In 2017 my Website was migrated to the clouds and reduced in size.
Hence some links below are broken.
One thing to try if a “www” link is broken is to substitute “faculty” for “www”
For example a broken link http://www.trinity.edu/rjensen/Pictures.htm
can be changed to corrected link http://faculty.trinity.edu/rjensen/Pictures.htm
However in some cases files had to be removed to reduce the size of my Website
Contact me at rjensen@trinity.edu if you really need to file that is missing

Accounting for Derivative Financial Instruments and Hedging Activities
Bob Jensen at Trinity University

Glossary --- http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm 

Derivative Financial Instrument Frauds --- http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

FAS 133 and IAS 39 Glossary and Transcriptions of Experts Accounting for Derivative Instruments and Hedging Activities --- http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm \

PwC:  Derivative instruments and hedging activities - 2013 second edition (updated July 2015) ---
http://www.pwc.com/us/en/cfodirect/publications/accounting-guides/guide-to-accounting-for-derivative-instruments-and-hedging-activities-2013-edition.html

History:  A Condensed Multimedia Overview With Video and Audio from Experts --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm
This file has video and audio clips of experts! 

A Longer and More Boring Introduction to FAS 133, FAS 138, and IAS 39 --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/133intro.htm 
This file has audio clips of experts!

Video Tutorials on Accounting for Derivative Financial Instruments and Hedging Activities per FAS 133 in the U.S. and IAS 39 internationally --- http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/ 

Flow Chart for FAS 133 Accounting --- http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Flow Chart for IAS 39    Accounting --- http://faculty.trinity.edu/rjensen/acct5341/speakers/39flow.htm

References for Comparisons of IFRS versus U.S. GAAP

From Ernst & Young in November 2012
US GAAP versus IFRS: The basics 
While convergence was a high priority for the FASB and the IASB in 2012, differences continue to exist between US GAAP and IFRS. In this guide, we provide an overview by accounting area of where the standards are similar, where differences are commonly found in practice, and how and when certain differences are expected to disappear
http://www.ey.com/Publication/vwLUAssetsAL/IFRSBasics_BB2435_November2012/$FILE/IFRSBasics_BB2435_November2012.pdf

Jensen Comment
This is only a 54-page document. I still prefer the somewhat older but much longer PwC document.

Older links to such comparisons:

"A Look at the IASB’s Draft of Hedge Accounting Requirements," Deloitte via the CFO Journal, October 19, 2012 ---
http://deloitte.wsj.com/cfo/2012/10/19/a-look-at-the-iasbs-draft-of-hedge-accounting-requirements/

Jensen Comment
This is the most extensive review I've seen of the proposed IFRS 9 departures from IAS 39 in terms of hedge accounting. It covers such things as when a financial instrument can get get hedge accounting previously restricted to derivative financial instruments. Many of the changes are quite technical. The bottom line is that IFRS 9 will allow much more subjective judgment for hedge accounting. In my opinion, this will make financial statements potentially less comparable between companies and thereby destroys to some extent the argument that having global accounting standards increases the comparability in financial reporting.

IAS 133 (as amended a number of times), IAS 39 (as amended a number of times) and IFRS 9 (still being written) are arguably the most difficult accounting standards to teach and apply in practice. The major problems are the technicalities of the accounting added on top of the complicated technicalities of understanding how derivative financial instruments affect financial risks in the management of such risks in both the public and private sectors (e.g., government pension funds use derivatives to manage risks and possibly even speculate).

Deloitte's review does not go far in helping you understand the forthcoming IFRS 9. It goes a long ways in showing you how you're going to have to spend a lot more time and possibly money to understand IFRS 9 before you will ever be able to teach IFRS 9 to students.

The bad news is that hedge accounting will continue to have the worst coverage of all accounting standards in intermediate accounting textbooks.

The good news is that hedge accounting is probably too complicated to ever become a worrisome hurdle in Chartered Accountancy Examinations, CPA examinations, and other certification examinations. Hedge accounting is something you must learn on your own and on the job. IAS 39 was very similar to FAS 133, FAS 133/138 originally had some great illustrations where I learned most of what I know about hedge accounting. Sadly, the FASB eliminated most of those great illustrations when it moved to the Codification database. Boo on the FASB for this! Some of my Excel tutorials on those illustrations can be found in the listing of files at
http://www.cs.trinity.edu/~rjensen/

Also see
http://faculty.trinity.edu/rjensen/caseans/000index.htm

Sadly, I probably will not be updating my tutorials for IFRS 9 --- hey I'm supposed to be retired!

When Hedging Isn't Enough
by: Maxwell Murphy
May 06, 2014
Click here to view the full article on WSJ.com
 

TOPICS: Foreign Currency Exchange Rates, Hedging

SUMMARY: "Currencies in at least 20 countries have fallen 6% to 37% against the U.S. dollar in the past year." The global nature of business operations for even small companies in today's environment means "'companies have never been as exposed as they are now to the violent movements of foreign currencies across the globe,' said Wolfgang Koester... [who] advises...on currency risk." With this high volatility, options can be costly as a long-term solution and companies are reacting by "rethinking their relationships with suppliers and distributors, their corporate structures, and their prices."

CLASSROOM APPLICATION: The article is an excellent one to introduce basic foreign currency issues and hedging strategies in an advanced financial accounting class.

QUESTIONS: 
1. (Introductory) What are the reasons for recent wide swings in currencies relative to the U.S. dollar? Where are these currencies' home countries?

2. (Advanced) How does a strong U.S. dollar typically affect U.S. export sales? State how the Olney, Texas, company Air Tractor, Inc. provides an example of this situation.

3. (Advanced) Consider the case of Infor Inc. How does its CFO decide whether to accept payment from customers in foreign currency? What happens to the amount of reported sales in those foreign currencies? How does the use of the currency for local operating expenses offset that effect?
 

Reviewed By: Judy Beckman, University of Rhode Island

"IASB Previews New Hedge Accounting Rules," by Emily Chason, CFO Report, September 7, 2012 ---
http://blogs.wsj.com/cfo/2012/09/07/iasb-previews-new-hedge-accounting-rules/?mod=wsjpro_hps_cforeport

The draft is available from the IASB --- Click Here
http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Instruments-A-Replacement-of-IAS-39-Financial-Instruments-Recognitio/Phase-III-Hedge-accounting/Pages/Draft-of-IFRS-General-Hedge-Accounting.aspx 

Jensen Comment
Today I must leave early in the morning to take Erika to Concord for a medical treatment. I've not yet had time to read the above draft in detail. It appears, however, that this draft for IFRS 9 retains changes in IAS 39 that are objectionable to me relative to what I think is better in FAS 33 as amended.

Firstly, the thrust of the IFRS 9 changes will be to add more subjectivity (relative to FAS 133), especially in the area of hedge effectiveness testing. For example, if a farmer has hedges a growing crop of corn, he is likely to do so on the basis of standardized corn quality of corn futures and options trading on the CBOT or CME. It is unlikely that the corn that he ultimately takes to market will have the identical quality moisture content. In addition he will have trucking costs of getting his corn from say South Dakota to the trading market in Chicago. As a result of all this, his hedging contract acquired in June on the CBOT or CME exchange is not likely to be perfectly effective relative to the corn he brings to market in October. Thus there will be hedging ineffectiveness.

The original IAS 39, like FAS 133, had some bright line tests for the degree to which hedge accounting was allowed when there is hedge ineffectiveness. See the slide show illustrations at
www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/06effectiveness.ppt   

There is greater likelihood that in a particular instance of hedge ineffectiveness, the original IAS 39 would result in Client A having identical accounting for the hedge ineffectiveness as Client B. Under the new IFRS 9 this becomes less assured since clients are given considerable subjective judgment in deciding how to deal with hedge ineffectiveness.

Also under FAS 133, embedded derivatives in financial contracts must be evaluated and if the embedded derivative's underlying is not "clearly and closely related" to the underlying in the host contract, the embedded derivatives must be bifurcated and accounted for separately. This leads to a lot of work finding and accounting for embedded derivatives. IFRS 9 will eliminate all that work by not making clients look for embedded derivatives. Hence, the risk that comes from having embedded derivative underlyings not clearly and clossely associated with the underlyings of the host contract can simply be ignored. I don't by into this IFRS 9 bad accounting for the sake of simplification.

I think there are other areas of difference expected differences between IFRS 9 and FAS 133 as amended. Most of the differences lie in the subjectivity allowed in accounting for hedging contracts under IFRS 9 that is not allowed in FAS 133.

September 10, 2012 reply from Bob Jensen

This afternoon received a message from PwC about the IASB's proposed changes to hedge accounting. The PwC reply is consistent with, albeit somewhat more extensive, then my reply that I sent to the AECM early this morning.

The PwC response is at --- Click Here
http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=MSRA-8Y2HHH&SecNavCode=MSRA-84YH44&ContentType=Content 

Note that the IASB is not really opening up these proposed hedge accounting amendments to comments. Wonder why?

Also note that the proposed IASB's amendments diverge from rather than converge toward U.S. GAAP under FAS 133 as amended. At this point in time I don't think the IASB really cares about convergence of hedge accounting rules.

My quick and dirty response is that the revised hedge accounting standards under IFRS 9 is carte blanche for having two different clients and their auditors account differently for identical hedge accounting transactions because so much subjectivity will be allowed under IFRS 9. We may even have subsidiaries of the same client accounting for identical transactions differently.

Such is the myth of comparability one is supposed to get under principles-based global standards.

Further more, it may challenge auditing Firm X that has one client claiming a hedge is effective when another client would claim the hedge is ineffective. Will auditing Firm X certify divergent accounting for the same hedge. The answer is probably yes these days if both clients are too big to lose.

Bob Jensen

So Much for the Myth That Accounting Standards Are Neutral in Terms of Business Strategy (of course it did not take IFRS 9 to reveal this to us)
"Under New Accounting Standard, CFOs Could Change Hedging Strategies:
Will finance chiefs come under more pressure to adopt hedge accounting — even though it remains entirely optional under the new standard?"
by Andrew Sawyers
CFO.com, September 12, 2012
http://www3.cfo.com/article/2012/9/gaap-ifrs_hedge-accounting-ias-39-iasb-ifrs-derivatives-80-125-test-hedge-effectiveness 

A new international financial reporting standard (IFRS) on hedge accounting could prompt finance chiefs to change their companies’ hedging strategies under a more accommodating, principles-based regime that requires less testing.

The International Accounting Standards Board (IASB) has been pondering hedge accounting for several years in an effort to find a way to replace the unloved standard IAS 39: so unloved that it’s not part of the package of accounting standards endorsed by the European Commission for listed companies. The standard has made it tough to employ hedge accounting, which can be favorable to companies in certain circumstances.

In a recent podcast, Kush Patel, director in Deloitte’s U.K. IFRS Centre of Excellence, summarized the impact of the new rules: “More hedge-accounting opportunities, less profit and loss volatility — so as you’d expect, this has been well received.”

Under IAS 39, he said, “we saw a lot of companies change the way they manage risk: we saw them reduce the amount of complex, structured derivatives that were being used to hedge and they went for more vanilla instruments that could [qualify for] hedge accounting more easily. Now that IFRS 9 will remove some of these restrictions, I think it’s fair to say risk management could change.”

Andrew Vials, a technical-accounting partner at KPMG, said in a statement, “A company will be able to reflect in its financial statements an outcome that is more consistent with how management assesses and mitigates risks for key inputs into its core business.”

Will CFOs come under more pressure to adopt hedge accounting — even though it remains entirely optional under the new standard? “If hedge accounting becomes easier, there may be more emphasis on them to achieve hedge accounting — so although it’s voluntary, there is an element that they may feel more compelled to do hedge accounting” says Andrew Spooner, lead global IFRS financial-instruments partner at Deloitte.

The final draft of the new hedge-accounting rules was published on September 7 and will be incorporated into the existing IFRS 9 Financial Instruments at the end of the year. The IASB says it’s not seeking comments on this final draft, but is making it available “for information purposes” to allow people to familiarize themselves with it. The new rules will take effect from January 1, 2015, but companies will be allowed to adopt them sooner if they wish.

Spooner and Patel note three main areas in which the new rules are different from the old:

Changes to the instruments that qualify. It’s now easier, for example, to use option contracts without increasing income-statement volatility.

Changes in hedged items. It may not be possible, for example, for a company to hedge the particular type of coffee beans a food company buys. But it could hedge a benchmark coffee price, because it is closely related to the item it would like to hedge. Another change for the better: companies in the euro zone that want to hedge dollar purchases of oil can now more easily hedge the dollar price of the oil, then later hedge the foreign-exchange exposure without the oil-price hedge being deemed ineffective. There are also more favorable rules for hedging against credit risk and inflation.

Changes to the hedge-effectiveness requirements. Under IAS 39, a company could use hedge accounting only if a hedge is “highly effective,” meaning it must be capable of offsetting the risk by a range of 80%–125%. But the 80–125 test has been scrapped to be replaced by a principle-based test that is based on economic relationship: “You have to prove that there is a relationship between the thing you are hedging and the thing you are using,” says Patel. Having gotten rid of the quantitative threshold, there are “more opportunities for companies to reduce the amount of testing they do,” he says. “It’s a welcome change.”

Continued in article

"IASB Previews New Hedge Accounting Rules," by Emily Chason, CFO Report, September 7, 2012 ---
http://blogs.wsj.com/cfo/2012/09/07/iasb-previews-new-hedge-accounting-rules/?mod=wsjpro_hps_cforeport

The PwC response is at --- Click Here
http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=MSRA-8Y2HHH&SecNavCode=MSRA-84YH44&ContentType=Content 

The draft is available from the IASB --- Click Here
http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Instruments-A-Replacement-of-IAS-39-Financial-Instruments-Recognitio/Phase-III-Hedge-accounting/Pages/Draft-of-IFRS-General-Hedge-Accounting.aspx 

Bob Jensen's free tutorials on accounting for derivative financial instruments and hedging activities ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm

Intrinsic Value Versus Full Value Hedge Accounting --- http://faculty.trinity.edu/rjensen/caseans/IntrinsicValue.htm 

I'm sharing some old (well relatively old) accounting theory quiz and exam material that I added to a folder at http://www.cs.trinity.edu/~rjensen/Calgary/CD/

Derivative Financial Instruments Frauds ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds  

FAS 133 Trips Up Fannie Mae 

Hedging Paradox:  
In finance, there is no way to cover your Fannie without exposing your Fannie somewhere else.
Gypsy Rose Lee would've said her fan (hedge) can only cover one Fannie cheek at a time. 

