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FASB Fallout
Treasurers and CFOs are by no means agreed about the effects of the FASB
proposed standard on the accounting treatment of derivatives. In assessing
the effects on the four companies below, these financial officers are perplexed
by some of the gray areas of the exposure draft, particularly the treatment
of FX risk. By oversimplifying the definitions and not treating all derivatives
as equal, this new standard, some say, will bring boom times to new product
wizards at derivatives shops.
But for all companies, the main question is still, "How will it
affect us?" And the answer, while not absolutely set in stone, seems
to be, "Not too much." Which is the best that can be hoped for
from a new accounting standard-no one's favorite piece of e-mail.
Joan Varrone
Treasurer, Watkins Johnson
My concerns about the new accounting standards for derivatives instruments
is as follows: the mark-to-market of hedges of anticipated transactions
through a new component of income, or comprehensive income, causes concern
in that it creates volatility in earnings at this new income line. While
FASB may think that the market will ignore this income figure, if it is
disclosed it is bound to receive scrutiny. The irony of the situation is
that companies that choose not to hedge anticipated transactions may appear
to have smoother earnings when in fact the future cash flow and earnings
of such a company may be exposed and subject to more volatility than a company
that has implemented a well-thought-out hedging program.
In addition, the inclusion of currency translation adjustments in comprehensive
income will affect companies with overseas manufacturing assets financed
by capital and retained earnings. While a hedge of these assets would offset
the translation adjustment, it might not make economic sense as a cash instrument
is being used to protect an asset which will not be converted into cash.
There is also an issue of practicality in the proposal to move a hedge
of an anticipated transaction for comprehensive income into net income once
the hedge matures, regardless of the timing of the underlying transaction.
It is very difficult to predict the timing of transactions when hedging,
for example, third-party orders. This is particularly troublesome if you
are hedging an individual transaction versus a portfolio of many small transactions.
The ability to roll hedges forward and back in response to the movement
in the timing of the underlying exposure is an important hedging tool in
managing a currency hedging program. It is clear that FASB has not had practical,
hands-on experience in managing a hedging program.
Richard Laiderman
Senior vice president, corporate treasury, Bank of America
Even though under the FASB proposal the maturity of a derivatives hedge
must match the maturity of the underlying instrument, we would probably
not want to change the maturities of our hedges, since we believe our current
hedges accurately reflect our net enterprise risk. Microhedging is not only
inefficient in terms of transaction costs, but it is more open to abuse.
We cannot understand why FASB seems to prefer microhedging.
Instead we would probably select new hedging instruments which do not
fall within the scope of FASB's new definition of derivatives. We would
expect many such instruments to emerge circumventing FASB's weak attempt
to define derivatives. It is interesting to note that the definitions also
appear to classify as derivatives many normal floating rate loans which
are priced at multiples of an index, such as 1.25 times prime or LIBOR.
I think interest rate swaps will continue to be an important risk management
tool although less so than presently. I do not agree that fixed and floating
obligations are treated differently. It is simply that when looked at on
a stand-alone transactional basis, there is generally little price risk
in a floating rate obligation so there is nothing to hedge. As I understand
it there is no difference; changes in market value can be hedged for either
fixed or floating rate loans. If a floating rate loan has price risk due
to caps, floors, basis, credit or any other reason, it could be hedged on
a fair value basis.
We do not currently hedge anticipated FX risk. We may start now that
forwards are allowed, but it is not likely to be a significant activity.
Our activity is mostly net investment hedging where the new standards have
not really changed from the existing FAS No. 52. We had understood FASB's
mandate was to change both FAS No. 52 and FAS No. 80 in a combined and consistent
way. It is unclear why they have left FX risk on net investments unchanged
and inconsistent with, albeit better than, the rest of the new standard.
It is better because it allows the bifurcation of risk types. Bifurcation
should be allowed for all hedging activities since that is how the markets
are organized to manage risk.
As a financial institution our agricultural and commodities activities
are mainly on behalf of our customers. For our own account, hedging is restricted
to interest rate risk and FX risk. It does seem, however, that the new standards
have been designed to accommodate industrial and agricultural firms by excluding,
from the definition of derivatives, contracts which require ownership or
delivery of the underlying.
Dale Ribaudo
Treasurer, Dexter Corporation
It is definitely time for the accounting profession to move forward on
this topic so that we can finally bring an end to the on going debate and
inconsistent treatment surrounding disclosure of derivative instruments.
Given the scope of the proposed changes, the first item on our agenda at
Dexter will be to evaluate the impact of the new rules on our currency management
practices. We will focus on the issue of hedging anticipated third party
and intercompany transactions. Under existing accounting literature, it
has been difficult to hedge anticipated transactions on behalf of our operations
and achieve hedge accounting treatment using forward contracts or complex
options. This has been quite frustrating for the treasury group as we attempt
to assist those operating managers who have wanted to lock in their future
gross margins using forward contracts while still obtaining hedge accounting
treatment.
Obviously options could have been used as an alternative, but they were
not the preferred instrument in all cases. Although we continue to hedge
firm commitments, the proposed rules should allow corporate treasuries to
greatly expand their hedging of forecasted transactions and thereby remove
some the gross margin volatility caused by currency exchange rate volatility.
Unfortunately, we all will have to deal with the added accounting complexity
of the proposed rules including the monthly calculation of forward fair
values. From a currency management perspective, the FASB has given the practitioners
a very workable solution but it does not come without an added amount to
complexity in the area of financial reporting.
Robert A. Westoby
Director, global treasury operations, Monsanto Co.
Monsanto's position regarding the use of derivatives is to match exposures
to the derivative product, including maturity. This position will remain
unchanged. We expect to be able to continue to use interest rate swaps but
we will need to assess the accounting and cash impacts from the different
treatments.
In the area of currency transactions, a key issue has always been to
match exposures to the hedging strategy by period. We believe the wider
the array of products available, the better.
Managing exposures (in the commodity or agricultural markets) will be
reassessed by analyzing the accounting and cash impacts from any proposed
or introduced changes. Only after this is done will we decide on any changes.
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