using the same example previously commented. With the same data, assume that Company A designates the interest rate swap as a hedge of the changes in the fair value of the note payable attributable to changes in market interest rates. Table 3 shows the effects of this alternative approach on the accounting for this hedging relationship. As you can verify by comparing Table 1 with Table 3, the effects on earnings of this approach are the same as those of the fair value hedge under SFAS 133 provisions. That is, the swap converts the debt from a fixed rate to a variable rate. However, the alternative approach does not change the carrying amount of the debt, so such a debt is accounted for in the same way as if Company A had designated the swap as a cash flow hedge of the variable rate interest receipts on the investment. Following this approach, the debt, the investment and the swap are accounted for in the same way, regardless of the type of hedging relationship involved. Consequently, there would be no comparability problems arising from applying this approach. Therefore, and to sum up, the effective portion of a gain or loss on a hedging derivative instrument should be recognized as a component of other comprehensive
786
F. G. Hern´andez Hern´andez Table 3 Effects of the alternative approach on fair value hedge Swap debit (credit)
January 2, 2001
0
OCI debit (credit)
(9,103)
9,103
December 31, 2001
(9,103)
9,103
5,000 8,842
December 31, 2002
4,739
Payments (receipts) Changes in fair value of swap Reclassification to earnings December 31, 2003
(5,000) 261 $0
Cash debit (credit)
$60,000
$(60,000)
$60,000
$(60,000)
$60,000
$(65,000)
0
Payments (receipts) Changes in fair value of swap Payments (receipts) Changes in fair value of swap Reclassification to earnings
Earnings debit (credit)
(8,842) (5,000)
$5,000
(4,739)
$65,000
$(65,000)
$60,000
$(55,000)
(261) 5,000 $0
$(5,000) $55,000
$(55,000)
income. It should be this way whatever is the derivative instrument or the risk being hedged. The gain or loss recognized in accumulated other comprehensive income should be reclassified into earnings in the same period or periods during which the hedged item affects earnings. If the hedged item is a recognized asset, the gain or loss previously included in other comprehensive income should be reported in earnings in the period or periods in which the asset is sold, the expense of depreciation or interest is recorded, or the interest income is recognized. In the case that the hedged item is a recognized liability, the gain or loss on the hedging derivative should be reclassified into earnings in the period or periods in which that liability is settled, or a interest expense is registered. If the derivative instrument is used to hedge a forecasted acquisition of an asset, the gain or loss recognized in other comprehensive income should be included in the initial measurement of that asset. In this way, the deferred gain or loss should affect earnings at the same period as the asset is sold or depreciated, and there should be no need of verifying in each period which amount should be reclassified. Finally, if the derivative instrument hedges the forecasted incurrence of a liability, the gain or loss should be recognized in earnings when the liability affects earnings, in the way stated previously for the hedge of an existing liability. With respect to fair value measurement, if the derivative instrument is traded on an organized exchange, there will usually be reliable quoted prices, so the gain or loss on that instrument could be recorded daily. Moreover, the amount of such a gain or loss will be the same for any company holding that derivative. As stated earlier, if the derivative instrument is not traded on an organized exchange, its fair value should be determined by using some valuation technique. As Schuetze (2001) suggests, the FASB would have to develop standardized valuation techniques for use by reporting companies when estimating the cash sales price of an asset if there is no liquid market for that kind of an asset. However, in paragraph 56 of SFAS 107 (FASB, 1991), the FASB stated that it preferred general rather than
Derivatives and the FASB
787
detailed guidance even though general guidance may result in disclosures that are less comparable from entity to entity. In spite of the FASB’s preference for a general guidance on how to estimate fair values, it would be necessary to develop a detailed guidance or standard methods or assumptions for valuation purposes, in order to achieve that financial statements are comparable from company to company. Conclusions Despite the FASB states that SFAS 133 increases the visibility, comparability, and understandability of the risks associated with derivatives, implementing that Statement give as a result serious problems of comparability among financial statements from different companies. Under SFAS 133, the accounting treatment of derivatives and hedging activities can be very different among companies, so it has as a result in problems to compare the financial information from several entities since they can use several alternatives to report the same instruments or hedging activities. The way to avoid this kind of problem should be to use the same accounting treatment for all the derivatives and for all hedging activities. In this sense, the effective portion of the gain or loss on a derivative instrument used in a hedging relationship should have to be recognized in other comprehensive income and reclassified into earnings in the same period or periods during which the hedged item affects earnings. This approach of hedge accounting should avoid the problems of comparability arising from the application of FASB Statement No. 133, as the gains or losses on derivative instruments designated and qualified as part of a hedging relationship should be accounted for in the same way, regardless of the type of derivative instrument used and of the kind of risk being hedged. Although I have illustrated some of the problems of applying the SFAS 133 provisions, insufficient time has elapsed for proper analysis of the impact of SFAS 133. Future research could consider the effect on the companies’ securities price of the application of SFAS 133. Studies in the future could also investigate the changes in use of different types of derivatives, and how the managers have adjusted their hedging strategies. Acknowledgements I would like to thank George Benston for many helpful comments and Tony Tinker (The Editor) and two anonymous reviewers for constructive suggestions. Notes 1. You’ve read about large losses associated with the use of derivatives by firms such as Procter & Gamble ($137 million), Metallgesellschaft ($1 billion), Barings PLC ($1.3 billion) or Orange County, California ($1.7 billion).