Freddie Mac Paves the Way With Risk Stress Tests and Then Fails on Macro Hedge Accounting  

Yield Burning Frauds 

Introduction to FAS 138 (Amendments to FAS 133) and some key DIG issues at http://www.cs.trinity.edu/~rjensen/000overview/mp3/138intro.htm 

Canadian Workshop Topics --- http://faculty.trinity.edu/rjensen/caseans/000indexLinks.htm

Tutorials and Helpers --- http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#Tutorials 

Accounting for Executory Contracts Such as Purchase/Sale Commitments and Loan Commitments ---
http://faculty.trinity.edu/rjensen/TheoryOnFirmCommitments.htm  

”Testing and Accounting for Hedge Ineffectiveness Under FAS 133, by Angela L.J. Huang and  Robert E. Jensen, Derivatives Report, February 2003, pp. 1-10.  http://www.riahome.com/estore/detail.asp?ID=TDVN

I have a draft paper entitled "The Theory of Interest Rate Swap Overhedging" at http://faculty.trinity.edu/rjensen/315wp/315wp.htm 
This is a very rough start on developing this theory.  I would appreciate any feedback you can give on this paper.

Bob Jensen’s Amendment to the Teaching Note prepared by Smith and Kohlbeck for the following case:  “Accounting for Derivatives and Hedging Activities Comparisons of Cash Flow Versus Fair Value Accounting,” by Pamela A. Smith and Mark J. Kohlbeck
     Issues in Accounting Education, Volume 23, Number 1, February 2008, pp. 103-118
Bob Jensen's Amendment is at http://faculty.trinity.edu/rjensen/CaseAmendment.htm
 

New in Paperback!
GLOBAL DERIVATIVE DEBACLES --- http://www.worldscibooks.com/economics/7141.html 
From Theory to Malpractice
by Laurent L Jacque (Tufts University, USA & HEC School of Management, France)

336pp
978-981-4366-19-9(pbk): US$29 / £19   US$20.30 / £13.30
978-981-283-770-7: US$54 / £36   US$37.80 / £25.20
978-981-283-771-4(ebook): US$70   US$49

Table of Contents (80k)
Preface (61k)
Chapter 1: Derivatives and the Wealth of Nations (173k)

Bob Jensen's Timeline of Derivative Financial  Instruments Frauds ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

"Hidden Numbers Make Banks Even Bigger," by Floyd Norris, The New York Times, March 14, 2013 ---  Click Here
http://www.nytimes.com/2013/03/15/business/new-rules-will-give-a-truer-picture-of-banks-size.html?nl=todaysheadlines&emc=edit_th_20130315&_r=2&pagewanted=all&#h[]

It sounds like a simple question. How big is that bank?

But it is not.

Under American accounting rules, banks that trade a lot of derivatives can keep literally trillions of dollars in assets and liabilities off their balance sheets. Since 2009, they have at least been required to make disclosures about how large those amounts are, but the disclosures leave out some things and — amazingly enough — in some cases do not seem to add up.

The international accounting rules are different. They also allow some assets to vanish, but not nearly as many. As a result, it is virtually impossible to confidently declare how a particular European bank compares in size with an American bank.

Much of that will change when first-quarter financial statements start coming off the printing presses in a few weeks. For the first time, European and American banks are supposed to have comparable disclosures regarding assets. Their balance sheets will still be radically different, but for those who care, the comparison will be possible.

This comes to mind because these days it seems that big banks do not much want to be thought of that way. A rather angry argument has broken out regarding whether “too big to fail” institutions get what amounts to a subsidy from investor confidence that no matter what else happens, they would not be allowed to fail. The banks deny it all. Subsidy? Penalty is more like it, they say.

We’ll get back to that argument in a moment. But first, there is some evidence that the big American banks may have scaled back their derivatives positions last year. At five of six major financial institutions, the amount of assets kept off the balance sheet appears to be lower at the end of 2012 than it was a year earlier.

Still, the numbers are big. JPMorgan Chase, the biggest American institution, had $2.4 trillion in assets on its balance sheet at the end of 2012. But it has derivatives with a market value of an additional $1.5 trillion that it does not show on its balance sheet, down from $1.7 trillion a year earlier.

So is JPMorgan getting bigger? Measured by assets on the balance sheet, the answer is yes. That total was up $93 billion from 2011. But after adjusting for the hidden assets, the bank appears to have shrunk by $109 billion last year. If the bank used international accounting rules, it appears it would be getting smaller.

Not having those assets on the balance sheet makes the bank look less leveraged than it might otherwise appear to be. If you simply compare the book value of the bank with its assets, it appears it has $11.56 in assets for every dollar in equity. Add in those derivatives, and the figure leaps to $18.95.

It is not as if those assets are not real, or that they are perfectly offset by liabilities also kept off the balance sheet. There is a similar amount of liabilities that are not shown, but there is no way to know just how they match up with the assets in terms of riskiness. The nature of derivatives makes it hard to assess aggregate totals.

If a bank has a $1 million loan to someone, that is an asset that would go on the balance sheet at $1 million. Presumably the worst that could happen is that the bank would lose the entire amount. But a large derivative position might currently have a market value of $1 million, and thus would be shown as being worth the same amount, whether on or off the balance sheet. But if the market moves sharply, the profit or loss could be many multiples of that figure.

Under American accounting rules, banks that deal in derivatives can net out most of their exposure by offsetting the assets against the liabilities. They do this based not on the nature of the asset or liability, but on the identity of the institution on the other side of the trade — the counterparty, in market lingo.

The logic of this has to do with what would happen in a bankruptcy. What are called “netting agreements” allow only the net value to be claimed in case of a failure. So the bank shows the sum of those net positions with each party.

But those positions are not offsetting in terms of risk, or at least there is no way to know if they are. The figures shown in the financial statements and footnotes simply describe market values on the day of the balance sheet. If prices move the wrong way, as asset can turn into a liability, or a liability can become much larger. And both can happen at the same time. The asset might be an interest rate swap, while the liability is a wheat future. Obviously, they are not particularly likely to move in tandem.

To return to JPMorgan, on its balance sheet are derivative assets of $75 billion, and derivative liabilities of $71 billion. Neither number is very large relative to the size of the bank, and you might think that swings in values would be unlikely to be very large.

But those numbers are $1.5 trillion smaller than the actual totals. Obviously, the swings on a portfolio of that size could be much larger.

A few years ago, the accounting rule makers set out to get rid of the netting, and make balance sheets more accurate. But there were complaints from banks and others, and the American rule makers at the Financial Accounting Standards Board concluded that was not a good idea. So there is still netting in the United States. Some of it, involving repos and reverse repos, is not disclosed at all now, but will be when the new rules kick in.

The sort-of invisible derivative assets and liabilities are only part of the reason that it is so hard to really get a handle on just how risky any given bank is.

Continued in article

I never could understand the reasons for this amendment to FAS 133 that originally did not allow such offsetting. At the time I blamed it on the zeal for convergence with the IASB and political pressures that seemed to be even greater in Europe than the U.S. Perhaps I was wrong in this.

I'm beginning to think that when something smells fishy there probably are some rancid fish hiding somewhere

I've never been in favor of what I think is one of the worst decisions ever made by the FASB that runs counter to the original FAS 133 requirements.
"Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities," ASU No. 2011-08, FASB --- Click Here
http://www.fasb.org/cs/BlobServer?blobkey=id&blobwhere=1175825893217&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs

Why Is the FASB Issuing
This Accounting Standards Update (Update) ? The main objective in developing this Update is to address implementation issues about the scope of Accounting Standards Update No. 2011 - 11, Balance Sheet (Topic 210) : Disclosures about Offsetting Assets and Liabilities . Stakeholders have told the Board that because the scope in Update 2011 - 11 is unclear, diversity in practice may result . Recent feedback from stakeholders is that standard commercial provisions of many contracts would equate to a master netting arrangement . Stakeholders questioned whether it was the Board’s intent to require disclosures for such a broad scope, which would significantly increase the cost of compliance . The objective of this Update is to clarify the scope of the offsetting disclosures and address any unintended consequences.

What Are the Main Provisions?
The amendments clarify that the scope of Update 2011 - 11 applies to derivatives accounted for in accordance with Topic 815, Derivatives and Hedging, including bifurcated embedded derivatives , repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with Section 210 - 20 - 45 or Section 815 - 10 - 45 or subject to an enforceable master netting arrangement or similar agreement .

Who Is Affected by the Amendments in This Update?
The amendments in this Update affect entities that have derivatives accounted for in accordance with Topic 815, including bifurcated embedded derivatives , repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with Section 210 - 20 - 45 or Section 815 - 10 - 45 or subject to an enforceable master netting arrangement or similar agreement . Entities with other types of financial a ssets and financial liabilities subject to a master netting arrangement or similar agreement also are affected because these amendments make them no longer subject to the disclosure requirements in Update 2011 - 11.

How Do the Main Provisions?
Differ from Cur rent U.S. Generally Accepted Accounting Principles ( GAAP ) and Why Would They Be an Improvement? The amendments clarify the intended scope of the disclosures required by Section 210 - 20 - 50 . The Board concluded that the clarified scope will reduce significant ly the operability concerns expressed by preparers while still providing decision - useful information about certain transactions involving master netting arrangements . The amendments provide a user of financial statements with comparable information as it r elates to certain reconciling differences between financial statements prepared in accordance with U.S. GAAP and those financial statements prepared in accordance with International Financial Reporting Standards (IFRS).

When W ill the Amendments Be Effective?
An entity is required to apply the amendments for fiscal years beginning on or after January 1, 2013, and interim periods within those annual periods . An entity should provide the required disclosures retrospectively for all comparative periods presented . The effective date is the same as the effective date of Update 2011 - 11.

How Do the Provisions Compare with International Financial Reporting Standards (IFRS)?
The disclosures required by the amendments in Update 2011 - 11 are the result of a joint project between the FASB and the International Accounting Standards Board (IASB), which was intended to provide comparable information about balance sheet offsetting between those entities that prepare their financial statements on the basis of U.S. GAAP and those entities that prepare their financial statements on the basis of IFRS . The amendments in this Update clarify that the scope of the disclosures under U.S. GAAP is limited to include derivatives accounted for in accordance with Topic 815 , including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with Section 210 - 20 - 45 or Section 815 - 10 - 45 or subject to a n enforceable master netting arrangement or similar agreement.

Continued in article

I personally was more concerned about how banks changed income smoothing practices.
"The Impact of SFAS 133 on Income Smoothing by Banks through Loan Loss Provisions," by Emre Kilic Gerald J. Lobo, Tharindra Ranasinghe, and K. Sivaramakrishnan Rice University, The Accounting Review, Vol. 88, No. 1, 2013, pp. 233-260 ---
http://aaajournals.org/doi/pdf/10.2308/accr-50264

We examine the impact of SFAS 133, Accounting for Derivative Instruments and Hedging Activities , on the reporting behavior of commercial banks and the informativeness of their financial statements. We argue that, because mandatory recognition of hedge ineffectiveness under SFAS 133 reduced banks’ ability to smooth income through derivatives, banks that are more affected by SFAS 133 rely more on loan loss provisions to smooth income. We find evidence consistent with this argument. We also find that the increased reliance on loan loss provisions for smoothing income has impaired the informativeness of loan loss provisions for future loan defaults and bank stock returns.

2010 IASB Exposure Draft

"IASB publishes exposure draft on hedge accounting," IAS Plus, December 9, 2010 ---
http://www.iasplus.com/index.htm

The International Accounting Standards Board (IASB) has published for public comment an exposure draft on the accounting for hedging activities. The exposure draft proposes requirements designed to enable companies to better reflect their risk management activities in their financial statements, and, in turn, help investors to understand the effect of those activities on future cash flows.

The proposed model is principle-based, and is designed to more closely align hedge accounting with risk management activities undertaken by companies when hedging their financial and non-financial risk exposures.

Summary of the ED proposals A new hedge accounting model which combines a management view that aims to use information produced internally for risk management purposes and an accounting view that seeks to address risk management issue of the timing of recognition of gains and losses Look only at whether a risk component can be identified and measured, as opposed to determining what can be hedged by type of item (financial or non-financial) Base qualification for hedge accounting on how entities design hedges for risk management purposes and permit hedging relationships to be adjusted without necessarily stopping and potentially restarting hedge accounting Treat the time value premium of a purchased option as a cost of hedging, which will be presented in other comprehensive income (OCI) Extending the use of hedge accounting to net positions (to improve the link to risk management) A comprehensive set of new disclosures that focus on the risks being hedged, how those risks are being managed and the effect of hedging those risks upon the primary financial statements

The exposure draft forms part of the IASB’s overall project to replace IAS 39 Financial Instruments: Recognition and Measurement, and when its proposals are confirmed they will be incorporated into IFRS 9 Financial Instruments. The exposure draft does not include consideration of portfolio macro hedge accounting which the IASB will continue to discuss.

The exposure draft ED/2010/13 Hedge Accounting is open for comment until 9 March 2011. The IASB intends to finalise and issue the proposals during the first half of 2011.

Click for:

• IASB press release (PDF 40k)
• Access to the Exposure Draft (link to IASB's website)
• IASB Snapshot: Hedge Accounting (PDF 106k)
• History of the IASB's hedge accounting project on IAS Plus

Jensen Comment
Because preparers and auditors complained over the years about the complexity of IAS 39, the IASB in this ED mistakenly assumes that doing away with bright lines in favor of ambiguity reduces complexity. But replacing bright lines with ambiguity in and of itself creates more rather than less complexity. It is analogous to replacing a bright line speed sign reading "20 mph maximum" with "Drive Safely in this School Zone."

For example the ED replaces the bright line 80-125 rule for effectiveness limits of in offset testing of effectiveness with ambiguity about when a hedge of a hedged item should be deemed effective. Similarly, IAS 39 was relatively clear about when portfolios of hedged items could be hedged as a portfolio. The ED creates a very ambiguous term "Group Hedging" that is both ambiguous and takes international hedge accounting further and further away from the U.S. FAS 133 standard that allows portfolio or group hedging in under vastly more limiting and clear cut rules.

Effectiveness testing of purchased options used as hedging instruments is pretty clear cut under FAS 133 and IAS 39. The new IASB ED complicates accounting for the time values of options used for hedging purposes. It introduces the concept of "aligned time value" which will really confuse most auditors and financial analysts.

The net result will be that two different companies are likely to treat many hedging contracts differently when applying hedge accounting under the revised IFRS 9 into which FAS 39 is to be phased into IFRS 9. By introducing greater ambiguity the price will be that comparability between financial statements of different companies will be destroyed or highly uncertain.

