Will two new proposals spur a compromise?

By John Thackray

Four years ago, when FASB held a Silicon Valley hearing on proposals to revise the off-balance-sheet treatment of executive stock options, the meeting attracted marching bands and scores of noisy demonstrators wearing buttons proclaiming, "Down with FASB." In the end, the protesters prevailed, FASB retreated and options remained an off-balance-sheet item.

FASB's hearings on its exposure draft regarding the accounting treatment for derivatives, held November 15­20, were a bit more staid, but there was no shortage of outrage.

For board members the hearing was something akin to opening a show on Broadway you were certain would flop. Before the meeting, a review by the FASB staff of the written comments from more than 250 sources showed only two wholeheartedly in favor of the proposal. According to an analysis of the comment letters by CIBC Wood Gundy and Price Waterhouse, 85 percent disagreed with the exposure draft and called for either its modification or outright demolition.

The hearing began with FASB chairman Dennis R. Beresford's laconic opening remarks, which stressed the critical part these open hearings had had on the standard-setting process. Then the four-day-long parade of gentlemanly mudslinging at the exposure draft began.

Common cause

The early testifiers gave strong indications that as much as they hated the exposure draft, they liked many of the features of two separately crafted counterproposals from Ernst & Young and Arthur Andersen, which had been made public some weeks earlier. Among their endorsers were groups as diverse as the End Users of Derivatives Association (EUDA), General Electric and the Financial Executives Institute.

As the hearing rolled on, board members, who seemed to be a little stunned at the ubiquity of the discontent of the testifiers, began questioning witnesses as to what they thought of the alternatives from the accounting giants. Intentionally or not, the board thus indicated that these rogue models would be given prominence in private deliberations during the coming months and could provide a platform for diluting the exposure draft. "I guess I'm optimistic that what we proposed will be attractive to them," says Arthur Andersen's John E. Stuart. "A lot of people are making comments that have some similarity to ours, so we're not just out there by ourselves on some of these points."

The Ernst & Young and Arthur Andersen proposals both attempt to conform to FASB's long-range goal of establishing value-based accounting-the so-called conceptual framework-by allowing derivatives to be marked to market and put in the balance sheet every year. After this concession both go off in separate directions. Although the Arthur Andersen proposal approves of the "comprehensive income" category as the repository of many value changes in derivatives, Ernst & Young, hewing to a more conservative line, wants no truck with this newfangled category.

Both accounting firms would take a less restrictive view than FASB of what constitutes a legitimate hedge. In their separate ways, both proposals reduce the extreme earnings volatility that is the predicted effect of the exposure draft. Andersen states the problem elegantly on page two of its 49-page comment letter:

"We sense that FASB has struggled with a tradeoff between improving financial reporting to achieve accounting consistent with 'the economics' (that is, representational faithfulness) and the need to prevent perceived abuses, set limits, reduce subjectivity. We opt for the first and believe that the Board has leaned too much to the second," particularly in its prohibitions on basis adjustment for cash flow hedges, its prohibitions against bifurcation and its restrictive definition of permissible hedges.

Nixed basis risk

Both proposals reject the exposure draft's position on the income statement timing and measurement and want instead "basis adjustment" as it exists at present. The exposure draft, for example, when considering gains and losses from a futures contract to hedge a proposed commodity purchase, would record those gains and losses in earnings at the time the goods are actually purchased. Thus the exposure draft's accounting prevents adjusting the basis (or locking in the price) of the commodity and goes against the very reason to hedge. The exposure draft's effect would be similar for a forward rate agreement (FRA) entered into by a corporation in anticipation of issuing debt. Gains and losses on the FRA would be booked to earnings when the public debt is issued and not treated as a countervailing adjustment to the price of the loan.

Innocent until guilty

The exposure draft may reflect the board's suspicion that present accounting practices fail to reveal abuses and hide forms of hedging that are really speculation in disguise. Ernst & Young's Michael Joseph notes that both his firm's and Arthur Andersen's model "start from the assumption that management is responsible. We both support the idea of not having the exposure draft's most detailed criteria. Companies who say they are hedging should be believed that that indeed that is what they're doing."

The Ernst & Young model, like the Andersen proposal, is willing to tolerate a lot more subjectivity than the exposure draft permits. For Ernst & Young this means allowing companies to make an election of where a transaction belongs in one of three categories: trading, risk management (that is, hedging) or "other" derivatives.

The exposure draft and Andersen proposal both want to hook derivatives to specific assets and liabilities. Ernst & Young, however, say that in the real world, especially the real world of banks and insurance companies, companies hedge their overall risk management exposures. Hence the "other" elective bucket it has put forward, where items that have no specific offsets can be lodged. This group of derivatives would be recognized at fair value with changes in value recorded in a separate component of equity until realized. Meanwhile, situations in which the link between the derivative and the asset of liability is direct would be thrown into the second risk management bucket.

What's the merit of this approach? Simple, says Joseph. "Many companies are managing risk on the global basis by doing sensitivity analysis or VAR, that is, layering derivatives into the balance sheet to reduce the volatility of that aggregate measure. For them the process of having to take a derivative and designate it to a specific asset or liability is very artificial. Besides being a burdensome requirement it does not reflect the economic reality that what is being hedged is not, say, a bank's loan, but the relationship between the loan and the deposit."

Revised opinion

It is anybody's guess how deeply the board will ponder these suggestions. At one point in the hearing the most combative board member, James J. Leisenring, seemed vexed at the contradictions and inconsistencies between these rogue proposals and the exposure draft. "They are not the same. How would you reconcile the differences?" he demanded of the EUDA representatives. They replied that they simply thought the exposure draft was the least attractive of the three models.

"I'd hope that FASB would take their objectives plus the best elements of both accounting firm models and develop a workable solution for the business community," says Joseph. "One of the things that struck me during the open meeting when I testified was that they seem to have the view that they have to take our proposal in its entirely, or Andersen's in its entirely, or theirs in its entirety, as opposed to taking elements of each and coming up with something that is really superior. But that didn't seem to be part of their mind-set."

Maybe so. But some retreat from the exposure draft is likely to occur-unless the board is ready for another riot.

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