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F. G. Hern´andez Hern´andez
2. SFAS 133 really states a foreign currency hedge, but this type of hedge are actually divided into the following: (a) Hedge of a foreign-currency-denominated firm commitment, accounted for as a fair value hedge. (b) Hedge of an available-for-sale security, accounted for as a fair value hedge. (c) Hedge of a forecasted foreign-currency-denominated transaction, accounted for as a cash flow hedge. (d) Hedge of a net investment in a foreign operation. In this hedge, the gain or loss on the hedging derivative or nonderivative instrument is reported in other comprehensive income as part of the cumulative translation adjustment. 3. FASB Statement 80 stated that a change in the market value of a futures contract that hedged the price or interest rate of an anticipated transaction should be included in the measurement of the subsequent transaction.
References Ashley, L. & Bliss, R., “Financial Accounting Standard No. 133—The Reprieve”, Chicago Fed Letter, No. 143, July 1999. Association for Financial Professionals (AFP), 2001, “The Impact of FAS 133 on the Risk Management Practices of End Users of Derivatives”, available online at [pdf-non/research/fas1330601.pdf] [accessed August 19, 2002]. Barton, J., “Does the Use of Financial Derivatives Affect Earnings Management Decisions?”, The Accounting Review, Vol. 76, No. 1, 2001, pp. 1–26. Beatty, A., “The Effects of Fair Value Accounting on Investment Portfolio Management: How Fair Is It?”, Review (Federal Reserve Bank of Saint Louis), Vol. 77, No. 1, 1995, pp. 3–17. Benston, G. J., “Accounting for Derivatives: Back to Basics”, Journal of Applied Corporate Finance, Vol. 10, No. 3, 1997, pp. 46–58. Clark, M. W. & Li, J. F., “SFAS No. 115: New Accounting Rules for Investments in Debt and Equity Securities”, The Ohio CPA Journal, Vol. 53, No. 1, 1994, pp. 29–33. DeMarzo, P. M. & Duffie, D., “Corporate Incentives for Hedging and Hedge Accounting”, The Review of Financial Studies, Vol. 8, No. 3, 1995, pp. 743–771. Financial Accounting Standards Board (FASB), “Statement of Financial Accounting Standards No. 80”, Accounting for Futures Contract (Stamford, CT: FASB, 1984). Financial Accounting Standards Board (FASB), “Statement of Financial Accounting Standards No. 105”, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentration of Credit Risk (Norwalk, CT: FASB, 1990). Financial Accounting Standards Board (FASB), “Statement of Financial Accounting Standards No. 107”, Disclosures about Fair Value of Financial Instruments (Norwalk, CT: FASB, 1991). Financial Accounting Standards Board (FASB), “Statement of Financial Accounting Standards No. 115”, Accounting for Certain Investments in Debt and Equity Securities (Norwalk, CT: FASB, 1993). Financial Accounting Standards Board (FASB), “Statement of Financial Accounting Standards No. 119”, Disclosure About Derivative Financial Instruments and Fair Value of Financial Instruments (Norwalk, CT: FASB, 1994). Financial Accounting Standards Board (FASB), “Statement of Financial Accounting Standards No. 133”, Accounting for Derivative Instruments and Hedging Activities (Norwalk, CT: FASB, 1998). Financial Accounting Standards Board (FASB), “Statement of Financial Accounting Standards No. 137”, Accounting for Derivative Instruments and Hedging Activities—Deferral of the Effective Date of FASB Statement No. 133—An Amendment of FASB Statement No. 133 (Norwalk, CT: FASB, 1999). Hentschel, L. & Smith, C. W., “Risk and Regulation in Derivatives Markets”, Journal of Applied Corporate Finance, Vol. 7, No. 3, 1994, pp. 8–21. Journal of Accountancy, “Economic Impact of Accounting Standards—Implications for the FASB”, Journal of Accountancy, Vol. 143, No. 5, 1977, pp. 89–99.
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