I repeat that replacing bright lines with ambiguity may actually increase complexity rather than reduce complexity. The complexity of hedge accounting essentially arises from the immense complexity and variations of hedge accounting contracts. IAS 39 was rooted in FAS 133 which I viewed as a good standard, as amended,  that provided more consistent accounting for derivative financial instruments and hedging activities. The new IAS 39 ED is a move in the wrong direction from FAS 133.

Greater ambiguity is not the solution to dealing with complexity. Ambiguity does eliminate the main problems accountants have with derivatives when the main problems are not really understanding derivatives rather than writing ambiguous accounting standards for complex derivatives contracts.

Warning:  In 2009 the FASB and the IASB are contemplating huge revisions of FAS 133 and IAS 39

SERIOUS Doubts Over Proposed Changes to FAS 133 and IAS 39

The FASB proposes dubious changes in FAS 133 on Accounting for Derivative Financial Instruments and Hedging Activities while the IASB is studying similar changes in IAS 39. With the SEC currently sitting on the fence in deciding if and when to replace FASB standards with IASB standards, I fully predict that IAS 39 will pretty much follow the revise FAS 133 as it did when IAS 39 was initially adopted, although IAS 39 will continue to have wider coverage of financial instruments in general whereas FAS 133 will narrowly focus on derivative financial instruments and hedge accounting.

When the FASB initially signaled possible revisions for changing hedge accounting rules in FAS 133, a wave of protests from industry hit the fan. The article below is the response of Ira Kawaller who serves on the FASB's Derivatives Implementation Group (DIG) and who is one of the leading consultants on FAS 133 and hedging in general which is his where he has historic roots as a PhD in economics --- http://www.kawaller.com/about.shtml
Ira has written nearly 100 trade articles on FAS 133. I don't think he consults on IAS 39. Ira's home page is at http://www.kawaller.com/about.shtml
Ira also maintains a small hedge fund where he walks the talk about interest rate hedging. However, I'm no expert on hedge funds and will not comment on any particular hedge fund.

I might note in passing for enthusiasts of the new FASB Codification Database for all FASB standards that FAS 133 coverage in the Codification database is relatively sparse. Professionals and students in hedge accounting most likely will have to connect back to original (non-codified) FASB literature. For example, none of the wonderful illustrations in Appendices A and B of FAS 133 are codified. And the extremely helpful, albeit complicated, pronouncements of the FASB's Derivatives Implementation Group (DIG) are excluded from the Codification database --- http://www.fasb.org/derivatives/
Most of the DIG pronouncements are included in context at http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
I will never have a lot of respect for the Codification database until it includes much, much more on FAS 133.

Below is a publication in which Dr. Kawaller presents serious doubts regarding revisions to FAS 133 that the FASB is now considering (and the IASB is now considering for IAS 39).

The problem is even more severe for entities with fixed-rate exposures. In this case, there’s a clear disconnect between what swaps are designed to do versus what the FASB requires for hedge accounting.
"Paved With Good Intentions:  The Road to Better Accounting for Hedges," The CPA Journal, August 2009 --- http://www.kawaller.com/pdf/CPA_Paved_w_Good_Intent_Aug_2009.pdf

With 10 years of experience under the current regime of accounting for derivative contracts and hedging transactions, the FASB has determined that it’s time to make some adjustments. Accountants should be wary of the changes. Besides affecting the accounting procedure relating to these instruments and activities, the proposed changes may also seriously impact the manner in which certain derivative hedges are structured— particularly in connection with interest rate risk management activities.

Accounting rules for derivatives and hedging transactions were put forth by the FASB in SFAS 133, Accounting for Derivative Instruments and Hedging Activities. This standard was initially issued in June 1998. It has been amended twice since then, with relatively minor adjustments, but in 2008 the FASB issued a more substantive exposure draft with significant proposed changes. Although the comment period on this exposure draft is over, the project appears to be in limbo. Proposed changes have neither been accepted nor rejected. Further adjustments are likely to be made as the FASB moves to harmonize U.S. accounting guidance with International Financial Reporting Standards (IFRS). When attention turns to derivatives, this latest exposure draft could very likely serve as a starting point. The prospective decisions about the accounting treatment for these derivatives could have a profound impact on the structure and composition of derivatives transactions

The Current Standard SFAS 133 has long been recognized as one of the most complicated accounting standards the FASB has ever issued. A core principle of this standard is that derivative instruments must be recognized on the balance sheet as assets or liabilities at their fair market value. The critical issue, then, is the question of how to handle gains or losses. Should they be reported in current income or elsewhere? Ultimately, SFAS 133 ended up providing different answers for different situations. The “normal” treatment simply requires gains and losses recognized in earnings. This treatment, however, is often problematic for companies that use derivatives for hedging purposes. For such entities, the preferred treatment would recognize gains or losses of derivatives concurrently with the earnings impacts of the items being hedged. The normal accounting treatment generally won’t yield this desired result, but the alternative “hedge accounting” will.

For purposes of this discussion, attention is restricted to the two primary hedge accounting types: cash flow and fair value. For cash flow hedges, the exposure being hedged (i.e., the hedged item) must be an uncertain cash flow, forecasted to occur in a later time period. In these cases, effective gains or losses on derivatives are originally recorded in other comprehensive income (OCI) and later reclassified from OCI to earnings when the hedged item generates its earnings impact. Ineffective results are recorded directly in earnings. In essence, this accounting treatment serves to defer the derivatives’ gains or losses—but only for the portion of the derivatives’ results that are deemed to be effective—thus pairing the earnings recognition for the derivative and the hedged item in a later accounting period.

Continued in article

Bob Jensen and Tom Selling have been having an active, to say the least, exchange over hedge accounting where Tom Selling advocates elimination of all hedge accounting (by carrying all derivatives at fair value with changes in value being posted to current earnings). Bob Jensen thinks this is absurd, especially for derivatives that hedge unbooked transactions such as forecasted transactions or unbooked purchase contracts for commodities. Not having hedge accounting causes asymmetric distortions of earnings where the changes in value of the hedging contracts cannot be offset by changes in value of the (unbooked) hedged items. You can read more about our exchanges under the terms "Insurance Contracts" at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#I-Terms
Scroll down to "Insurance Contracts"

Good News and Bad News:  Update on IAS 39 Revisions

I call your attention to the IAS Plus summary of the
Notes from the IASB Special Board Meeting
October 6,  2009 --- http://www.iasplus.com/index.htm

The IASB met for a special meeting relating to the IAS 39 replacement project. Several Board members including the Chairman, FASB members, and FASB staff joined the meeting via video link.

Many of these items are especially interesting when teaching IFRS, when teaching contemporary issues in accountancy, and when teaching about accounting for derivative financial instruments and hedge accounting (although recent amendments of IAS 39 have taken this famous/infamous and very complicated standard beyond the scope of the original IAS 39 and the current FAS 133 in the U.S.)

There are various items taken up in the October 6 IASB meeting not discussed below. Hence if you're interested in the entire meeting go to the IASB Special Board Meeting summary: 
October 6,  2009 --- http://www.iasplus.com/index.htm

One significant difference that will arise between IAS 39 and FAS 133 lies in the IAS decision to end the requirement of bifurcation of host contracts (such as mortgage loans) from embedded derivatives (such as the embedded option to pay the loan off before maturity) when the underlying (such as a LIBOR interest rate) of the host contract is not "clearly and closely related" to the underlying of the embedded derivative.

Accounting for embedded derivatives

The Board was presented with the alternative to eliminate bifurcation of embedded derivatives. Several Board members were concerned that this decision together with the frozen spread approach adopted for measurement of financial liabilities would lead to hybrid instruments with a financial liability as a host not to be valued at fair value. By implication this means that the derivative part of the hybrid instruments would be valued at the frozen spread approach and not fair value. The staff defended this position by arguing that the credit adjustment to the derivative portion of the hybrid contract would not be significant. One Board member was particularly concerned about the effect of this decision on convergence – a point reinforced by a FASB member who expressed his view that such IASB decision would make convergence in this area next to impossible.

Nonetheless, the Board narrowly approved the elimination of bifurcation of financial liabilities as well as financial assets.

The above decision will lead to fewer derivative financial instruments being booked under FAS 39 relative to what would be booked under FAS 133. It seems to me to be politically incorrect to bring about such changes at a time when the SEC is still wavering to eliminate U.S. GAAP in favor of IASB standards.

What the IASB seems to have ignored is the valuation problems created by unique (customized) instruments that are not traded in the markets. Suppose Security AB with a "closely related" embedded Option B is Bond A that is actively traded with the embedded embedded Option B for paying off the debt before maturity. Early payoff embedded options are extremely common in bonds that are actively traded in the securities markets. Usually the embedded options for early payoff are deemed clearly and closely related under IAS 39 rules such that the embedded Option B previously did not have to be bifurcated and accounted for separately as a derivative financial instrument. Market values of Security AB impound both the value of the security and its embedded (non-bifurcated) option. Until the IASB changed its position on October 6, however, embedded options that were not clearly and closely related had to be bifurcated and accounted for separately.

For example, suppose Security ABXY is Security AB plus embedded Options X and Y that are not "clearly and closely related" in terms of underlyings.  Further assume Options X and Y can be valued in their own options markets. In other words there are deep and active markets for valuing Security AB, Option X, and Option Y. There is no deep and active market for the customized Security ABXY. Security ABXY is a unique, customized security that is not traded in an active and deep market.

It is highly unlikely that the total value of Security ABXY is the additive sum of the values of Security AB plus the value of Option X plus the value of Option Y. These components of Security ABXY are likely to interact such that valuation of Security ABXY becomes exceedingly difficult if the embedded Options X and Y are not bifurcated. In terms of FAS 157, it is no longer possible to apply the sought-after Level 1 valuation for Security ABXY, even though Level 1 can be applied if the embedded Option X and Options Y were bifurcated.

Alas, throughout history accountants have been very good at naively adding up components of value that are not truly additive. For example, throughout the history of accounting firms have added up balance sheet asset values and reported the sum as the total value of Total Assets when the assets have interactions (covariances) that are totally ignored in the summation process. Only when buyers and sellers negotiate for the purchase/sale of the entire bundle (in mergers and acquisitions) do accountants reveal that, in truth, they understand that the accounting figure for "Total Assets" on the balance sheet is sheer nonsense.

**********

I was especially intrigued by the following module in the IAS Plus Notes:

Application of cash flow hedge accounting mechanics to fair value hedges

The Board considered the application of the Board's September 2009 decision to replace fair value hedge accounting with a mechanism that permitted recognition outside profit or loss of gains and losses on financial instruments designated as hedging instruments – that is, applying the mechanics of cash flow hedge accounting also to fair value hedges. The major implication would be the application of the so-called 'lower-of test' to fair value hedges. The 'lower-of test', currently applied to cash flow hedges only, ensures that only ineffectiveness due to excess cash flows on the hedging instrument (that is, the derivative) is recognised in profit or loss.

The Board members disagreed with the extension of the 'lower-of test' to fair value hedges. The Board was concerned that it was inconsistent with the nature of fair value hedging, could lead to changes in eligibility of portions, could have unintended consequences in the area of deliberately under-hedging, and in effect would lead to a situation that there would be no ineffectiveness in fair value hedges as such. A FASB member clarified that in the FASB approach to hedge accounting (given the recent discussions over the issue) the 'lower of test' would not be applied to fair value hedges.

After a short debate the Board decided by a bare majority (8 votes) to retain the 'lower-of test' for cash flow hedges only. A third of the Board members abstained in this vote.

Jensen Comment
Cash flow hedge accounting in FAS 133 and IAS 39 is relatively straight forward when a derivative financial instrument (e.g., forward contract, futures contract, swap, or option) is used to hedge cash flow risk in a hedged item (forecasted transaction or a booked item subject to cash flow risk such as a variable-rate bond or purchase contract setting the purchase price at an unknown future spot price or rate).

Cash flow hedge accounting, like foreign exchange hedge accounting, entails offsetting changes in value of the hedging derivative with a posting to an equity account (FAS 133 requires posting to OCI). The simplifying feature of cash flow hedge accounting is that it makes no difference whether the hedged item is booked (e.g., a bond asset or liability having variable rate revenue) or unbooked (e.g., a forecasted transaction to buy inventory or to buy/sell fixed-rate bonds at a future date where the fixed-rate is currently unknown).

The reason cash flow hedging is not affected by a difference between a booked or unbooked hedged item is that a hedged item subject to cash flow risk has no future value risk. Consider a variable rate bond having a booked value of $1,000. There is future cash flow risk, but the future value of the bond will always be $1,000 assuming no change in credit risk (I am only considering a hedge of cash flow risk here). Similarly, if Southwest Airlines has a forecasted transaction to buy a million gallons of jet fuel at spot rates six months from now, there is no risk that the value on the purchase will differ from the value of jet fuel on that future date. Value risk arises when the forecasted transaction is instead a firm commitment to buy at some price other than spot rates. But if there is a firm commitment price there is no cash flow risk (only value risk that the purchase price will differ from the spot price on the date of the purchase).

Fair value hedge accounting is more complicated because it matters greatly whether the hedged item is booked or not booked. For example, there is no cash flow risk of booked inventory already bought and paid for in a warehouse. There is, however, purchase-price value risk that the spot price of that inventory diverge from the price already paid for the inventory. Companies frequently hedge the fair value of inventory (although this is not necessarily a hedge of profit if selling prices are not hedged and only purchase prices are hedged if purchase and selling prices are not perfectly correlated).

Hedge accounting is not usually allowed (or called for) when hedging a booked item carried at fair value. In theory the changes in value of the hedged item should offset the changes in the value of the hedging derivative contract and any hedging ineffectiveness should be charged to current earnings in any case. If the hedged item is carried at historical cost, no such offset would arise and hedge accounting is called for at least to the extent the hedge is effective. Under FAS 133 and IAS 39, the hedge accounting for such a hedged item calls for change the basis of accounting of the hedged item during the hedge accounting period. Instead of the customary historical cost accounting (say for jet fuel inventory), the hedge accounting rules call for a change to fair value accounting of that inventory during the hedging period.

The most confusing part of fair value hedge accounting arises when the hedged item is not booked. For example, purchase contracts are typically not booked in accounting (never have been and hopefully never will be). For example, if Southwest Airlines signs a firm commitment to buy jet fuel six months from now at $2.89 per gallon the firm commitment is not booked. There is no cash flow risk since the purchase price is fixed. There is value risk, however, that the spot price in six months will be higher or lower than the $2.89 purchase (forward, strike) price.

