Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005 107

Statement 133: Not Perfect, but a Step in the Right Direction

by Jane Adams, Maverick Capital

Statement 133, the accounting rule that has governed accounting for derivatives since 2000, has come in for a good deal of criticism. Although some of it is justifi ed, most is based

on a fundamental misconception about what fi nancial accounting is supposed to do.

One goal of GAAP, at least in theory, is to provide two sets of information about a company (or any organization) at a particular point in time:

1) a balance sheet that reports the entity’s rights and obligations (that is, assets and liabilities); and

2) an income statement that reports period-by-period changes in the values of those rights and obligations.

As I will argue, the core provisions of Statement 133 are consistent with this goal and represent progress toward achieving it. By requiring companies to mark their deriva-tives to market and report those values on corporate balance sheets (and changes in those values in income statements), Statement 133 gives investors a clearer picture of what a fi rm owns and owes. Before such reporting became mandatory in 2000, there were no standardized fi nancial reporting requirements for derivatives. The absence of rules constrain-ing when and how the effects of corporate derivatives would be reported in the fi nancial statements, and the resulting diversity in corporate practices, meant that investors had little way of knowing 1) what the net positions were and 2) how derivatives were being used. When it came to deriva-tives, even with the disclosures required by FASB, investors were truly in the dark.1

But if the fair value accounting prescribed by State-ment 133 has provided clarity for investors about corporate derivative positions, it has also led to at least the percep-tion of more volatile earnings—a perception that, however questionable (as I will argue below), has been one of the main reasons for corporate resistance to the rule. Much of this volatility seems “undeserved” or “artifi cial” to those

business executives who would describe their use of deriva-tives as mainly to hedge underlying exposures. But what’s important to recognize here—and seems widely misunder-stood—is that the objective of GAAP income statements is not to provide a “normalized” or “smoothed” measure of fi nancial performance. And GAAP earnings per share was never meant to be used, as it so often is, as the defi nitive measure of corporate performance—a single number that can simply be capitalized at some market- or industry-wide P/E multiple to arrive at a company’s value. It is the job of analysts, not accountants, to determine which elements of a company’s P&L are likely to be recurring and central to the business…and which are not. As for the critics’ charge of excessive volatility, much of this volatility is likely, on closer inspection, to refl ect risks that are inherent in the fi rm’s business. And such risks, as I will argue, would in fact be represented more accurately by corporate balance sheets prepared under fair value accounting—and not by the elective hedge accounting allowed by Statement 133.

Today’s GAAP Creates a Need for Hedge Accounting that Would Not Exist in a Fair Value WorldWhat I’ve described up to this point is the theory of GAAP.2 Now let’s talk about the practice. GAAP fi nancial reporting is incomplete and, indeed, woefully inadequate as a basis for analyzing the value of securities. The problems with GAAP can be grouped into three categories: failures of recognition, failures of measurement, and failures of disclosure. Most of these problems, as discussed below, stem from a funda-mental tension in today’s “mixed attribute” accounting model—a tension that is exposed and accentuated by FAS 133’s requirement that derivatives be marked to market.

Recognition Problems. As now constituted, GAAP fails to recognize all rights and obligations of business

1. Requirements for derivative disclosures were developed piecemeal by the FASB during the early 1990s. Yet even with those disclosures, investors remained vulnerable and exposed to losses like those experienced by P&G and Gibson Greeting in the early ’90s. Such losses also coincided with, and likely furthered, investors’ call for fair value accounting. Even though the FASB’s fi rst Exposure Draft on fi nancial instruments disclo-sures appeared in 1987 and was followed in 1991 by a Discussion Memorandum on recognition and measurement of fi nancial instruments, most of the challenges associated with implementing fair value accounting, both for fi nancial instruments such as derivatives

as well as other corporate assets and liabilities, have yet to be addressed. And as this article suggests, fair value accounting remains a work in progress.

2. I recognize that the FASB pulled its punch when developing the Concepts State-ments underlying GAAP, and that Concepts Statement No. 5, Recognition and Measure-ment in Financial Statements of Business Enterprises, stopped well short of adopting any attribute, let alone comprehensive fair value, as the most relevant measurement attribute.

108 Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005

entities. For example, operating leases, purchase orders, and other executory contracts are among the kinds of commit-ments that are not currently captured on the balance sheet. Statement 133 represents an improvement in this aspect of GAAP by requiring all derivative contracts—most of which were previously recorded at “cost”—to be reported at their fair values. But, as noted earlier, there will be cases when marking derivatives to market exaggerates the volatility and market price sensitivity of earnings—for example, when a derivative is used to hedge the unrecognized exposure of an executory contract. Statement 133 addresses this “one-sided” mark by providing elective hedge accounting to remedy this selective recognition problem.

