Appendix 5.2. Disclosure Reform After the P&G-BT Swaps. Introduction FAS 119. The Securities and Exchange Commission Reforms

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1 Appendix 5.2 Disclosure Reform After the P&G-BT Swaps Introduction Since 1992, the Financial Accounting Standards Board (FASB) has been meeting formally to develop corporate derivative reporting standards that are transparent, consistent, and comparable. The goal has been to build a reporting system that would allow anyone to determine the types of derivative risks a company is bearing and to calculate the sensitivity of the company s earnings and cash flows to those risks. But finding an optimal reporting standard has not been easy. It makes no sense to evaluate derivatives in isolation because many derivative exposures are taken to hedge other positions; so, a way has to be found to link derivatives to existing balance-sheet positions and expected transactions, as well as linking changes in derivative positions to changes in balance-sheet positions and to gains and losses recognized in the income statement. FAS 119 In 1994, FASB passed FAS 119 (Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments), which was a significant step forward. FAS 119 established rules for the measurement, recognition, and disclosure of accounting information on derivative financial transactions. But FAS 119 turned out to be only an intermediate step toward FASB s eventual goal of transparent disclosure. Companies and regulators found the standards to be vague about the type of information they should report and how it should be reported. As a result, every company seemed to have its own way of reporting the different types of market risks, thereby making it difficult to compare financial information among companies. The Securities and Exchange Commission Reforms In 1997, the Securities and Exchange Commission (SEC) helped to rectify this deficiency by amending its rules concerning the form, content, and A.5.2.1

2 FAS 133 A requirements for financial statements in the U.S. Securities Acts. 1 These amendments were important because they helped clarify the accounting disclosure requirements for FAS 119 and gave better direction to companies about quantitative and qualitative information needed to report the market risk of derivatives and other financial instruments. The SEC amendments defined key items that companies were supposed to include in their financial footnotes when they reported derivative transactions. Among the most important were (1) a discussion of the method used to account for derivatives and the method used if certain criteria were not met, (2) the method used to account for existing derivatives and anticipated derivatives at every point in their life cycles (i.e., inception, ongoing, termination, and maturity), (3) the types of derivative financial instruments and derivative commodity instruments accounted for under each method, (4) a discussion of the criteria needed for the accounting method used, including a description of the conditions for hedge or deferral accounting and accrual or settlement accounting, and (5) a clear indication of when and where the derivative values would be reported in the financial statements. The SEC amendments helped, but FASB was still wrestling with the proper accounting rules for the disclosure of derivative instruments. FASB was frustrated by the lack of guidance on what constituted a hedge and how hedges should be recorded. There were strong suspicions that companies were manipulating hedge accounting rules (i.e., cherry-picking ) by declaring derivative profits at the most convenient times and arbitrarily changing which particular derivative hedged which particular exposure. Finally, disclosures under the SEC regulations appeared in a section separate from the footnotes of companies 10-K reports, and the level of aggregation was too high for many meaningful analyses. FAS 133 In 1996, FASB published a draft of a new standard (FAS 133), but the reforms were severely criticized by a wide range of powerful vested interest 1 See Regulation S-X and Regulation S-K of the Securities and Exchange Commission, 17 CFR Parts 210, 228, 229, 239, 240, and 249 [Release Nos ; ; IC-22487; FR-48; International Series No. 1047; File No. S ]. RIN 3235-AG42, RIN 3235-AG77, Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative Information About Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments. The amendments to Regulation S-K did not apply to investment companies.