Now the accounting becomes complicated because there is no booked hedged item value to be offset by a change in the booked hedging derivative change in value. Fair value hedge accounting of unbooked hedged items calls for changes in the value of the booked hedging contract to be offset by a posting to an equity account. In FAS 133 the FASB recommends a badly-named equity account called Firm Commitment. For example, to see how this works 03forfut.pps slide show file listed at http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/
The above slide show compares cash flow hedging versus fair value hedging of booked items versus fair value hedging of unbooked (forecasted transaction) hedged items.

Above I said that the "Firm Commitment" equity account called for in FAS 133 is badly named because changes in the value of fair value hedging contracts are not firm commitments (although they may hedge a firm commitment unbooked hedged item). I would've preferred some other name like "unrealized change in fair value hedging contracts" as an equity account.

Now the debate centers on whether the "Firm Commitment" equity account used for fair value hedge accounting of unbooked hedged items is tantamount to the "OCI" equity account used for booked and unbooked cash flow and FX hedge accounting?

Firstly, there is a difference since fair value hedges to not impact any equity account if the hedged items are booked and carried at fair value themselves. Fair value hedges of unbooked items create the special and confusing aspect of hedge accounting relief for fair value hedging.

What the IASB is currently debating with respect to amending IAS 39 is whether hedge accounting would be greatly simplified by always offsetting changes in hedge contact fair value to OCI (by whatever name) to the extent the hedge is effective. Presumably the changes in the value of a booked hedged item would also be charged to OCI (e.g., like available for sale investment changes in value are currently accounted for under the amended FAS 115/130). Such accounting could apply equally to cash flow, fair value, and FX hedges.

If the above simplification sounds too ideal, what is holding it up? Why did the IASB turn down this simplification in the October 6, 2009 special board meeting?

The reasoning of the IASB on October 6 seems to have been that the proposed "simplification" of fair value hedge accounting is would not leave any hedge ineffectiveness to be charged to current earnings for some fair value hedges whereas all hedge ineffectiveness of cash flow and FX hedges  is charged to current earnings.

Hedges are often not fully effective at interim points in time. Options as hedging derivatives, for example, are notoriously ineffective as hedges and seldom meet the "80-125 percent test" of hedge effectiveness specified in Paragraph BC 106 of IAS 39. One reason is that speculators are more often more dominant in options trading markets vis-a-vis commodities markets themselves.

Option values are divided into two components --- time value plus intrinsic value (equal the amount by which an option is in-the-money). Interim changes (before option expiration) in total option hedging value seldom satisfy the "80-125 percent test" or hedge effectiveness. It is common in hedge accounting under FAS 133 and IAS 39 rules to charge all changes in an option's time value to current earnings and only allow hedge accounting relief to changes in intrinsic value (which are zero until if and when the option is in-the-money).

It would be a sorry state of affairs if the IASB had essentially voted for hedge ineffectiveness to be ignored for fair value hedging. This would be entirely inconsistent with hedge accounting for cash flow and FX hedges where both FAS 133 ahd IAS 39 require that hedge ineffectiveness be posted to current earnings. This is also required at present for fair value hedge ineffectiveness. How sad it would be if the IASB voted in a huge inconsistency for treating hedge ineffectiveness for fair value hedging relative to cash flow and FX hedge accounting.

Whew! That was a close one that came within eight votes, at the IASB special meeting on October 6, of injecting a huge inconsistency between fair value hedging versus cash flow and FX hedge accounting. If the proposed amendment had passed it would greatly simplify the accounting at the expense of greatly complicating financial statement analysis.

For added illustrations go to http://faculty.trinity.edu/rjensen/CaseAmendment.htm

My PowerPoint shows, examination materials, and free tutorials are at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/

My overall links to FAS 133 and IAS 39 free tutorials are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm

One Feature of the Proposed Regulation of OTC Derivatives is Insane
OTC Derivatives Should Be Regulated in Some Respects, But They Should Never Be Standardized

PwC Notes one of the main reasons (shown in read) at Click Here

Why should the right balance be struck when it comes to regulating OTC derivatives?

Some OTC derivatives have been criticized for contributing to the financial crisis. But new proposals may affect how all derivatives are traded and designed.

Most financial derivatives have been safely and prudently used over the years by thousands of companies seeking to manage specific risks.

OTC derivatives are privately negotiated because they are often highly customized. They enable businesses to offset nearly any fi nancial risk exposure, including foreign exchange, interest rate, and commodity price risks.

Proposals to standardize terms for all OTC derivatives could inadvertently limit the ability of companies to fully manage their risks.

Jensen Comment
The reason that it would "limit the ability of companies to fully manage their risks" is that OTC derivatives are currently very popular hedging contracts because it is often possible over-the-counter to write customized hedging contracts that exactly match (in mirror form) the terms of a hedged item contract or forecasted transaction such that the hedge becomes perfectly effective over the life of the hedge.

If companies have to hedge with standardized contracts such as futures and options contracts traded on organized exchange markets it's either impossible or very difficult to obtain a perfectly matched and effective hedge. For example, corn futures are traded in contracts of 25,000 bushels for a given grade of corn. If Frito Lay wants to hedge a forecasted transaction to purchase 237,000 bushels of corn, it can only perfectly hedge 225,000 bu. with five futures contracts or 250,000 bu. with six futures contracts. Hence it's impossible to perfectly hedge 237,000 bu. with standardized contracts.

However, if Frito Lay wants to perfectly hedge 237,000 bu. of corn it can presently enter into one OTC forward contract for 237,000 bu. or an OTC options contract for 237,000 bu. If the hedged item is eventually purchased in the same geographic region as the hedging contract (such as Chicago), the hedge should be perfectly effective at all points in time during the contracted hedging period.

If the hedging contract is written in terms of a Chicago market and the corn is eventually purchased in a Minneapolis market, then their may be slight hedging ineffectiveness (due mainly to transportation cost differences between the two markets), but there is absolutely no mismatch due to quantity (notional) differences.

Why is customization so important from the standpoint of accounting and auditing?
Under FAS 133 and IAS 39, hedge accounting relief is available only to the extent hedges are deemed effective. The ineffective portion of value changes in the hedging contracts must be posted to current earnings, thereby increasing the volatility of earnings for unrealized value changes of the hedging contracts.

If new regulations requiring standardization of OTC derivatives, then the regulations themselves may dictate that many or most hedging contacts are, at least in part, ineffective. As a result reported earnings will needlessly fluctuate to a greater extent due to the regulations rather than because of economic substance. Dumb! Dumb! Dumb!

In particular, students may want to refer to the hedge accounting ineffectiveness testing Appendix B Example 7 beginning in Paragraph 144 of FAS 133 and Appendix A Example 7 beginning in Paragraph 93 of FAS 133. Bob Jensen's extensions and spreadsheet analysis of the Paragraph 144 illustration are available in Excel worksheet file 133ex07a.xls listed at http://www.cs.trinity.edu/~rjensen/
Sadly, the FASB left both of these examples, along with the other outstanding Appendix A and B examples out of its sparse handling of accounting for derivative financial instruments in its Codification Database.

In particular, Examples 1 thru 10 in Appendix B of FAS 133 are the best places that I know of to learn about hedge accounting and effectiveness testing. My extended analysis of each example can be found in the 133ex01a.xls thru 133ex10a.xls Excel workbooks at http://www.cs.trinity.edu/~rjensen/ 
My students focused heavily on those ten examples to learn about hedge accounting. They also learned from my videos 133ex05a.wmv and 133ex08a.wmv files listed at http://www.cs.trinity.edu/~rjensen/video/acct5341/

Teaching Cases:  Hedge Accounting Scenario 1 versus Scenario 2
Two Teaching Cases Involving Southwest Airlines, Hedging, and Hedge Accounting Controversies ---
http://faculty.trinity.edu/rjensen/caseans/SouthwestAirlinesQuestions.htm

This is a Good Summary of Various Forms of Business Risk  --- http://www.erisk.com/portal/Resources/resources_archive.asp 

1. Enterprise Risk Management
2. Credit Risk
3. Market Risk
4. Operational Risk
5. Business Risk
6. Other Types of Risk?

iGAAP (International GAAP) 2007 Financial Instruments: IAS 32, IAS 39 and IFRS 7 Explained (Third Edition)
Deloitte & Touche LLP (United Kingdom) has developed iGAAP 2007 Financial Instruments: IAS 32, IAS 39 and IFRS 7 Explained (Third Edition), which has been published by CCH. This publication is the authoritative guide for financial instruments accounting under IFRSs. The 2007 edition expands last year's edition with further interpretations, examples, discussions from the IASB and the IFRIC, updates on comparisons of IFRSs with US GAAP for financial instruments, as well as a new chapter on IFRS 7 Financial Instruments Disclosures including illustrative disclosures. iGAAP 2007 Financial Instruments: IAS 32, IAS 39 and IFRS 7 Explained (628 pages, March 2007) can be purchased through CCH Online or by phone at +44 (0) 870 777 2906 or by email: customer.services@cch.co.uk .
IAS Plus, March 24, 2007 --- http://www.iasplus.com/index.htm

Don't toss hedge accounting just because it's complicated

I have trouble with Tom’s argument to toss out hedge accounting in FAS 133 and IAS 39 --- Click Here
 http://accountingonion.typepad.com/theaccountingonion/2009/06/regulate-derivatives-start-with-better-accounting.html

It’s foolish not to book and maintain derivatives at fair value since in the 1980s and early 1990s derivatives were becoming the primary means of off-balance-sheet financing with enormous risks unreported financial risks, especially interest rate swaps and forward contracts and written options. Purchased options were less of a problem since risk was capped.

Tom’s argument for maintaining derivatives at fair value even if they are hedges is not a problem if the hedged items are booked and maintained at fair value such as when a company enters into a forward contracts to hedge its inventories of precious metals.

But Tom and I part company when the hedged item is not even booked, which is the case for the majority of hedging contracts. Accounting tradition for the most part does not hedge forecasted transactions such as plans to purchase a million gallons of jet fuel in 18 months or plans to sell $10 million notionals in bonds three months from now. Hedged items cannot be carried on the balance sheet at fair value if they are not even booked. And there is good reason why we do not want purchase contracts and forecasted transactions booked. Reason number 1 is that we do not want to book executory contracts and forecasted transactions that are easily broken for zero or at most a nominal penalties relative to the notionals involved. For example, when Dow Jones contracted to buy newsprint (paper) from St Regis Paper Company for the next 20 years, some trees to be used for the paper were not yet planted. If Dow Jones should break the contract, the penalty damages might be less than one percent of the value of a completed transaction.

Now suppose Southwest Airlines has a forecasted transaction (not even a contract) to purchase a million gallons of jet fuel in 18 months. Since it has cash flow risk, it enters into a derivative contract (usually purchased option in the case of Southwest) to hedge the unknown fuel price of this forecasted transaction. FAS 133 and IAS 39 require the booking of the derivative as a cash flow hedge and maintaining it at fair value. The hedged item is not booked. Hence, the impact on earnings for changes in the value would be asymmetrical unless the changes in value of the derivative were “deferred” in OCI as permitted as “hedge accounting” under FAS 133 and IAS 39.

If there were no “hedge accounting,” Southwest Airlines would be greatly punished for hedging cash flow by having to report possibly huge variations in earnings at least quarterly when in fact there is no cash flow risk because of the hedge. Reported interim earnings would be much more stable if Southwest did not hedge cash flow risk. But not hedging cash flow risk due to financial reporting penalties is highly problematic. Economic and accounting hit head on for no good reason, and this collision was avoided by FAS 133 and IAS 39.

Since the majority of hedging transactions are designed to hedge cash flow or fair value risk, it makes no sense to me to punish companies for hedging and encouraging them to instead speculate in forecasted transactions and firm commitments (unbooked purchase contracts at fixed prices).

The FASB originally, when the FAS 133 project was commenced, wanted to book all derivative contracts and maintain them at fair value with no alternatives for hedge accounting. FAS 133 would’ve been about 20 pages long and simple to implement. But companies that hedge voiced huge and very well-reasoned objections. The forced FAS 133 and its amending standards to be over 2,000 pages and hellishly complicated.

But this is one instance where hellish complications are essential in my viewpoint. We should not make the mistake of tossing out hedge accounting because the standards are complicated. There are some ways to simplify the standards, but hedge accounting standards cannot be as simple as most other standards. The reason is that there are thousands of different types of hedging contracts, and a simple baby formula for nutrition just will not suffice in the case of all these types of hedging contracts.

Bob Jensen's free tutorials and videos for FAS 133 and IAS 39 are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm

June 29, 2009 reply from Tom Selling [tom.selling@GROVESITE.COM]

First, I picked my OilCo example because it was also accounted for as a ‘hedge’ of an anticipated transaction—just like your Southwest example. I hope you agree that OilCo was speculating. As to Southwest, you say that Southwest was hedging, but I say they were speculating. If fuel prices had gone south instead of north, Southwest would have been at a severe cost disadvantage against the airlines that did not buy their fuel forward (and they would have become a case study of failure instead of success). In essence, the forward contracts leveraged their profits and cash flows. That’s not hedging, it’s speculating.

FAS 133 has been an abject failure, as have all other ‘special hedge accounting’ solutions that came before it. There will always be some sort of mismatch between accounting and underlying economics, but ‘special hedge accounting’ is not the way to mitigate that. You say that some companies would have been unfairly penalized by entering into hedges without hedge accounting. I say, with current events providing evidence, that much more value was destroyed because special hedge accounting provided cover for inappropriate speculation. To managers, it has been all about keeping risks off the balance sheet and earnings stable; reducing (transferring) economic risks that shareholders may be exposed to is an afterthought. And, besides, most of the time shareholders can reduce their risks by diversification. As we have seen the hard way, transaction risk reduction (what FAS 133 requires) can be more than offset by increases in enterprise risk. On a global scale, FAS 133 (and IAS 39) has done much more to enable managers to use derivatives as instruments of mass economic destruction than help them manage economic risks. And of course, instead of 2000 pages of guidance (and the huge costs that go along with it), we’d have 20 pages.

Although I did not mention it in my blog post, I could be reluctantly persuaded to allow hedge accounting for foreign currency forwards, but that’s as far as I would go.

Best,
Tom

June 30, 2009 reply from Bob Jensen

Hi Tom,

Southwest Airlines was hedging and not speculating when they purchased options to hedge jet fuel prices. If prices went down, all they lost was the relatively small price of the options (actually there were a few times when the options prices became too high and Southwest instead elected to speculate). If prices went up, Southwest could buy fuel at the strike price rather than the higher fuel prices. If Southwest had instead hedged with futures, forward, or swap derivative contracts, it is a bit more like speculation in that if prices decline Southwest takes an opportunity loss on the price declines, but opportunity losses do not entail writing checks from the bank account quite the same as real losses from unhedged price increases.