Measurement Problems. GAAP is a “mixed attribute” model in which some items are reported at fair value,3 some at historical cost, and some at a combination of the two (for example, lower of cost or market). Such a mixture produces measures that border on irrelevant. Positions with identical net cash fl ows can be treated differently, using fair value for one item and historical cost for another (as often happens, for example, in the case of marketable debt securities). When derivatives that are used to hedge an item carried at histori-cal cost are required to be marked to market, the volatility and market price sensitivity of earnings again may appear exaggerated. Statement 133 addresses the measurement problem resulting from this “one-sided” mark by providing elective hedge accounting.

In fact, Statement 133 offers two kinds of hedge accounting: “cash fl ow” hedge accounting, which amounts to reporting the derivatives position at fair value but keeping changes in those values out of the income statement; and “fair value” hedge accounting, which involves reporting both the derivatives position and the hedged position at fair value on the balance sheet, and reporting the changes in both positions in the income statement. But, as I will argue, the fact that companies can choose between these two kinds of hedge accounting—and are not even required to use hedge accounting in such cases—creates a compara-bility problem for investors. It effectively means that three identical companies with the same derivatives positions and exposures could make three different elections—cash fl ow hedging, fair value hedging, and fair value for the deriva-tives position only—and end up looking quite different

to investors. The best solution to this problem would be mandatory fair value accounting for all assets and liabilities, which would not only provide comparability but eliminate the need for hedge accounting and all its associated rules.

In sum, Statement 133 is clearly a response to the recog-nition and measurement defi ciencies of GAAP. But by failing to insist on comprehensive fair value accounting, it has perpetuated the basic incongruity in GAAP that stems from mixing historical costs and current market values.4

Disclosure Problems. To add to the problems caused by permitting three companies with identical exposures to appear different, Statement 133 failed to mandate disclo-sures that would enable analysts to see through the false differences. The FASB’s Exposure Draft (ED) led analysts to believe that the standard would require companies to disclose, among other things, 1) whether the derivatives are being used as hedges, 2) the amounts of all derivative gains and losses, and 3) where such gains and losses are recorded in the income statement. The ED also proposed other required disclosures that would have enabled analysts to adjust the balance sheet and income statement to compensate for certain hedge accounting elections. But such requirements never made it into the version that became Statement 133; the FASB reneged on all of that disclosure.5

On the positive side, Statement 133’s provision for hedge accounting under certain circumstances does address some of the reporting problems that would otherwise occur as a result of GAAP’s recognition and measurement defi ciencies. Take the case of a company with a long-term commitment to take delivery of soybeans at a fi xed price that sells futures contracts to hedge its exposure to a drop in soybean prices. Unless the company receives some special accounting for either the commitment (not recognized currently in the company’s balance sheet) or the futures contracts (changes in value recorded and settled in cash daily), its fi nancial statements would exaggerate the sensitivity of the company’s earnings to changes in soybean prices. Under Statement 133, such a company can elect to use hedge accounting—that is, to report its soybean purchase commitment at fair value so that the changes in both contracts, the futures position and the purchase commitment, are reported concurrently in earnings. And hedge accounting can also be used to elimi-nate the measurement differences that result from reporting

3. Some have raised the issue of the “reliability” of fair value estimates as the ultimate impediment to fair value accounting. Granted, a tradeoff exists between relevance and reliability. I and other analysts believe that fair value information is so relevant that it should be the required measurement attribute. Recognizing that different levels of reli-ability exist depending on the source of the fair value data, we would compensate for the measurement uncertainty with expanded disclosures. These envisioned disclosures would describe the different valuation approaches (for example, along the lines of the FASB’s fair value hierarchy), the instruments and magnitude of assets or liabilities mea-sured under that approach, and a rollforward of the prior period to current-period balance that disaggregates the components of the change into its sources—for example, into changes in valuation, cash received or paid, and other additions or investments.

4. In addition, the permissive cash fl ow hedge accounting encompassed in the State-

ment 133 model moves us even farther away from both FASB’s conceptual core and fair value accounting.

5. The FASB also provided other elections when it fi nally issued Statement 133 but failed to require companies to disclose the election chosen and quantify the effects. For example, if a company selected fair value hedge accounting for its fi xed-rate debt and has recorded changes in value to the debt as a consequence of the hedge, FASB provided that company with a choice as to when it would start amortizing that mark into interest expense (amortization must begin no later than when the hedge is terminated). Consequently, while a company may tell analysts that it has swapped its fi xed-rate debt to variable, its actual calculation of interest expense might not refl ect the consequence of that action.

Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005 109

soybeans held in inventory at historical cost while using futures to hedge the exposure to a price decrease.

But a better solution, as suggested, would be to record all positions at fair value, as opposed to the “micro” match-ing of positions required by Statement 133 (and heavily criticized by companies). In this case, there would be 1) no recognition problem; 2) no need for all the special rules and restrictions that govern when and how to use hedge account-ing; and 3) no undisclosed effects of different elections on a company’s P&L.

When Hedge Accounting Becomes MisleadingAlthough many corporate executives are likely to disagree, Statement 133’s approach went too far when it extended hedge accounting to forecasted transactions. No matter how probable, forecasted transactions do not represent current rights and obligations. For example, although a hurricane is highly likely to occur at some point in August 2005, it should not be accounted for as a loss to an insurance company in December 2004 or in June 2005. Similarly, a planned issuance of debt by a company in October 2006 does not make it a current obligation of the company today. Nor should a company’s next-month foreign currency sales be viewed as contributing to today’s assets and liabilities. It’s true that analysts are interested in forecasting those effects—but they are not assets or liabilities, or revenues or expenses, of the company today, and it is not the business of GAAP to try to capture and report them as if they were. Again, that’s what the analysts are paid to do.

Corporate efforts to “fi x” the prices at which forecasted transactions will occur have consequences today if we stick to GAAP’s mandate of refl ecting all present rights and obligations. Consider the use of futures contracts to hedge next month’s harvest of soybeans. The soybeans are neither currently owned nor contracted for, and so there is nothing to mark. By contrast, the cash settlement require-ments of the futures contracts require recording of changes in the value of the futures contract. Or consider a forward starting swap that “locks in” the rate at which debt will be issued. Both the futures contract and the swap create present exposures—one to soybeans, the other to interest rate changes—that were not previously part of the compa-ny’s existing rights and obligations.

Any hedging model that tries to accommodate the strong corporate preference to associate a change in today’s market price with a forecasted transaction that will not take place until months in the future falls outside the stric-

tures of GAAP. And it does so in two ways. First, failing to record any loss on the swap (due, for example, to a drop in interest rates) would effectively require accountants to accelerate some future revenue into today’s fi nancial results to make present exposures appear neutral (which they are in fact not). The loss is clearly not an asset and should not be reported as one. Second, permitting hedge accounting on forecasted transactions requires that losses on the swap be recorded in a capital account called “other comprehensive income.” But there is no conceptual justifi cation for such an account. It has been used by the FASB as a politically expedient solution, a “holding ground” for the conse-quences of current and past transactions that companies do not want to recognize currently.6

Uncertainty About What Constitutes HedgingThere is no agreement about what constitutes risk reduc-tion or, for that matter, what constitutes “economic reality.” A fi nancial institution may approach risk management by seeking to narrow an interest rate repricing gap expo-sure in a particular time period. However, many fi nancial institutions have a target interest rate gap that may involve increasing a repricing gap in a particular period. Should both actions be treated as risk reduction, and should hedge accounting be conditioned on risk reduction (which is not the case under Statement 133)? And what about a company whose existing asset and liability exposures are perfectly matched, but which seeks to fi x a variable price in the future? Should that be treated as a risk-reducing transaction in today’s statements?

I would argue, and most analysts would agree, that under present-day GAAP it is impossible to answer such questions. The only reliable way of providing consistent answers is to adopt an accounting system that represents all of the fi rm’s existing exposures, and all of its assets and liabilities, includ-ing derivatives positions—and measures them at their fair value. To the extent we succeed in this effort, we will come as close as we can to capturing economic reality.

jane adams is a Managing Director at Maverick Capital. Prior to joining Maverick in 2002, she held positions as Project Manager at the FASB, Director of Accounting Standards at the AICPA, and Deputy Chief Accountant in the Offi ce of the Chief Accountant at the U.S. Secu-rities and Exchange Commission. Ms. Adams is a member of the CFA Institute’s Corporate Disclosure Policy Council.

6. I accept that in some cases the FASB requires certain effects, such as currency translation adjustments under the functional currency methodology, to be recorded in other comprehensive income (OCI). But the only purpose served by other uses of OCI,

such as for available-for-sale securities or cash fl ow hedges, is to relieve the fair value tensions in the current model.