Accounting Made Simple

THE MONEY MANAGER

The accounting standard is now for all categories of people interested in the operations of a company

New guidelines make balance sheets more transparent, says Mohan Bhatia

The latest statement of financial accounting standard 133 (SFAS#133) provides comprehensive working rules for the accounting of derivative financial instruments and hedging activities. On the one hand, the standards will increase the understanding of risks associated with derivatives (since derivatives are to be reported at fair value, as either assets or liabilities) and on the other, will reduce the inconsistencies and incompleteness of previous accounting guidelines.

For starters, the beauty of SFAS 133 is that it is instrument independent. This in itself is a funadamental development as eariler accounting standards were built around particular instruments.

For instance, while the earliest statement SFAS#52 dealt only with accounting of forwards, the next statement (SFAS#80) addressed the accounting of futures. In recent years, there have been many attempts to fit newly developed instruments into one of the existing instruments for accounting purposes. This created a lot of inconsistencies. With SFAS 133, any instrument having a set of defined attributes will be termed as derivative and accounted as such.

Thus the standard goes one step below the given name, to the intention of its use. The key elements in defining derivative are:

* A derivative's cash flows or fair value must fluctuate and vary based on the changes in an underlying variable;

* The contract must be based on a notional amount of quantity, even if the title to that underlying never changes hands;

* The contract can be readily settled by net cash payment.

Thus, while all know generic instruments like FRAs, futures, swaps, options and their combinations are automatically covered, it also includes other transactions like convertible debt held as a investment, commodity purchase agreements, some structured notes and some insurance contracts.

While definitions of underlying, notional amounts remain substantially the same, FAS 133 extends the concept of net settlement to include contracts that can be settled in assets that are readily convertible into cash.

Earlier, settlement meant closing a contract for cash or by delivery of the underlying. These characteristics of a derivative may be satisfied if an established market mechanism exists that facilitates net settlement outside the contract. Any institutional arrangement that enables either party to be relieved of the rights and obligations under the contract without incurring a significant transaction cost is considered a net settlement.

All considered, the accounting changes mark a fundamentaly fresh insight into derivative accounting.

Traditionally, derivatives were called off balance sheet items because its accounting relied on historical costs. Many of the instruments did not require an initial cash outflow, hence were not reported in the balance sheet. SFAS 133 begins with the basic insight that derivatives are no longer off-balance sheet items. Because they have a bearing on the future balance sheet, they are assets and liabilities and should be reported in the current financial statements.

Extending the logic, the accounting standard is no longer meant for the finance department but for all categories of people interested in the operations of the company. This includes the top management, inclusing directors, investors, creditors and regulators.

The statement requires that every derivative instrument should be recorded in the balance sheet either as an assets or a liability at fair value and changes in fair value need to be recognised in the year in which the change takes place, unless specific hedge criteria are met.

Once the basic principle building blocks are in place, the SFAS sets out the criteria for determining a hedge, noting also that the accounting treatment for trading and hedging transactions may be completely different. That is, the principle does not require that every hedge activity be accounted as a hedge.

For transactions to be booked under hedge accounting, it only requires companies to document, designate and assess the effectiveness of the hedge. A derivative can be specifically designated as a hedge if certain conditions are met. A hedge itself can be of 3 types:

* Fair Value Hedge: Based on an exposure to changes in the fair value of a recognised asset or liability or unrecognised firm commitment;

* Cash flow hedgeL: Based on an exposure to variable cash flows of a forecasted transaction;

* Foreign Currency Exposure: when the exposure of a net investment pertaisn to a foreign operation, an unrecognised firm commitment, or a foreign currency denominated forecasted transaction.

This statement specifically prohibits any non-derivative financial instrument from being designated as a hedge except that of the foreign currency exposure of an unrecognised firm commitment denominated in a foreign currency or a net investment in a foreign operations which can be recognised as hedge.

Under previous GAAPs, hedges were either effective or ineffective. To that extent, there was no concept of partial effectiveness. But in practice, a 100 per cent effective hedge is a rarity. There is always some residual risk which is not hedged and which may become substantial with the passage of time. SFAS 133 recognises this fact.

The statement requires that the assessment of effectiveness be consistent with the risk management strategy documented for that particular hedging relationship . It explicitly allows companies to apply a short cut method to determine hedge effectiveness. If certain key terms of the swap and hedge item match, then the company may assume perfect effectiveness and follow hedge accounting without having to reassess effectiveness prospectively. The credit worthiness of counterparties is not a condition for assuming perfect effectiveness.

Some available short cut methods to determine effectiveness of an interest rate swap, for instance, are when the swap's notional amount matches the hedged item's principal amount, or when the fair value of the swap at the inception is zero, or when there is single formula to compute net settlement, and the hedged items are not prepayable.

Similarly working rules for a cashflow IRS are that the coupon receipt or payment made during the tenure of swap only and not beyond tenure are designated as hedged. That there is no floor or cap on swap's coupon payments or comparable floor or cap on both or when the re-pricing dates match or when the rates are tied to same index.

This accounting statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts. It only requires that an entity recognise all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value.

Critics believe that new standards will cause unnecessary fluctuations in earnings and therefore increase the cost of capital. However they fail to recognise that volatility is caused by changes in the underlying transaction and not by accounting standards. The standards never increase volatility, they only recognise the volatility and depict true picture of the business in financial statements and disclosure of information generally decrease the cost of capital.

By concealing the financial impact of derivatives from financial statements, a company may benefit in short run. But in the long run, its capital cost will increase leading to inefficient decisions. The new statement will unmask volatility in earnings and provide much needed correct financial statement to users, and in addition will reduce the cost of capital in long run.

(Mohan Bhatia teaches Risk Management at the premier college for bankers. He can be contacted at bhatia100@hotmail.com)