In any case, Southwest's only possible loss was the premium paid for the purchase options and did not quite have the same unbounded opportunity losses as with futures, forwards, and swaps. In reality, companies that manage risks with futures, forwards, and swaps generally do not have unbounded risk due to other hedging positions.

What you are really arguing is that accounting for most derivatives should not distinguish “asymmetric-booking” hedging derivative contracts from speculation derivative contracts. I argue that failure to distinguish between hedging and speculation is very, very, very, very misleading to investors. I do not think FAS 133 is an "abject failure." Quite to the contrary (except in the case of credit derivatives)!

I have to say I disagree entirely about “derivatives” being the cause of misleading financial reporting. The current economic crisis was heavily caused by AIG’s credit derivatives that were essentially undercapitalized insurance contracts. Credit derivatives should’ve been regulated like insurance contracts and not FAS 133 derivatives. Credit derivatives should never have been scoped into FAS 133.

The issue in your post concerns derivatives apart from credit derivatives, derivatives that are so very popular in managing financial risk, especially commodity price risk and interest rate fluctuation risk. Before FAS 119 and FAS 133 it was the wild west of off-balance sheet financing with undisclosed swaps and forward contracts, although we did have better accounting for futures contracts because they clear for cash each day. Scandals were soaring, in large measure, due to failure of the FASB to monitor the explosion in derivatives frauds. Arthur Levitt once told the Chairman of the FASB that the FASB’s three biggest problems, before FAS 133, were 1-derivatives, 2-derivatives, and 3-derivatives --- http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

When you respond to my post please take up the issue of purchase contracts and non-contracted forecasted transactions since these account for the overwhelming majority of “asymmetric-booking” derivatives contracts hedges being reported today. Then show me how booking changes in value of a hedging contract as current earnings makes sense when the changes in value of the hedged item are not, and should not, be booked.

Then show me how this asymmetric-booking reporting of changes in value of a hedging contract not offset in current earnings by changes in the value of the item it hedges provides meaningful information to investors, especially since the majority of such hedging contracts are carried to maturity and all the interim changes in their value are never realized in cash.

Show me why this asymmetric-booking of changes in value of hedging contracts versus non-reporting of offsetting changes in the value of the unbooked hedged item benefits investors. Show me how the failure to distinguish earnings changes from derivative contract speculations from earnings changes from derivative hedging benefits investors.

What you are really arguing is that accounting for such derivatives should not distinguish hedging derivative contracts from speculation derivative contracts. I argue that failure to distinguish between hedging and speculation is very, very, very, very misleading to investors.

Derivative contracts are now the most popular vehicles for managing risk. They are extremely important for managing risk. I think FAS 133 and IAS 39 can be improved, but failure to distinguish hedging derivative contracts from speculations in terms of the booking of value changes of these derivatives will be an enormous loss to users of financial statements.

The biggest complaint I get from academe is that professors mostly just don’t understand FAS 133 and IAS 39. I think this says more about professors than it does about the accounting. In fairness, to understand these two standards accounting professors have to learn a lot more about finance than they ever wanted to know. For example, they have to learn about contango swaps and other forms of relatively complex hedging contracts used in financial risk management.

Finance professors, in turn, have to learn a whole lot more about accounting than they ever wanted to know. For example, they have to learn the rationale behind not booking purchase contracts and the issue of damage settlements that may run close to 100% of notionals for executed contracts and less than 1% of notionals for executory purchase contracts. And hedged forecasted transactions that are not even written into contracts are other unbooked balls of wax that can be hedged.

There may be a better way to distinguish earnings changes arising from speculation derivative contracts versus hedging derivative contracts, but the FAS 133 approach at the moment is the best I can think of until you have that “aha” moment that will render FAS 133 hedge accounting meaningless.

I anxiously await your “aha” moment Tom as long as you distinguish booked from unbooked hedged items.

Bob Jensen

June 30 and July 31, 2009 replies by Tom Selling and BOB JENSEN

Hi, Bob:

All of my responses you will be in italics, below.

Tom Selling

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Bob Jensen
What you are really arguing is that accounting for most derivatives should not distinguish “asymmetric-booking” hedging derivative contracts from speculation derivative contracts. I argue that failure to distinguish between hedging and speculation is very, very, very, very misleading to investors. I do not think FAS 133 is an “abject failure.” Quite to the contrary (except in the case of credit derivatives).

Tom Selling
What is your evidence that failure to distinguish between hedging and speculation is misleading to investors?  My own anecdotal evidence is that investors reverse engineer the effect of hedge accounting, to the extent they can, on reported income by transferring hedging gains and losses from OCI to net income. That's because investors believe that management is hedging its bonuses and not shareholder value.

Bob Jensen  
My evidence is that millions of sole proprietorships extensively hedge prices and interest rates, including a huge proportion of farmers in the United States. Sole proprietors constitute the depth of derivatives markets.

a sole proprietor has no disconnect between shareholder value and his/her compensation. and yet sole proprietors hedge all the time. many often speculate as well, but there is a huge difference in the financial risk between hedging and speculating (USING THE FINANCE DEFINITION OF HEDGING RATHER THAN TOM SELLING'S AMBIGUOUS DEFINITION).

a sole proprietor has access to all accounting records of the business. investors do not have access and rely on accountants and auditors to keep them informed according to gaap.

and what’s to say that there’s always a disconnect between matching compensation versus shareholder value? sure there are lots of instances where managers have taken advantage of agency powers, but if this were true of virtually all corporations there would no longer be outside passive investors in corporations. you can fool some of the people some of the time, but not all the investors all of the time.

a subset of the evidence on executive compensation and shareholder value is given at http://snipurl.com/execcomp01

if managers are willing to cheat on hedging AT THE EXPENSE OF SHAREHOLDERS, they’re most likely WANTING to cheat on every other opportunity, thereby making accounting standard setting as futile for many other standards other than hedge accounting in fas 133.

I AM NOT SO CYNICAL ABOUT MOST MANAGERS. IF YOU’RE CORRECT, FINANCIAL MARKETS WILL COLLAPSE.

Fas 133 is wonderful in that it allows the balance sheet to carry derivatives and current fair value and keeps the changes in value out of current earnings if changes in hedged item booked value cannot be used to offset the one-sided, ASYMMETRICAL changes in derivative value caused by not booking the hedged items.

YOU SEEM TO AVOID THE FOLLOWING WEAKNESS IN YOUR ARGUMENT:
your argument has a huge inconsistency. there is no change in current earnings for effective hedges of booked items MAINTAINED AT FAIR VALUE. but if the hedged items are not booked, the change in current earnings can be enormous simply because the perfectly offsetting change in value of the hedged item is not booked. somehow this inconsistency does not seem to bother you.

IN FACT, WHEN ACCOUNTING FOR HISTORICAL COST INVENTORIES THAT HAVE A FAIR VALUE HEDGE, FAS 133 REQUIRES THAT, DURING THE HEDGING PERIOD, WE DEPART FROM HISTORICAL COST ACCOUNTING SO THAT FAIR VALUE CHANGES OF THE INVENTORY CAN OFFSET FAIR VALUE CHANGES IN THE HEDGING DERIVATIVE. THIS IS NOT POSSIBLE, HOWEVER, WHEN THE HEDGED ITEMS ARE NOT BOOKED SUCH AS IN THE CASE OF FORECASTED TRANSACTIONS THAT ARE HEDGED ITEMS.

some of your claims that hedging is speculation would make finance professors shake their heads BECAUSE THEY HAVE A MORE PRECISE DEFINITION OF SPECULATION VERSUS HEDGING. Please examine the spreadsheet that i use in my hedge accounting workshops. the spreadsheet is called “hedges” in the graphing.xls workbook at http://www.cs.trinity.edu/~rjensen/Calgary/CD/

Tom Selling
As for symmetric versus asymmetric booking, the FAS 133 solution (fair value hedging) is to completely screw up the balance sheet by recording inconsistent amounts based on ridiculous hypotheticals.  I am a balance sheet guy: get the balance sheet as right as possible at a reasonable cost; derive accounting income from selected changes in assets and liabilities. 

bob jensen
i don’t understand your argument. all derivatives scoped into fas 133 are carried on the balance sheet at fair value whether or not the hedged items are booked.

nOTHING IS being “screwed up” on the balance sheet!

the debate between us concerns the income statement impacts of hedging versus speculating.

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Bob Jensen
I have to say I disagree entirely about “derivatives” being the cause of misleading financial reporting. The current economic crisis was heavily caused by AIG’s credit derivatives that were essentially undercapitalized insurance contracts. Credit derivatives should’ve been regulated like insurance contracts and not FAS 133 derivatives. Credit derivatives should never have been scoped into FAS 133.

Tom Selling
You will never end up with a coherent set of accounting rules that are based on distinctions such as hedging versus speculation, or even hedging versus insurance.  Getting back to the example of Southwest Airlines, the fact that they used options to manage their future fuel costs when they thought that options were "cheap" enough just reinforces my view that they were speculating, and they happened to end up being a winner.  Perhaps, in contrast to other airlines, Southwest had some free cash flow that they could use to speculate because they were able to engineer for themselves a lower cost structure than their competitor.  But, that doesn't change my view they were speculating. Try this example: if I were to incessantly fiddle with the amount of flood insurance on my house based on long-range weather forecasts, that, too, would be speculating-- notwithstanding the fact that the contract I am doing it with is nominally an 'insurance contract.'

Bob Jensen
i would not accept this argument from a sophomore tom. the issue of hedging is often to lock in a price today rather than speculate on what the price will be in the future. that’s “hedging” of cash flow! IT IS NOT SPECULATION as defined in finance textbooks (USING THE FINANCE DEFINITION OF HEDGING RATHER THAN TOM SELLING'S AMBIGUOUS DEFINITION).

you are trying to CONFUSE the definition of cash flow “speculation.” cash flow speculation in derivatives means that by definition you have unknown cash flows due to FUTURE price or rate changes.

in contrast, cash flow hedging means locking in a price or rate. you are not distinguishing between locking in a contracted price versus speculating on a future priceS.

if you have no cash flow risk you MUST have value risk. such is life!
fas 133 makes it very clear that if you have no cash flow risk, you MUST LIVE WITH value risk. and if you have no value risk, you have cash flow risk. rules for hedge accounting exist for both types of hedging in fas 133.

I KNOW YOU LIKE TO THINK THAT A LOCKED IN PRICE DUE TO A HEDGE IS A TYPE OF "SPECULATION," BUT THIS IS NOT HOW "SPECULATION" IS DEFINED IN FINANCE. I DOUBT THAT HAVING DEFINITIONS FOR "LOCKED-IN PRICE SPECULATION" VERSUS "FUTURES PRICE SPECULATION" WILL ADD MUCH TO THE EFFICIENCY OF OUR ARGUMENT BASED IN THE FINANCE DEFINITIONS OF A CASH FLOW "HEDGE" VERSUS "SPECULATION,"

i think what you are really confusing in your argument is the distinction between cash flow risk and value risk. These two financial risks are more certain than love and marriage. you must have one (type of risk) without the other (type of risk). and the fas 133 rules are different for hedges of value versus hedges of cash flow.

Tom Selling
In short, where you see derivatives and insurance contracts, I only see contracts whose ultimate consequences are contingent on uncertain future events.   They should all be fair value with changes going to earnings.   

Bob Jensen
there’s a huge difference between hedging and insurance.
insurance companies charge to spread risk. for example, SUPPOSE an insurance company sells hail insurance in iowa, it’s ACTUARILY "certain" that all crops in iowa will not be destRoyed by hail in one summer. but we can’t be certain what small pockets of iowa farmers will have their crops destroyed BY HAIL. hence most iowa farmers buy hail insurance, thereby spreading the risk among those who will and those who won’t have hail damage TO CROPS IN IOWA. insurance companies are required by law to have sufficient capital to pay all claims under actuarial probabilities OF HAIL LOSSES.

however, when an iowa farmer buys an option in april that locks in the price of his corn crop in THE october HARVEST, this is not spreading the risk among all iowa farmers. perhaps he buys the option directly from his neighbor who decides to speculate on the price of october corn and get an option premium to boot. this is a cash flow risk transfer but is not the same as spreading the risk of hail damage among all iowa farmers

there’s a huge difference between insurance and hedging contracts in that virtually all insurance contracts rely on actuarial science. life expectancy, hail, fire, wind, floods can be estimated with much greater scientific precision than the price of oil 18 months into the future. actuarial estimation is not without error, but actuaries won’t touch commodity pricing  and interest rate pricing where historical extrapolations are virtually impossible.

One reason private insurance companies CAN sell hail insurance and not flood insurance to iowa farmers is that highland farmers are almost assured of not having floods but no farmer in iowa is assured of not having hail damage.

 without forcing all iowa farmers to buy flood insurance. the government had to put taxpayer money into flood coverage of lowlanders. this was not the case of FOR hail, FIRE, AND WIND DAMAGE risk.

one reason private insurance companies would not sell earthquake insurance is that actuary science for earthquakes is lousy. we can predict where earthquakes are likely to hit, but science is extremely unreliable when it comes to predicting what century.

fas 133 does recognize that there are many similarities between insurance and hedging in some context. these are discussed in paragraph 283 of fas 133. BUT THE DEFINITIONS OF INSURANCE VERSUS HEDGING ARE QUITE different IN FAS 133.

ONE PLACE THE FASB SCREWED UP in fas 133 IS IN NOT RECOGNIZING THAT CREDIT DERIVATIVES ARE MORE LIKE INSURANCE THAN commodity HEDGING. not making aig have capital reserves for credit derivatives was a huge, huge mistake. those cash reserves most likely would not have covered the subprime mortgage implosion that destroyed value of almost all cdo bonds, but at least there would have been some capital backing and some regulation of wild west credit derivatives of aig.

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Bob Jensen
The issue in your post concerns derivatives apart from credit derivatives, derivatives that are so very popular in managing financial risk, especially commodity price risk and interest rate fluctuation risk. Before FAS 119 and FAS 133 it was the wild west of off-balance sheet financing with undisclosed swaps and forward contracts, although we did have better accounting for futures contracts because they clear for cash each day. Scandals were soaring, in large measure, due to failure of the FASB to monitor the explosion in derivatives frauds. Arthur Levitt once told the Chairman of the FASB that the FASB’s three biggest problems, before FAS 133, were 1-derivatives, 2-derivatives, and 3-derivatives --- http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

Tom Selling
The way I see the basic problem that FAS 133 did fix was to require fair value for all contracts within its scope.   Prior to that, a $10 billion interest rate swap could stay off the balance sheet no matter how far interest rates strayed.  As you pointed out in a previous e-mail, the hedge accounting provisions in FAS 133 were a concession to special interests.  I could be wrong, but I don't recall a single investor group pounding the table and insisting that there be 2000 pages of rules to permit managers to smooth their income. 