3 A APPENDIX 5.2: Disclosure Reform After the P&G-BT Swaps groups (e.g., corporations, banks, dealers, regulators, and members of Congress). As a result, FASB went back to the drawing board, and in June 1998, it published a new version of FAS 133 (Accounting for Derivative Instruments and Hedging Activities), which established accounting and reporting standards for derivative instruments, including hedging transactions and instruments with derivatives embedded in them. FAS 133 turned out to be one of the timeliest, most controversial, complicated, and comprehensive standards ever published by the FASB. 2 REACTION TO FAS 133 FAS 133 was controversial because it standardized the accounting treatment for all derivative instruments, and it lifted the value of derivative transactions out of companies footnotes and supplemental reports and placed them squarely in the balance sheets and income statements. Many companies objected to the new rules because they felt their reported earnings and cash flows would become more volatile. They also felt that their financial ratios would be altered so drastically that comparisons to the past would be impossible. 3 Others worried that the new rules would promote the use of over-the-counter derivatives, which are more expensive and less liquid than exchange-traded derivatives. The emphasis on over-the-counter derivatives was driven by the need under FAS 133 to line up specific hedges with explicit balance sheet positions and to prove that these hedges would be effective more about this later. On the users side, financial analysts criticized FAS 133 because, like the 1997 SEC amendments, disclosures appeared in two different sections of companies 10-K reports and the level of aggregation was too high for many financial analyses. 2 FAS 133 amended FASB Statement No. 52, Foreign Currency Translation, to permit special accounting for the derivative hedges of forecasted foreign currency transactions. It supersede[d] FASB Statement No. 80, Accounting for Futures Contracts, No. 105, Disclosure of Information About Financial Instruments With Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, and No. 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments. It amend[ed] FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, to include in Statement 107 the disclosure provisions about concentrations of credit risk from Statement 105. This Statement also nullifie[d] or modifie[d] the consensuses reached in a number of issues addressed by the Emerging Issues Task Force. See Financial Accounting Standards Board, Summary of Statement No. 133 Accounting for Derivative Instruments and Hedging Activities (Issued June 1998), summary/stsum133.shtml. Accessed 20 January At the time, over 96% of large banks derivatives were for trading purposes (under 4% for hedging), and, therefore, they were already marked to market on their balance sheets. By contrast, only about 21% of small banks derivatives were for trading purposes, which meant that about 79% were hedges. Clearly, the small banks were more threatened than the large banks by the new rules requiring all entities to justify their hedges. See Lisa Ashley and Robert Bliss, Chicago Fed Letter: Financial Accounting Standard No. 133 The reprieve, No. 143 (July 1998), 1 3.

4 FAS 133 A FOUR PRINCIPLES OF FAS 133 Even though FAS 133 was a complicated and detailed statement, it was built on four fundamental principles: 1. All derivatives should be measured and reported by all companies on their balance sheets at their fair market values because derivative instruments had defined property rights or obligations that qualified them as assets or liabilities Changes in the value of all derivatives by all companies should be measured and recognized as either income or changes in equity (i.e., other comprehensive income ) when they occur. 3. Hedge accounting for derivatives is possible, but only if companies meet stringent criteria. 4. Disclosure should be transparent, consistent, comparable, and extensive. Under the new rules, some positions that previously were not recorded as derivatives had to be counted as derivatives. For instance, embedded options had to be isolated from the host contract and measured whenever (1) the derivative s risk features were different from the host, (2) the host position was not revalued at its fair value, and (3) the embedded option, if it were separate, would be a derivative as defined by FAS 133. In the same sense, the new rules disallowed companies from using hedge accounting for certain derivatives that previously were thought of as hedges, such as knock-in and knock-out deals, written options (unless it was offsetting a long option), basis swaps (unless both variables were linked closely with two separate cash-flow positions), and derivatives connected to purchase and sale contracts done in the normal course of business where physical delivery of the commodity was probable. 5 HEDGE ACCOUNTING UNDER FAS 133 If a derivative instrument does not qualify as a hedge, then changes in its value are recorded as income in the current period. To qualify for the special hedge accounting under FAS 133, a derivative has to be classified as a fairvalue hedge, cash-flow hedge, or foreign currency hedge. A fair-value 4 Note that it is the value of the derivative that is being recorded. Therefore, a derivative with a receivable worth $1 million and a payable worth $1 million would have a value of $0. Only if the receivable and/or payable values changed would the value of the derivative change. Also note that this standard requires embedded derivatives (e.g., callable loans, loans with prepayment provisions, convertible debt, and knock-in notes), which are not clearly and closely related to the risks and characteristics of the host contracts, to be separated from the hedged positions and accounted for separately as derivatives. 5 This exclusion did not apply to financial instruments.

5 A APPENDIX 5.2: Disclosure Reform After the P&G-BT Swaps hedge is a derivative position that partly or fully neutralizes changes in the value of an existing asset, liability, or fixed commitment. When a company qualifies for this treatment, then changes in the value of the derivative and changes in the value of the position being hedged are marked to market and recognized in current earnings. Therefore, net earnings are affected only if the hedge is not perfect. A cash-flow hedge is a derivative position taken to neutralize the cashflow risks associated with assets, liabilities, and forecasted transactions, such as loans tied to a floating rate (e.g., LIBOR), the planned purchase or sale of an asset, or the planned issuance of debt. Unlike fair-value hedges, changes in the value of a cash-flow hedge are not reported in current earnings, but rather the effective portion of these hedges is accumulated outside earnings in other comprehensive income, which is a portion of the equity account. The ineffective portion of the hedge is recorded in current earnings. When the hedged position matures, the accumulated earnings or losses that have been recorded in other comprehensive income are reclassified as current earnings and serve to offset the changes in value of the hedged position. Finally, a foreign currency hedge is a position taken to neutralize the earnings or cash-flow risks associated with changes in the foreign-currency denominated value of: 1. An unrecognized firm commitment (same treatment as a fair-value hedge), 2. Available-for-sale security (same treatment as a fair-value hedge), 3. Forecasted transaction (same treatment as a cash-flow hedge), or 4. Net investment in a foreign operation (treated under FAS 52). In general, FAS 133 follows the same rules as the fair-value hedge and the cash-flow hedge, and these rules do not differ significantly from the practices that were already in place prior to 1998 (under FAS 52) for foreign exchange derivative accounting. 6 FAS 133 put heavy reporting requirements on U.S. companies and even auditors have had problems distinguishing a cash-flow hedge and a fairvalue hedge. The level of detail a company needs to qualify for hedge accounting is extensive, complicated, and demanding. Under the initial standard, only derivative contracts qualified as hedges, and the only onbalance-sheet positions that qualified to be hedged were those that could affect either earnings or cash flows. FAS 133 required companies to 6 The only exception is the gain or loss from hedging a net investment in a foreign operation, which is still covered by FAS 52.

