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Now for the Hard Part
By Barclay T. Leib
If Microsoft's financials are any indication, get ready for plenty of FAS 133-inspired earnings volatility.
"From time immemorial, man has been guided by three primitive instincts: To find food, to find shelter, and to find ways to keep derivatives and hedging activities off financial statements.”
So quips Wharton professor Robert Verracchia. And yet, as almost everyone is aware, an 800-page accounting bulletin, called FAS 133, sits squarely on the rear credenza of most corporate treasurers these days. That document, along with 540 pages of interpretive notes, directs that derivatives contracts be moved out of their traditional home in the footnotes of corporate annual reports and be placed directly on the quarterly balance sheets of America. The standard will soon be embedded in a slurry of 10Q reports to be released at the end of this quarter that may or may not be intelligible to traditional Wall Street analysts.
After years of comment, dissent and uproar, FAS 133 is here and is starting to show its impact in various ways.
For starters, FAS 133 has already resulted in some large transition adjustments by several companies that have early reporting cycles. Lucent was able to improve its total first-quarter revenue calculation with a $30 million gain from its FAS 133 transition, while Disney took a $50 million charge to its fiscal second-quarter earnings.
| "Now the accountants rule everything. Because of FAS 133, we can't do any of the trades we used to—no risk-reversal deals, no three-way option combinations.” |
But the biggest bombshell to date was Microsoft's announcement that it had shouldered a huge $350 million FAS 133-transition loss in its fiscal first quarter last summer. Although the specific culprit in that instance still hasn't been fully disclosed, Microsoft's huge warrant portfolio in private tech companies during a rocky equity market clearly played a part. Microsoft previously held warrant positions at cost or marked-to-market through the balance sheet under the rules of FAS 115. But now, under FAS 133, these warrant valuations and other hedges appear to be swinging all over the place.
Microsoft reported further swings in its investment income for the quarter ended December 31, 2000. In an explanation of that quarter's earnings, the company showed unrealized non-cash losses of $31 million for changes in the time value of options on fair-value hedges, $73 million for changes in the fair value of options for cash-flow hedges, and $342 million for changes in the fair value of derivative instruments not designated as hedging instruments.
Despite all these swings within its earning statement, and according to sources close to the company, Microsoft has not changed the manner, amounts or instruments it uses to hedge. The company does not want to let simple accounting changes alter hedging decisions deemed economically necessary and efficient. But few know what further mark-to-market losses may be popping up in its portfolio this year, let alone in the accounting of other corporations reporting FAS 133-adjusted income for the first time.
Indeed, as corporate treasurers, accountants and auditors alike scratch their proverbial heads about all the new reporting requirements, there is at least some risk that many companies less stalwart than Microsoft may start to completely shun the derivatives world. "A great number of companies are still trying to figure out what the standard means to them on a transactional basis,” says Stephen Wolf, a vice president of derivatives marketing at J.P. Morgan. "I think many of the uncertainties will continue as we move into the end of Q1, before substantially improving thereafter.”
Best intentions
The basic mandate of FAS 133 is to mark all derivatives to market unless one can meet certain documentation tests in advance of the accounting entries. A company can only use non-mark-to-market hedge accounting under very specific circumstances: if a corporate treasurer is able to designate in advance a specific asset or a future cash flow that requires hedging, develop a proposed hedge, and then prospectively and retrospectively test that hedge's effectiveness against the benchmark exposure. FASB has been deliberately vague in defining how to measure effectiveness, suggesting only that a high correlation be found using either regression analysis or cash-flow analysis, but not prohibiting other methodologies. Even when hedge accounting is allowable, any "ineffective portion” of a hedge—including the changes in the time-value portion of an option or a change in an option's value due to changes in implied volatility—must be stripped out and reported immediately to earnings.