Bob Jensen
ACTUALLY THE FASB INITIALLY DID NOT WANT TO MAKE ANY EARNINGS IMPACT CONCESSIONS FOR HEDGE ACCOUNTING. THE ORIGINAL FASB THOUGHT WAS TO DO JUST AS YOU SAY AND BOOK ALL DERIVATIVES AT FAIR VALUE WITHOUT 2,000 PAGES OF ADDED HEDGE ACCOUNTING RULES.

THE HEDGE ACCOUNTING RULES CAME ABOUT BECAUSE COMPANIES JUMPED ON THE FASB FOR “PUNISHING” HEDGING COMPANIES BY CREATING ENORMOUS UNREALIZED EARNINGS VOLATILITY IN INTERIM PERIODS THAT WOULD NEVER BE REALIZED WHEN HEDGES WERE SETTLED AT MATURITY DATES.

WITHOUT HEDGE ACCOUNTING, COMPANIES GO PUNISHED FOR HEDGING AS IF THEY WERE SPECULATING WHEN THEY ARE HEDGING (USING THE FINANCE DEFINITION OF HEDGING RATHER THAN TOM SELLING'S AMBIGUOUS DEFINITION). I KNOW YOU LIKE TO THINK THAT A LOCKED IN PRICE DUE TO A HEDGE IS A TYPE OF "SPECULATION," BUT THIS IS NOT HOW "SPECULATION" IS DEFINED IN FINANCE. I DOUBT THAT HAVING DEFINITIONS FOR "LOCKED-IN PRICE SPECULATION" VERSUS "FUTURES PRICE SPECULATION" WILL ADD MUCH TO THE EFFICIENCY OF OUR ARGUMENT BASED IN THE FINANCE DEFINITIONS OF A CASH FLOW "HEDGE" VERSUS "SPECULATION,"

IT’S UNFAIR TO EQUATE CONCESSIONS TO SPECIAL INTEREST GROUPS TO HEDGE ACCOUNTING RULES IN FAS 133. I FIND THE ARGUMENTS FOR HEDGE ACCOUNTING VERY COMPELLING SINCE IN MOST INSTANCES OF HEDGING THE FLUCTUATIONS IN UNREALIZED VALUE CHANGES WASH OUT FOR HEDGE CONTRACTS THAT ARE SETTLED AT MATURITY DATES. IT WAS THE ARGUMENTS THAT WERE COMPELLING RATHER THAN POLITICAL CONCESSIONS TO SPECIAL INTEREST GROUPS. THE SIMPLE ARGUMENT WAS THAT BY LOCKING IN PRICES OR PROFITS COMPANIES WERE BEING PUNISHED AS IF THEY WERE SPECULATING (I DISCUSS YOUR CONFUSED DEFINITION OF “SPECULATION” ELSEWHERE IN THIS MESSAGE.)

prior to fas 133, companies were learning that it was very easy to keep debt off the balance sheet with interest rate swaps. there is ample evidence of the explosion of this as companies shifted from managing risk with treasury bills to managing risk with swaps.

there were many scandals due, in large measure, to bad accounting for derivatives prior to fas 133 --- http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
of course lack of regulation of the derivatives markets themselves was an even bigger problem.

---

Bob Jensen
When you respond to my post please take up the issue of purchase contracts and non-contracted forecasted transactions since these account for the overwhelming majority of “asymmetric-booking” derivatives contracts hedges being reported today. Then show me how booking changes in value of a hedging contract as current earnings makes sense when the changes in value of the hedged item are not, and should not, be booked.

Tom Selling
I already took up that question.  One of the points I was trying to make in the OilCo case is that hedge accounting, while designed to reduce the volatility of reported earnings, often increases the volatility of economic earnings.  That's why OilCo's stock price went down as oil prices went up.  Let me try state it in terms of a manufacturer of a commodity product that contains a significant amount of copper.   Changes in market prices of the end product can be expected to be highly correlated with changes in the price of copper.  Therefore, a natural hedge is already in place for the risk that copper prices will rise in the future.  If you add a forward contract to purchase copper to the firm's investment portfolio, then you are actually adding to economic volatility instead of subtracting from it.  (I trust you don't need a numerical example, but I could provide one if you want it.)  If you add an at-the-money option to purchase copper, you are destroying value by paying a premium for what is essentially an insurance contract on a long run risk that doesn't exist.

I think the fundamental difference between our positions, Bob, is that you believe that management is acting to maximize (long-run) shareholder value, and I (and perhaps the like Leslie Kren), more cynically believe that management is acting to lock-in their short-run, earnings-based compensation.  The 'special hedge accounting' provisions of FAS 133 is just one tool that they have for doing so.  And as icing on the cake because of its incredible complexity, it lines the pockets of 'advisors', financial intermediaries, auditors, and even educators like you and me. 

Bob Jensen
OPTION VALUE = INTRINSIC VALUE + TIME VALUE
YOU ARE INSULTING THE INTELLIGENCE OF FINANCE PROFESSORS WHO WOULD SHAKE THEIR HEADS WHEN READING:   “ If you add an at-the-money option to purchase copper, you are destroying value by paying a premium for what is essentially an insurance contract on a long run risk that doesn't exist.”

THERE IS LONG RUN RISK THAT THE FUTURE PRICE WILL GO UP OR DOWN. WHEN YOU BUY AN OPTION AT THE MONEY, THERE IS NO INTRINSIC VALUE BY DEFINITION. BUT THE REASON THE PRICE(PREMIUM) OF THE OPTION IS NOT ZERO IS THAT IT HAS TIME VALUE DUE TO THAT CONTRACTED INTERVAL OF TIME IT HAS TO GO INTO THE MONEY. CASH FLOW HEDGING WITH AN OPTION IS NOT “INSURANCE CONTRACTING” AS DEFINED IN FAS 133. THIS IS A HEDGE THAT LOCKS IN A PURCHASE OR SALES PRICE AT THE STRIKE PRICE SUCH THAT IT IS NOT NECESSARY IN THE FUTURE TO GAMBLE ON AN UNKNOWN FUTURE PRICE.

a subset of the evidence on executive compensation and shareholder value is given at http://snipurl.com/execcomp01

if managers are willing to cheat on hedging AT THE EXPENSE OF SHAREHOLDERS, they’re most likely WILLING to cheat on every other opportunity, thereby making accounting standard setting as futile for many other standards other than hedge accounting in fas 133.

---

Bob Jensen
Then show me how this asymmetric-booking reporting of changes in value of a hedging contract not offset in current earnings by changes in the value of the item it hedges provides meaningful information to investors, especially since the majority of such hedging contracts are carried to maturity and all the interim changes in their value are never realized in cash.

Tom Selling
Just because it may not be recognized in cash, that doesn't mean changes in value are not relevant to investors.  I suppose that's an empirical question.  But I should also add that by your comment, may I infer that you are also in favor of maintaining a held-to-maturity category for marketable debt securities?  If so, then we have a lot more important things to talk about than just hedge accounting!  Him him him him him him him

Bob Jensen
I AM A STRONG ADVOCATE OF HTM ACCOUNTING SIMPLY TO KEEP PERFORMANCE FICTION OUT OF THE FINANCIAL STATEMENTS. THIS IS ESPECIALLY THE CASE WHERE THERE ARE PROHIBITIVE TRANSACTIONS COSTS FROM EARLY SETTLEMENTS. MY ARGUMENTS HERE ARE MY CRITICISMS OF EXIT VALUE AT http://faculty.trinity.edu/rjensen/theory01.htm#FairValue

THE IASB IMPOSES GREATER PENALTIES FOR VIOLATORS OF HTM DECLARATIONS THAN DOES THE FASB, BUT AUDITORS ARE WARNED TO HOLD CLIENTS TO HTM DECLARATIONS.

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Bob Jensen
Show me why this asymmetric-booking of changes in value of hedging contracts versus non-reporting of offsetting changes in the value of the unbooked hedged item benefits investors. Show me how the failure to distinguish earnings changes from derivative contract speculations from earnings changes from derivative hedging benefits investors.

Tom Selling
Hedging and speculation is a question of intent, and I don't believe they can be reliably separated.  To this I would add that transaction hedging in FAS 133 is really not economic hedging. In order to make the distinction between hedging and speculation auditable, FAS 133 prohibits macro hedges.  Thus, managers claim that the hedges that actually enter into in order to get the income smoothing they need are actually less efficient (i.e., riskier) than if they were permitted to have hedge accounting for macro hedges.

Bob Jensen
once again you are confusing cash flow hedging from value hedging. i covered this above.

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Bob Jensen
What you are really arguing is that accounting for such derivatives should not distinguish hedging derivative contracts from speculation derivative contracts. I argue that failure to distinguish between hedging and speculation is very, very, very, very misleading to investors.

Derivative contracts are now the most popular vehicles for managing risk. They are extremely important for managing risk. I think FAS 133 and IAS 39 can be improved, but failure to distinguish hedging derivative contracts from speculations in terms of the booking of value changes of these derivatives will be an enormous loss to users of financial statements.

Tom Selling
Empirical question.  See above.

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Bob Jensen
The biggest complaint I get from academe is that professors mostly just don’t understand FAS 133 and IAS 39. I think this says more about professors than it does about the accounting. In fairness, to understand these two standards accounting professors have to learn a lot more about finance than they ever wanted to know. For example, they have to learn about contango swaps and other forms of relatively complex hedging contracts used in financial risk management.

Tom Selling
I can't speak for other accounting professors who may choose to remain ignorant of the details of FAS 133.  I think it's a question of incentives.  But, I think I know FAS 133 pretty well (although surely not as well as you), and certainly well enough to have an informed opinion. I don't think FAS 133 stinks because it is too difficult to learn.  It stinks because, contrary to what you believe, I think that managers game the system and in the process are destroying shareholder value, and even our economy.

---

Bob Jensen
Finance professors, in turn, have to learn a whole lot more about accounting than they ever wanted to know. For example, they have to learn the rationale behind not booking purchase contracts and the issue of damage settlements that may run close to 100% of notionals for executed contracts and less than 1% of notionals for executory purchase contracts. And hedged forecasted transactions that are not even written into contracts are other unbooked balls of wax that can be hedged.

Tom Selling
I can't speak for finance professors either, but my very loose impression is that they will make the simplifying assumption that accounting doesn't matter.  In other words, the contract between shareholders and management is efficient in the sense that managers cannot gain by gaming the accounting rules.  Ha Ha Ha.

Bob Jensen
IF WHAT YOU SAY IS TRUE THAT VIRTUALLY ALL MANAGERS OUR OUT TO SCREW INVESTORS, THEN CAPITALISM AS WE KNOW IT IS DOOMED. IT IS SERIOUSLY CHALLENGED AT THE MOMENT, AND MAYBE WE WILL TURN ALL OF OUR LARGE CORPORATIONS OVER TO THE GOVERNMENT THAT NEVER SCREWS ANYBODY. WHY DIDN’T WE THINK OF THIS BEFORE. THE SOVIET UNION HAD IT RIGHT ALL ALONG.

a subset of the evidence on executive compensation and shareholder value is given at http://snipurl.com/execcomp01

if managers are willing to cheat on hedging AT THE EXPENSE OF SHAREHOLDERS, they’re most likely WantING to cheat on every other opportunity, thereby making accounting standard setting as futile for many other standards other than hedge accounting in fas 133. I AM NOT SO CYNICAL ABOUT MOST MANAGERS. IF YOU’RE CORRECT, FINANCIAL MARKETS WILL COLLAPSE.

“Accounting Doesn’t Matter”
once again this is a sophomore statement. although i’m often critical that individual financial reporting events studies are not replicated, the thousands of such studies combined point to the importance of events, especially earnings announcements, on investor behavior. only sophomores in finance would make a claim that “accounting does not matter.”

There may be a better way to distinguish earnings changes arising from speculation derivative contracts versus hedging derivative contracts, but the FAS 133 approach at the moment is the best I can think of until you have that “aha” moment that will render FAS 133 hedge accounting meaningless.

---

Bob Jensen
I anxiously await your “aha” moment Tom as long as you distinguish booked from unbooked hedged items.

Tom Selling
I like FAS 159 as a temporary measure, despite the inconsistencies it creates—they are no worse than FAS 133’s inconsistencies. 

 Offsetting changes in the value of unbooked hedged items are to the totality of our grossly inadequate accounting standards as a flea is to Seabiscuit's rear end.  Here's the best I can do: change the name of the balance sheet to "statement of recognized assets and liabilities"; change the name of the income statement to "statement of recognized revenues, expenses, gains and losses."  At least that way, readers will have a better idea of what accountants are feeding them.

Bob Jensen
fas 159 says absolutely nothing about a fair value option for unbooked contracts and forecasted transactions other than it does not allow fair value booking for these anticipated (often contracted) transactions

And I certainly would not make fair value accounting for derivatives an option under fasb standards.

hence fas 159 is of no help at all in accounting for hedging contracts of hedged items that are not booked.

Thanks,
Bob Jensen

July 1, 2009 reply from Tom Selling [tom.selling@GROVESITE.COM]

Bob, I’m sorry that you misunderstood some of my arguments. Perhaps I was not clear. I will conclude with a couple of general points, and you should feel free to have the last word.

First, your arguments are largely premised on the assumption that everyone accepts your definition of “hedging.” FAS 133 defines a derivative for the purpose of applying FAS 133, but notably, it does not define hedging. That’s because, even more than “derivatives,” it defies a principles-based definition that can be applied without 2000 pages of rules. Moreover, your definition entails locking in a price or rate of a transaction. My own conceptualization involves reduction of enterprise risk. One of my points is that reduction in transaction risk can increase enterprise risk. I thought my OilCo example was crystal clear on that point, and would expect every sophomore to understand it.

Second, when I stated that FAS 133 screws up the balance sheet, I was referring to the inconsistent measurements of hedged items--not hedging instruments. I stand by my earlier statement: hedge accounting screws up the measurement of assets and liabilities in order to get a desired income statement result. You may accept that tradeoff, but I don’t.

Finally, sole proprietor farmers don’t hold diversified portfolios, which explains why they use forward contracts to hedge. And, if they used more costly options, I’d call it either insurance or speculation. I certainly wouldn’t call it hedging.