6 DIG and FAS 138 A document, at the derivative s inception and on an ongoing basis, a considerable amount of information, including the following: 1. Hedging instrument, 2. Hedged item, 3. Relationship between the hedging instrument and the hedged item, 4. Dates of forecasted transactions, 5. Overall risk management objective, 6. Nature of the risk being hedged, 7. Method used to measure the expected effectiveness (and ineffectiveness) of the hedge, 7 and 8. Risk strategy. Then, on a continuing basis, companies were required to mark their positions to market in order to show that the hedge was, indeed, effective. In general, companies had to identify and report, as well as measure or estimate, the value of all existing derivative positions, including changes in the value of existing and failed derivative positions. Because the new reporting requirements were extensive, expensive to implement, and confusing, companies needed a significant amount of time to implement them. Months were needed just to assess existing derivative contracts. More time was needed to modify company practices and procedures, but the longest amount of time was spent designing and implementing information systems to track the old and new derivative positions. In all, it could take 18 months or longer to complete the transition. As a result, companies were given two years, until 15 June 2000, to comply with the new standards. 8 DIG and FAS 138 Because FAS 133 was so complicated and left so many issues unresolved, a special group, called the FAS 133 Derivatives Implementation Group (DIG), 7 Companies could use statistical techniques, such as regression analysis or auto-regressive integrated moving average (ARIMA) techniques, to prove the efficacy of their hedges. Hedges had to be matched to particular assets, liabilities, or portfolios with similar risks in order to meet the effectiveness test. Therefore, cross-hedges were not allowed (e.g., hedging a euro exposure with Swiss franc futures contracts). A highly effective hedge was one that had a correlation to the hedged position between 0.80 and 1.25, where the correlation was measured as the change in the fair value of the hedge relative to the risk variable divided by the change in the fair value of the host position relative to the risk variable. If a hedge were 120% effective, then it would qualify as a hedge, but the extra 20% (i.e., the ineffective part) would be reported as current income. See FASB Statements 80 (Accounting for Futures Contracts), Issued: August 1984, FASB Statement 39 (Financial Reporting and Changing Prices: Specialized Assets Mining and Oil and Gas a supplement to FASB Statement No. 33) Issued: October 1980), and U.S. GAAP rules. 8 If a company s fiscal year coincided with the calendar year, it was given until 1 January 2001 to comply.

7 A APPENDIX 5.2: Disclosure Reform After the P&G-BT Swaps was formed to help clarify the rules. Through the group s efforts, FAS 138 (Accounting for Certain Derivative Instruments and Certain Hedging Activities an amendment of FASB Statement 133) was released on 15 June FAS 138 was not the same paradigm-shifting reform as FAS 133. Rather, it made slight, but meaningful, modifications to FAS 133 in terms of: 1. Expanding the derivative instruments that qualify as hedges, while forcing companies to test for effectiveness more frequently, 2. Allowing hedge accounting for certain natural hedges (i.e., nonderivative positions), 3. Permitting the hedge derivative to have more risk than the position being hedged, 4. Allowing cross hedging (e.g., hedging a Treasury bill exposure with a LIBOR-based financial instrument), 5. Permitting cross currency compound hedges (i.e., joint hedging of interest risk and foreign exchange risk), and 6. Authorizing intercompany foreign exchange hedges. Where Do We Go From Here? FASB 119, FAS 133, and FASB 138 were just the beginning wave of accounting reforms that are sure to continue. New derivative instruments will be developed, and as the market spreads to ever-increasing numbers of companies, the use and abuse of financial derivatives will continue to drive efforts to improve corporate transparency and accuracy.