According to Roger Ehrenberg, a managing director and head of corporate equity derivatives marketing at Deutsche Bank, "FAS 133 is going to keep accountants busy for a long, long time.” Moreover, a whole swarm of consultants, as well as software vendors, have arrived to help train accountants—most for the first time ever—in derivatives parlance and procedures. And unlike the hullabaloo that revolved around the Y2K issue, FAS 133 is not going away. Instead, by its very scope, it will continue to impact almost every medium-to-large-sized company in America.
Uncreative Monkeys
Not that long ago, corporate treasurers didn't have TO WORRY about such mark-to-market problems. Financial derivatives appeared only in the footnotes of annual reports, and they were carried on company books either at historic cost or amortized over the life of an exposure. Derivative losses could be recorded as assets, embedded derivatives were usually ignored, and hedge accounting was allowed for options but not forwards. All of this occasionally hid material income swings. Treasurers had wide latitude within which to make trading decisions, and some corporate treasuries actually became outright profit centers, complete with strategic positioning. Dow Chemical, for example, historically has had an active trading treasury, as has B.P. Amoco, Dell Computer, IBM and others.
"Those days are gone now,” says one Fortune 500-company senior treasury manager. "Now the accountants rule everything. It took us a great deal of time and effort to get ready for FAS 133. Now that it's here, we can't do any of the trades we used to—no risk-reversal deals, no three-way option combinations. Those trades may still get hedge accounting in certain instances, but our accountants are very conservative.”
So what type of trades does this corporation do now? The answer may still sound complicated, but in reality it is not. "Looking out at our foreign exchange exposures for the first quarter of 2002, for example,” he states, "all we do is buy a quarterly average rate option with a strike set at the average of this year's first quarter price, plus the correct forward points. Then, once we're within that hedged period, we will sell off our exposure day-by-day to match the average. The firm can prove hedge effectiveness on the strategy without jumping through too many hoops. But from my perspective, it's so matched, a monkey could do it.”
This executive is not alone in his misery. Ron Baker, a director in charge of FAS 133 issues at Enron Corp., says that almost half his time this year has been spent helping CFOs, comptrollers and other counterparties who are confused by the standard. "It's not only dealing with FAS 133,” he explains. "There are the additional changes made in FAS 138 and over 100 DIG interpretations.”
DIG stands for the Derivatives Implementation Group—an advisory group to the FASB staff composed of experts from the Big-Five accounting firms plus industry representatives (the latter group of which reputedly has a poor meeting attendance record). Knowledge of many of these DIG interpretations is essential to a full understanding of FAS 133. But the FAS DIG interpretations are so extensive that few have found the time to wade through all the literature.
| "All we do is buy a quarterly average rate option and sell off our exposure day-by-day to match the average. A monkey could do it.” |
There is also a basic confusion as to whose problem this is to solve. "Treasury expects the accounting department to have the answers,” says John Phillips, vice president of treasury management software company Selkirk Financial, "but the accountants and auditors are still struggling with the original interpretation, and are often unwilling to stick their necks out with new DIG rulings still appearing monthly.”
Phillips believes that many corporations are temporarily using home-grown spreadsheets for the first quarter, and are trying to keep their longer-term options open. But by the end of 2001's first quarter he expects that many will be looking for more permanent solutions—particularly once the auditors arrive and critique what has been done to date. Stan Friedman, CEO of Solution133.com, owned by PricewaterhouseCoopers, agrees. "In my 28 years in this business,” he says, "I have been through a great number of FASB Accounting Bulletins. This one is by far the most challenging. It is asking accountants to enter a whole new area—valuing derivatives and testing effectiveness.”
For the moment, therefore, instability and uncertainty rule. An earnings volatility problem may be lurking behind the scenes at many corporate treasuries, but it is unclear if most corporate executives and investors fully fathom the extent of the new problem.
"FAS 133 is rekindling corporate governance and guideline issues that haven't been visited since the 1970s,” says Omer Ettisham, FAS coordinator of Integrity Treasury Solutions. "Management is now rediscovering what treasury really does, and is starting to place new parameters on stated policies previously seldom enforced.”
Taken together, the problems add up to nothing short of Excedrin Headache 133.
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