Best, Tom

July 1, 2009 reply from Bob Jensen

Hi Tom,

Whenever you finish your proposal for changing FAS 133 and IAS 39, I think you should run it by finance experts to see if it makes sense in terms of what they call hedging. I think they will not especially like new definition of a hedge that locks in price in a cash flow hedge a "locked-in price speculation," They're more apt to think of a speculation as one in which the price is not locked in by a hedge.

Finance professors will be especially confused by your calling futures contracts hedging contracts and opions contracts speculations.When I consulted on hedging with an association of ethanol producers and farmers who supplied the corn, they were much more into purchased options than futures contracts for what they called “hedging purposes.” Note the finance definition of hedging below stresses options (and short sales).

Purchased options are very popular for hedging purposes since the financial risk is capped (at the price paid for the options). Futures, forwards, and swaps have a lot of risk unless users take sophisticated offsetting positions. In any case options are very popular in hedging.

One last point, but a very important point, that I forgot to mention. I’ve done some consulting for the Pilots Association of Southwest Airlines. One thing they were initially worried about was the possibility that Southwest could, in theory, manipulate earnings with FAS 133. It turns out that in both contract negotiations and bonus calculations, Southwest excludes hedge accounting and unrealized derivatives gains and losses.

I think this is also the case for a lot of major companies in terms of executive compensation. Hence the premise that executives manipulate hedge accounting for their own compensation is pretty weak.

Also FAS 133 disclosures make it possible, usually, to exclude unrealized derivatives gains and losses from financial analysis. Of course, it takes some sophistication to deal with AOCI versus changes in RE, but then again so does the new FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments ("FSP FAS 115-2") ---
http://www.fasb.org/pdf/fsp_fas115-2andfas124-2.pdf

FSP FAS 115-a, 124-a, and EITF 99-20-b, the proposal that softens the blow of recognizing other-than-temporary impairments, was essentially unchanged from the original proposal. It remains a chancre on the body of accounting literature. The credit portion of an other-than-impairment loss will be recognized in earnings, with all other attributed loss being recorded in "other comprehensive income," to be amortized into earnings over the life of the associated security. That's assuming the other-than-temporary impairment is recognized at all, because the determination will still be largely driven by the intent of the reporting entity and whether it's more likely than not that it will have to sell the security before recovery. This is a huge mulligan for banks with junky securities.
FASB's FSP Decisions: Bigger than Basketball?" Seeking Alpha, April 2, 2009 ---
http://seekingalpha.com/article/129189-fasb-s-fsp-decisions-bigger-than-basketball

 

hedge http://www.investorwords.com/2293/hedge.html

Definition

An investment made in order to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related security, such as an option or a short sale

Bob Jensen
"The New Role of Risk Management: Rebuilding the Model," Interview with Wharton professors Dick Herring and Francis Diebold, and also with John Drzik, who is president and chief executive officer of Oliver Wyman Group, Knowledge@wharton, June 25, 2009 --- http://knowledge.wharton.upenn.edu/article.cfm?articleid=2268

Bob Jensen's free tutorials and videos for FAS 133 and IAS 39 are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm

Bob Jensen's threads on the differences between U.S. and International GAAP are at http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#FASBvsIASB

Video Tutorials on Accounting for Derivative Financial Instruments and Hedging Activities per FAS 133 in the U.S. and IAS 39 internationally --- http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/ 

• Video Tutorial:  Introduction to Accounting for Derivatives and Hedging --- 
  000FAS133introduction.wmv
  
• Video Tutorial:  Overview of Bob Jensen's Helper Documents on Derivatives and Hedging --- 
  010FAS133Helpers.wmv 
  
• Video Tutorial:  Two Cases on Accounting for Options and Intrinsic vs. Time Value Accounting --- 
  015FAS133options.wmv
  
• Video Tutorial:  Two Cases on Accounting for Futures Contracts --- 
  020FAS133futures.wmv
  
  
• Video Tutorial:  Accounting for Interest Rate Swap Hedges and Valuation of Swaps --- 
   

  Video Tutorial:  Accounting for Interest Rate Swap Hedges and Valuation of Swaps --- 
  030FAS133InterestRateSwapAccounting.wmv --- http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/  
  Choose file 030FAS133InterestRateSwap.wmv

My SFAS 133 and IAS 39 Glossary and Transcriptions of Experts
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

Helpers for Accounting Educators --- http://faculty.trinity.edu/rjensen/default3.htm 

Accounting Theory --- http://faculty.trinity.edu/rjensen/theory.htm 

XBRL and XML --- http://faculty.trinity.edu/rjensen/XBRLandOLAP.htm 

Electronic Commerce --- http://faculty.trinity.edu/rjensen/ecommerce.htm 

"The Fallout from FAS 133: Should Congress Change Tax Law to Match New Accounting Standards?" by Ira Kawaller and John J. Ensminger: --- http://papers.ssrn.com/sol3/papers.cfm?abstract_id=256752

Abstract: Last June, the private Financial Accounting Standards Board implemented a new standard that requires companies that compile balance sheets to show changes in a derivative's value as an asset or loss, even if the derivative remains in an open position. This new standard radically conflicts with U.S. tax law, which largely leaves derivatives unreported on tax returns. Given this difference, lawmakers may now wonder if they should change tax law to require reporting of all derivates and other fair value financial assessments. Critics of such a change will argue that it radically departs from the current structure. But, despite this difficulty, the change would bring such advantages as simplifying tax law, unifying accounting practices, and - perhaps most importantly - closing a number of tax loopholes that creative accountants use to shelter clients' assets.

Where can you learn more about FAS 133?

February 15, 2006 message from XXXXX

Bob,

. . . .The purpose of my email is to solicit your opinion on the best resources I can leverage to answer various issues that arise and generally broaden my understanding of FAS 133. work in risk management but have difficulties with the accounting side of FAS 133.  [Other portions of message deleted]

Thanks for your time!

XXXXX

February 15, 2006 reply from Bob Jensen

Hi XXXXX,

I receive inquiries like this almost daily. Usually these questions come from accountants who do not have sufficient background in derivative instruments contracting and economic hedging and, as a result, have not been able to tackle FAS 133 and IAS 39. Sometimes the inquiries come from people like your self who have good background in finance and risk management but cannot comprehend the quirks of accounting that led to this monstrous set of incomprehensible rules for booking and/or disclosing derivative financial instruments.

When accountants do not understand derivatives and risk management, I tell them to work through one of the best textbooks I've ever seen (which has no accounting whatsoever inside):
Derivatives:  An Introduction by Robert A Strong, Edition 2
(Thomson South-Western, 2005, ISBN 0-324-27302-9)

When people like yourself who understand derivatives and risk management but cannot understand the quirks of accounting, I begin with an illustration of a basic quirk in accounting--- a quirk discussion that also introduces the concepts of "forecasted transaction" and "firm commitment" hedging under FAS 133 rules.

Unbooked Financial Risks
One of the first things we learned in Accounting 101 is that accountants traditionally do not book (and usually do not even disclose) purchase/sales contracts until legal title to the goods and services actually changes hands. Reasons are complicated, but the most fundamental reason is that defaulted purchase/sales contracts are usually settled in court or out of court for a small fraction of contracted amounts, i.e., settlements are usually based upon damages rather than contracted amounts in full. For example, when Dow Jones contracts with St. Regis Paper Company for paper purchases over the next 50 years of publishing The Wall Street Journal it would be absurd to try to book a soft estimate of the billions of the actual contracted dollars of this contract. Damage estimates are virtually impossible to estimate and change from month to month as more trees for paper harvesting are planted.

Hence the biggest problem finance and economics professors have with accounting professors is that purchase/sales contracts entail financial risks that accounting professors refuse to book. Furthermore these purchase/sales contract risks are commonly hedged. When the notional (quantity) and underlying (price or rate) are contracted, the purchase/sales contract is called a "firm commitment" under FAS 133. There is no cash flow risk in firm commitments, but they can be hedged for fair value (when future spot prices differ from contracted prices). When the notional (quantity) is contracted or otherwise reasonably certain and the underlying is not specified there is cash flow risk that can be hedged with a cash flow hedge defined in FAS 133. Also firm commitments and forecasted transactions can be hedged for foreign currency (FX) risk apart from U.S. dollar risks. Most accountants do not even understand that it is impossible to simultaneously hedge for fair value and cash flow.

FAS 133 as Source Material for Comedy Central TV
My purpose here is not to launch into a tutorial about purchase/sales contract hedge accounting rules under FAS 133. Rather my purpose is to illustrate the dilemma caused by traditional quirks in accounting. Where finance and accounting professors differ is on the basic concept of financial risk. Finance professors are confused when there are financial risks that can be hedged even though those risks are virtually ignored by accountants because legal title has not changed hands. Then along comes FAS 133 that declares the hedge contracts for unbooked hedged items must be booked and maintained at fair value even though the hedged items themselves are not booked until title passes. This begins to sound like great source material for Comedy Central TV --- perhaps the Cobert Report!

Where To Begin
Adding pain to misery is the fact that FAS 133 rules for fair value hedges differ greatly from rules for cash flow and FX hedges. Finance professors find the stated reasons in FAS 133 incomprehensible. Accounting professors don't bother to open FAS 133 and never get out of the starting gate in understanding derivatives, hedging, risk management, and FAS 133.

So where do you begin to understand the accounting quirks in FAS 133? My first piece of advice is to totally ignore accounting textbooks, including those that may claim to be derivatives accounting textbooks. These are worthless. Second ignore the finance and economics textbooks since authors of these books do not understand accounting quirks.

You mentioned Ira Kawaller. Ira is an economist who admits to having difficulties understanding accounting quirks. This is why he sometimes brings me into partner with him on teaching FAS 133 --- my role is to teach accounting quirks of FAS 133. I also give my own workshops on this topic --- http://faculty.trinity.edu/rjensen/resume.htm#Presentations

I also provide free online FAS 133 and IAS 39 tutorials and videos --- http://faculty.trinity.edu/rjensen/caseans/000index.htm

But the bottom line is that my audiences and my readers conclude that my biggest success in life is confusing them about accounting for derivatives. My defense is that it is very difficult to explain the huge gap between financial risk versus what accountants book. I get a lot of compliments for what I provide online, but the most common complaint is that my online materials are a nightmare to navigate

Where should you dig into to learn about the accounting quirks of FAS 133? The bottom line is that I don't know! You can pay thousands of dollars to attend one of our seminars, but these are so broad brushed that our audiences feel like they've just had a meal on hors'deovers.

The bottom line is that it is probably best to dig into the FASB's "Green Book" line for line as painful as that becomes for 873 pages of jargon ---
http://fasbpubs.stores.yahoo.net/dc133-3.html
 

Also request the FASB's supplemental documentation (119 pages to date) of error corrections in the Green Book.

Secondly, memorize the FAS 133 and IAS39 rules rather than try to find a rationale. For example, it is utterly frustrating trying to reason why hedge accounting for cash flow/FX hedges use OCI offsets that are verboten  fair value hedges (never OCI for FV hedges). You should just to do or die, not reason why.

I do suggest that you especially look at my Excel workbooks at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133AppendixB/

I also suggest that you look at my PowerPoint files at http://www.cs.trinity.edu/~rjensen/Calgary/CD/ 

There is much pressure outside and within the FASB and the IASB to simplify rules for accounting for derivative financial instruments. This is a bit like appeals to reduce felony statutes to a mere Ten Commandments on stone tablets. Simplification sounds great as a principle, but in my viewpoint oversimplification will be disastrous. The reason is that there are thousands of different kinds of risk management contracts, and it's impossible to derive ten commandments covering all the variations arising in the practice of risk management.

Some argue that fair value accounting (in place of historical cost accounting) is the answer, but I have my doubts about this oversimplification ---
http://faculty.trinity.edu/rjensen/FairValueDraft.htm
Also see
http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue

For example, fair value accounting is no panacea to accounting for purchase/sales contracts.

Bob Jensen

The name of the game is derivatives!

Will your bonus for last year come anywhere close to $9 million?  
Global commercial banks are expected to award bumper bonuses in the next three months, following a pattern set by the US investment banks in December. Forex dealers anticipate year-on-year increases of up to 50% in their annual packages, on the back of a highly lucrative year in foreign exchange as major and emerging markets currencies went haywire. An unusually active fourth quarter in particular boosted many traders' profit and loss accounts as they wound down for year-end, sending up bonus expectations accordingly. Goldman Sachs, Merrill Lynch, Morgan Stanley and Lehman Brothers were among the banks that announced their bonus payouts in December. Peers at rival banks reported that forex dealers at Morgan Stanley saw average year-on-year rises of 20%, while the very top staff in foreign exchange and derivatives may have seen as much as $9 million each. "This type of figure is not inconceivable at the top three or four banks," said one head of foreign exchange at a US bank in New York.
RiskNews Weekly on January 9, 2004

An Illustration of FAS 133 Implementation and Hedging Complexities

The bookkeeping error in which Fannie Mae failed to book $1.1 billion in derivative financial statements was reported as a computer error when implementing a new FAS 149 set of amendments to FAS 133 at Fannie Mae.  The explanation is plausible, the importance of this error were probably overblown by the media.  

However, Fannie May's otherwise impeccable attempts to implement FAS 133 and its amendments illustrate what a complicated complicated mess we are in today when implementing FAS 133 issued by the Financial Accounting Standards Board (FASB).  The same can be said about its IAS 39 counterpart issued by the International Accounting Standards Board (IASB).  These two standards and their various amendments are widely criticized and have tended to create more confusion than help among investors, analysts, accountants, banks, and other corporations.

A large part of the confusion that exists centers around the public perception of hedging.  Hedging suggests elimination of risks that are hedged.  In fact, however, hedging is merely a transfer from one type of risk to another type of risk.  Before getting into this, however, let's review the Fannie Mae example of a really solid effort to implement FAS 133 and its amendments.

What is Fannie Mae? --- Federal National Mortgage Association --- http://www.primecoastmortgage.com/Fannie_Mae.htm 

The role of Fannie Mae and the secondary mortgage market in housing finance
Fannie Mae plays a vital role in financing mortgages and increasing homeownership opportunities for more Americans. A privatization success story, Fannie Mae began in 1938 as an agency of the federal government, created to bring stability to the U.S. housing market. In 1968, Fannie Mae became a privately-owned and - managed corporation. At that time, the U.S. Congress rechartered Fannie Mae as a private company, mandating that it operate with private capital on a self-sustaining basis to enhance the flow of funds through the secondary market to American home buyers.

Fannie Mae operates exclusively in the secondary mortgage market - providing support to mortgage lending institutions in the primary market. Lenders who originate loans in the primary mortgage market may either hold the loans in their portfolios or sell them in the secondary mortgage market. By selling their loans in the secondary market, lenders are able to obtain additional funds with which to make more loans to home buyers.

