Good Morning, Volatility

FASB's latest accounting rules for derivatives may not be the nightmare once feared. But compliance could still cost considerable sleep.

D-Day is here. On June 16, the long-awaited and much-debated new rules on accounting for derivative transactions became part of generally accepted accounting principles in the United States. No more delays for Y2K-stressed treasury departments. No more opportunities to amend the rules. Beginning with their first fiscal year-end after the deadline, U.S. corporations — and foreign corporations with a stock listing in the United States — have to include their derivatives on balance sheets and adjust earnings to reflect changes in their market value.

Financial Accounting Standard (FAS) 133 is the first standard issued concerning derivatives since 1984 — a 16-year interval during which the use of derivative instruments by U.S. corporations has exploded. Not surprisingly, the standard is a complicated and controversial handful. It has 540 paragraphs and some 250 interpretations of how to apply the rules. At times, it gives explicit direction on how companies can qualify for hedge accounting treatment, where gains and losses on derivatives can be deferred until they mature. At other times, the guidance is vague. “The closer you look at [FAS 133], the uglier it gets,” says consultant Jeff Wallace of Greenwich Treasury Advisors, in Greenwich, Connecticut. “It will be a lot more difficult for companies to smooth out earnings.”

Ugly or not, FAS 133 is now part of GAAP. Not only will complying with the standard involve more work and more headaches for finance executives, it will also result in more earnings volatility. And with the derivative-induced blow-ups at such companies as Procter & Gamble Co. and Gibson Greetings Inc. a not-so-distant memory (not to mention Orange County and Long-Term Capital Management), many risk managers worry about how the market will react to the new information. “Derivative is still a four-letter word,” says Jonathan Boyles, director of financial standards at Washington, D.C.-based Fannie Mae, which held $240 billion worth of interest-rate swaps at the end of last year. “People may see our use of derivatives and think we’re taking on a lot of risk, when that’s not the case.” Indeed, with its multi- billion-dollar portfolio of mortgage loans, Fannie Mae relies on derivatives to mitigate its risk.

Not Unworkable

At least, says Boyles, the current version of FAS 133 is an improvement over the board’s initial proposal. The first draft of 133 drew widespread criticism when it was issued in June 1998. Corporate risk managers and derivatives experts identified dozens of ways the new rules would increase earnings volatility and bias corporate hedging strategies in an effort to avoid that volatility. On March 3, however, FASB issued an exposure draft of four amendments to the standard. While risk managers are hardly happy with the new burdens FAS 133 will impose on their accounting and treasury departments, the amendments have smoothed some ruffled feathers. “It’s workable now,” says Boyles, who has spent the past 18 months preparing his accounting systems to comply with 133.

Here’s a look at FASB’s amendments:

1. Interest-rate risk. From Boyles’s perspective, the most important amendment relates to the use of derivatives based on a benchmark interest rate. Fannie Mae’s most significant risk exposure is to changes in prevailing interest rates. If market rates rise, the value of Fannie Mae’s fixed-rate mortgages falls. To hedge that risk, the company can enter into an interest-rate swap to exchange its fixed rate for a floating rate.


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