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Is the Financial Accounting Standard 133 going too far? Back  
Corporate treasurers have given a mixed response to FAS 133, on one hand welcoming the uniformity to risk management it would bring, but they are also concerned it may erode the basis on which they make decisions. Jimmy Doyle highlights some views from the IGTA agm.
The June issue of Finance carried a statement from the IGTA (International Group of Treasury Associations) which expressed the concern of treasurers worldwide over the introduction of the new Standard on Accounting for Derivative Instruments and Hedging Activities or FAS 133 as it is known.

The statement had its genesis in a discussion at the annual general meeting of the IGTA which was held in Woking, Surrey in May of this year. There was fairly unanimous feeling among the delegates from nineteen treasury associations around the world, that while uniformity in risk management and hedging activities was very necessary, FAS 133 may be going too far and be seen to erode the basis upon which treasurers make prudent decisions. This article reflects some of the views of international treasurers as articulated by the delegates at the meeting.

The Financial Accounting Standards Board certainly is right in seeing the need for uniformity in reporting on the use of derivatives in financial accounts. However the opinion of treasurers is that in forcing the proposed accounting changes on companies they may force a change in management behaviour just to comply with the Standard. In other words prudent risk management decisions may be compromised by the need for conformity in accounting rules.

There is a growing need to compare accounting information across borders nowadays. The international investment community needs to be able to compare stocks on a like-for-like basis.

Acquisitive companies need to understand through the accounts the nature of risk management policies in place in a company being acquired. New rules on corporate governance mean that the directors must have full knowledge and agreement of the hedges in place in a company. These are very good reasons for seeking conformity in accounting standards.

It is critical that we do not end up in a situation where accounting requirements are masking the underlying business and economic reasons for hedging in the first place.

In general corporate treasurers can be happy that FAS 133 will offer greater flexibility in risk management. The downside to this however, is the increased flexibility will come at the expense of greater volatility in company earnings’ statements. This is the crux of the conflict between the accountancy criteria and the risk management criteria.

There are three main areas where the reporting/accounting requirements of FAS 133 seem to override the practical considerations of the treasurer.

The Standard places more importance on the tools being used for hedging rather than on the underlying risk being hedged. FAS 133 is aimed at reporting the accounting treatment of the underlying derivative rather than the treatment of the currency (as in FAS 52) or the commodity (FAS 80).

FAS 133 compromises fair value accounting. Deferral accounting as we know it, will become history. The FASB’s preference is for all financial instruments to be reflected in the Balance Sheet at fair value. The effect of this marking to market on a continuous basis would be considerable on the income statement.

The Board’s compromise solution is to offer a parking bay for gains and losses on hedges in the form of ‘Other Comprehensive Income’ (OCI) to companies who are traders of derivatives. The gains and losses are held in OCI until it is time to recognise them in the P&L account. OCI is part of income but not of current earnings. This means that there will be inconsistencies in the treatment of certain gains and losses.

The main criticism of FAS 133 is that it will greatly increase volatility in the income statement.
Volatility in earnings is something which all shareholders in general and the institutional investment community in particular, do not like. This is especially the case when it is caused by events seemingly unconnected with the company’s core business.

What this means is that the cost of an option premium (which used to be amortised in a straight line fashion) will now be seen to have a serious effect on earnings when it occurs, even though the eventual purpose of the hedge using the option is to reduce or eliminate the downside risk in a particular situation and thus save costs in the business.

This marking to market of the time value of the option, which causes income volatility, does not reflect the reality of the reason for the hedge in the first place.

This gives rise to the classic conflict between the accountant (the recorder) and the treasurer (the steward).

The conflict will peak if it is seen that the new derivatives accounting will effect the interpretation of financial statements by investment analysts. This is the main worry of business proprietors and their risk managers /treasurers. Assuming that the analysts completely understand the Standard and the use of derivatives in a set of accounts it remains to be seen whether or not they will criticise companies for their hedging activities. This would of course have a detrimental effect on the views of the investor community on a particular share.

The real danger therefore is that companies who are driven by share price and EPS performance may decide that risk management activities will need to be curtailed in order to eliminate the income volatility, thus leaving the underlying exposure unhedged and endangering the long-term future of the business.

Jimmy Doyle is a founder member and former chairman of the Irish Association of Corporate Treasurers (IACT) and is the IACT delegate to the IGTA.

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