The secondary mortgage market helps accomplish the following important housing objectives:

• it addresses imbalances of mortgage credit among regions of the United States by making funds available to capital-deficient areas of the country to finance new mortgage originations;
• it allows lenders to originate mortgages for sale rather than for portfolio investment;
• it standardizes mortgage loans, thereby attracting investors who traditionally have not invested in the primary market, further strengthening this market.

Fannie Mae's impact on housing needs
Fannie Mae is the nation's largest investor in home mortgages today. The corporation has provided home financing for over 32 million American families since its creation in 1938. Fannie Mae currently owns in its portfolio, or holds in trust for investors, one out of every five mortgages in the United States.

In 1994, Fannie Mae announced its Trillion Dollar Commitment to provide $1 trillion by the year 2000 to finance homes for over 10 million families most in need. This targeted housing finance initiative is serving families with incomes below the median for their area, minorities and new immigrants, families who live in central cities and distressed communities, and people with special housing needs.

Through its Trillion Dollar Commitment, Fannie Mae provides renters in America the information they need to buy homes, develops specialized products and services to break down arbitrary barriers to getting home mortgages, and focuses on eliminating lending discrimination in the housing finance industry.

Fannie Mae's homepage is at http://www.fanniemae.com/index.jhtml 

Fannie Mae FAQs --- http://www.fanniemae.com/faq/index.jhtml?p=FAQ 

The Timeline of the Recent History of Fannie Mae Scandals 2002-2008
 "Fannie Mayhem: A History," The Wall Street Journal, July 14, 2008 --- http://online.wsj.com/article/SB121599777668249845.html?mod=djemEditorialPage

• Fannie Mae Ugly 07/12/08 – Investors continued to flee Fannie Mae and Freddie Mac almost as frantically as the political class tried to reassure everybody there was nothing to worry about.       • The Price of Fannie Mae 07/10/08 – It's time Americans understood the price they could soon pay for the Beltway's confidence game with these high-risk "government-sponsored enterprises."       • Too Political to Fail 04/21/08 – Fannie Mae and Freddie Mac aren't held to the same standards of accountability as everyone else.       • Fannie Mayhem 11/20/07 – Chuck Schumer is lucky Congress ignored his idea that Fannie Mae and Freddie Mac should ride to the rescue of the housing market.       • Fannie More 10/23/07 – Barney Frank and Chuck Schumer have come up with a proposal that would increase the risk to taxpayers from Fannie Mae and Freddie Mac.       • Fannie to the Rescue? 09/29/07 – Fannie and Freddie went up the Hill to fetch a pail of money.       • Freddie Krueger Mac 05/10/07 – Just when you think they're defeated, Fannie Mae and Freddie Mac arise in Congress to kill any attempt to clean up their dangerous habits.       • The Fannie Tax 04/12/07 – Democrat Barney Frank and the Bush Administration seem to have found common ground on new rules for Fannie Mae and Freddie Mac. Naturally, there's a catch.       • Memo to Fannie 06/14/06 – A joke in Washington these days goes like this: "What's the difference between Enron and Fannie Mae? Answer: The guys at Enron have been convicted."       • Freddie's Friends on the Hill 04/27/06 – The Federal Election Commission sheds some light on how Freddie Mac rewards its friends.       • Fannie Mae's House 10/25/05 – Every Congressional session can be counted on to produce its share of bad bills. But the "reform" bill for Fannie Mae and Freddie Mac is in a class of its own.       • Fannie's Friends on the Hill 05/09/05 – Congress finally seemed ready to protect taxpayers from Fannie Mae and Freddie Mac. Then Republican Mike Oxley decided to ride to their rescue.       • Fannie Turns a Page 12/23/04 – Fannie Mae – a slick, semiprivate firm operating with the patronage of politicians – is the kind of institution one still expects to find in a country like France.       • Fannie the Centaur 12/17/04 – Understanding their half-man, half-beast nature is crucial to fixing Fannie Mae and Freddie Mac in the wake of their recent financial scandals.       • Fannie Mae Liberals 10/14/04 – There were many moments of high entertainment during the House hearings on Fannie Mae's creative accounting. But our favorite was the Mister Magoo performance given by Barney Frank (D., Massachusetts).       • Fannie Mae Enron? 10/04/04 – The company was cooking the books. Big time.       • Fannie Uncovered 09/23/04 – The housing-finance giant has been engaging in some accounting funny business.       • Fannie's Risky Business 02/25/04 – Alan Greenspan puts his credibility behind the cause of reforming Fannie Mae and Freddie Mac.       • Christmas for Fannie Mae 12/23/03 – The Federal Reserve Board releases a new staff study about the impact of taxpayer subsidies for Fannie Mae and Freddie Mac.       • White House Fannie Pack 11/11/03 – White House chief economist N. Gregory Mankiw dares to tell the truth about Fannie Mae and Freddie Mac. The mortgage giants were not amused, which means we're getting somewhere.       • Fannie Takes the Hill 10/09/03 – When the House of Representatives can't get even a modest regulatory bill out of committee, the dangers of Fannie Mae become clear in reality.       • Speaking Truth to Fannie 03/12/03 – The president of the Federal Reserve Bank of St. Louis warns of a potential crisis arising from Fannie Mae and Freddie Mac.       • Fan and Fred Get the Business 02/19/03 – The year has not started auspiciously for the two mortgage-finance behemoths.       • Fannie Mae's Risky Business 09/23/02 – We've been suggesting that Fannie Mae was exposed to too much interest-rate risk. All of a sudden investors seem to agree with us.       • Fannie Capitulates, Sort Of 07/15/02 – Fannie Mae and Freddie Mac end months of resistance, stonewalling and downright crankiness and agree to register their common stock with the Securities and Exchange Commission.       • Fannie's Inside Info 07/01/02 – Even in this post-Enron world, Fan and Fred do not provide as much information about these securities as private mortgage lenders do.       • Inside Fannie 03/19/02 – Fan and Fred don't function like other companies. They're allowed to pile up debt, implicitly guaranteed by taxpayers, without being held to even the minimum of corporate governance standards.       • Frantic Fannie 02/28/02 – Companies taking on so much risk and debt, and backed by taxpayers, ought to be more transparent in what they tell the world.       • Fannie Mae Enron? 02/20/02 – Fan and Fred look like poorly run hedge funds: lots of leverage and snarkily hedged risk. Does the word Enron ring any bells?

 

It just gets deeper and deeper for KPMG

Fannie Mae Sues KPMG
The mortgage lending company Fannie Mae filed suit on Tuesday against its former auditor KPMG, accusing the firm of negligence and breach of contract for its part in the flawed accounting that led to a $6.3 billion restatement of earnings. Fannie Mae states in its complaint that KPMG applied more than 30 flawed principles and cost it more than $2 billion in damages. Fannie Mae fired the accounting firm in mid-December 2004, just a week after the Securities and Exchange Commission ordered the company to restate more than two years of flawed earnings. A KPMG spokesman, Tom Fitzgerald, said the company planned to “pursue our own claims against Fannie Mae.”
"Fannie Mae Sues KPMG," The New York Times, December 13, 2006 --- http://www.nytimes.com/2006/12/13/business/13kpmg.html?_r=1&oref=slogin

Bob Jensen's threads on KPMG are at --- http://faculty.trinity.edu/rjensen/Fraud001.htm#KPMG

"Fannie Mae Faces Work After Restatement," by Marcy Gordon, SmartPros, December 8, 2006 --- http://accounting.smartpros.com/x55766.xml

Mortgage giant Fannie Mae has taken a significant stride in its march out of an accounting scandal by completing a restatement of past earnings but still faces tough work to make its financial reporting current.

The restatement for 2001 through June 30, 2004, made public on Wednesday, wiped out $6.3 billion in profit for the government-sponsored company, which finances one of every five home loans in the United States. But it was well below Fannie Mae's earlier estimate of $10.8 billion. Ordered by the government two years ago, the massive reworking of its accounting has cost the company some $1 billion this year to carry out.

Shares of Fannie Mae rose $1.64, or almost 3 percent, to $60.14 in early trading Thursday on the New York Stock Exchange. It has traded in a range of $46.17 to $62.37 over the last 52 weeks, compared with its peak of around $80 in early 2004.

It was the first earnings statement filed by Fannie Mae since late 2004. The scandal erupted in the fall of that year when federal regulators accused Washington-based Fannie Mae - with its long-standing prestige, vaunted political clout and reputation for financial excellence - of serious accounting problems and earnings manipulation to meet Wall Street targets.

Fannie Mae also announced Wednesday an increase in its quarterly dividend to 40 cents from 26 cents, where it had been since being slashed in half in January 2005.

"We believe that returning higher levels of capital back to shareholders is a top priority at Fannie Mae, and this marks an important first step," Moshe Orenbuch, an analyst at Credit Suisse, said in a research note issued Thursday.

The company hasn't said when it will get caught up and report its results for 2005 and 2006; it could take a year or two.

The restatement "is a key step forward for the company and represents two years of hard work," James B. Lockhart, director of the Office of Federal Housing Enterprise Oversight, said in a statement Wednesday. "Much remains to be done. ... Fannie Mae faces enormous challenges in fixing its operational and risk management systems, in (financial controls) compliance, and in producing audited financial statements for 2005 and 2006."

Jim Vogel, an analyst with FTN Financial Capital Markets, said in a research note that for Wall Street, the concern is "if there's a pattern of sustained quarterly losses that appear to reflect more difficulties in risk management than the market had thought."

OFHEO is the federal agency that regulates Fannie Mae and Freddie Mac, its smaller sibling in the $8 trillion home-mortgage market. Last May, it issued a blistering report alleging a six-year accounting fraud at Fannie Mae, the second-largest U.S. financial institution after Citigroup Inc. Regulators said the scheme included manipulations to reach quarterly earnings targets so that company executives could pocket hundreds of millions in bonuses from 1998 to 2004.

Lockhart also said Wednesday the agency plans to file a lawsuit before year's end to recover tainted bonus money from former Fannie Mae officials, including ex-chief executive Franklin Raines and chief financial officer Timothy Howard. Raines, a prominent Washington figure who was White House budget director in the Clinton administration, was swept out of office in December 2004 along with Howard. A number of senior executives and board directors have left the company.

Fannie Mae paid a record $400 million civil fine in a settlement with OFHEO and the Securities and Exchange Commission. It also agreed to limit the growth of its multibillion-dollar mortgage holdings, capping them at $727 billion, and to make top-to-bottom changes in its corporate culture, accounting procedures and ways of managing risk.

The company also disclosed Wednesday that its chief executive, Daniel Mudd, received a pay package of $13.1 million, including a $2.6 million bonus, for 2005. Mudd, who was the top operations official at the time of the accounting misdeeds, was elevated to the CEO in a management shakeup in December 2004.

In detailing its restatement, Fannie Mae cited a $7 billion net decrease from previously reported earnings for periods prior to 2002, a $705 million reduction for 2002, a $176 million increase for 2003 and a $1.2 billion increase for the first six months of 2004.

Over the last two years, Fannie Mae has disclosed a passel of new accounting problems that had been uncovered in several areas, including its core business of issuing securities backed by the billions of dollars of home mortgages annually that it buys from lenders and bundles together for resale to investors worldwide. Other problems were revealed in loans, houses acquired through foreclosures, interest on delinquent home loans and reverse mortgages.

They all were in addition to the accounting-rule violations that came to light in September 2004 involving derivatives, the financial instruments that Fannie Mae and Freddie Mac use to hedge against swings in interest rates.

Fannie Mae escaped criminal prosecution over the accounting failure. The Justice Department had pursued a criminal investigation, but federal prosecutors said in August that they had shut down their probe without bringing any action. The SEC still could bring civil actions against individual executives, including people no longer at Fannie Mae, with the burden of proof less stringent than in criminal prosecutions. Several shareholder lawsuits have been filed against the company and current and former executives.

Fannie Mae and Freddie Mac were created by Congress to pump money into the home-mortgage market to keep interest rates low and make home ownership affordable for low- and moderate-income people.

Freddie Mac, which also is government-sponsored and has its stock publicly traded, had its own accounting scandal that came to light in June 2003. The company misstated earnings by some $5 billion - mostly underreported - for 2000-2002 to smooth out volatility in profit and uphold its image on Wall Street as a steady performer.

Statement from the CEO of Fannie Mae Regarding FAS 133 Reporting Prior to the October 29, 2003  Adverse News Report --- http://www.fanniemae.com/ceoanswers/derivativesaccounting.jhtml 

Why do you have confidence that you have done your derivative accounting properly?

First, Fannie Mae filed fully audited financial statements with the SEC when we filed our Form 10 and Form 10-K on March 31, 2003. And as part of the registration process, the SEC reviewed our financial disclosures and critical accounting policies. As CEO of an SEC-registered company, I personally certified that our financial statements are accurate, as did our Chief Financial Officer, Tim Howard. Further, on May 14, 2003, Fannie Mae filed its Form 10-Q and will file all required SEC reports going forward.

More specifically, years before the FAS 133 accounting practices pertaining to derivatives were adopted, we worked closely with the Financial Accounting Standards Board (FASB) to make sure we understood how the new requirements would apply to our business. We then made substantial investments in additional accounting staff and new systems to track our derivatives transactions, given the unique challenges of these transactions. For example, we need to match up each derivative transaction -- one by one -- with the liability that we use the derivative to hedge.

Let me walk through how we account for our derivatives:

• First, we use derivatives primarily for two purposes: as substitutes for notes and bonds we issue in the debt markets and to hedge against fluctuations in interest rates on planned debt issuances.
  
• Second, we have a very controlled process to ensure against management mistakes.
  • Importantly, our accounting function does NOT reside within the business units. Those entering into business transactions and accountable for the business results do not determine the accounting of those transactions.
    
  • In anticipation of adopting FAS 133, we catalogued each type of derivative transaction done by Fannie Mae. As part of our implementation process, we consulted with our independent auditors -- KPMG -- about the appropriateness of our FAS 133 accounting policies, interpretations, and systems.
    
  • We continue today to maintain a current catalogue of each type of derivative transaction done and to set our accounting policy at the transaction level. We don't assume that the correct treatment for one transaction is automatically the correct or best treatment for a different transaction.
    
  • Prior to entering into a new type of derivative transaction, the business unit will describe the intended transaction. Our Controller will then recommend an accounting treatment. Our policy is to have the Controllers Office discuss this recommended accounting treatment with our outside independent auditors and to update the derivatives accounting policy that governs the transactions the business units can enter into. