Should FAS 133 Be ”Marked to Market”?

The discussion of accounting issues surrounding the creditworthiness of issuers may open the biggest hole in FASB's standard on accounting for derivative instruments and hedging activities.

Just how all-knowing are the financial markets? Look for debate to center around this question if the Financial Accounting Standards Board reopens discussion this summer on whether derivatives should be marked to market.

Financial Accounting Standard 133 — Accounting for Derivative Instruments and Hedging Activities — which took effect in 2000, requires companies to include their derivatives on balance sheets and adjust their earnings to reflect changes in market value.

Nearly a decade in the making, few FASB standards caused more outright resentment among business leaders than did FAS 133. Despite dire predictions on the part of financial companies that the requirement would increase volatility in both the balance sheet and earnings arenas and in the process choke off a burgeoning derivatives market, the debate, in the United States at least, has largely settled down.

Now, as part of the effort to wrap up another often-contentious discussion, regarding the board’s Fair Value Measurement project, FASB will consider setting up a separate project (or projects) dedicated to the some of the derivatives-related issues raised during the fair-value comment period. For one, a project based on the Emerging Issues Task Force release EITF 02-3, would deal with accounting for energy-trading and risk-management contracts that are considered derivatives.

But the discussion of accounting issues surrounding the creditworthiness of derivatives issuers may open the biggest hole in FAS 133. In comments on the Fair Value Measurement project, many financial companies complained that marking to market may not always be the way to go, given that the market price may not always reflect creditworthiness.

“We do not believe that in all circumstances the current marketplace reflects the creditworthiness of the obligor to the derivative contract when derivative transactions are unwound or sold,” wrote JPMorganChase executive vice president and controller Joseph L. Sclafani. “We suggest the board meet with us and other derivative dealers to obtain a fuller understanding of the issue from a market perspective.”

Goldman Sachs Group managing director and principal accounting officer Sarah E. Smith expressed similar concerns. “Credit standing of an entity clearly has an impact on the economic value of that entity’s trading liabilities,” she wrote. “Reflecting that impact on the balance sheet results in a better fair value estimate.”

But shouldn’t a consideration like this be priced into the market?

“One would think so,” says Linda MacDonald, manager of the Fair Value Measurement project, adding that the board has decided that early this June, it will consider whether to revisit the derivatives issue. “There are a lot of issues we need to cover with that one.”

In the meantime, FASB — which cancelled the meeting it had scheduled for last Wednesday, May 4 — has released a tentative agenda for its upcoming session this Wednesday. Items on the table for this week’s meeting, which starts at 8 a.m. (an hour earlier than usual), include:

• Employee compensation: classification of freestanding financial instruments. The board will consider comment letters received on proposed FASB Staff Position EITF 00-19-a, which deals with the application of EITF Issue No. 00-19 to freestanding financial instruments originally issued as employee compensation and will discuss whether to proceed to a draft of a final staff position.

• Financial instruments: liabilities and equity. The board will address the following issues related to accounting for single-component instruments: display and measurement (including accounting for issuance costs), recognition of forward contracts, and subsequent classification assessment and the accounting upon reclassification.

• Revenue recognition. The board will discuss whether the objective and scope of the project should be changed.

• Short-term international convergence: accounting changes and error corrections.

• Life settlements. Under discussion will be measurement-model alternatives for life settlements, as well as disclosure requirements and transition.

• An update on amendment of Statement 87, Employers’ Accounting for Pensions, and Statement 35, Accounting and Reporting by Defined Benefit Pension Plans.

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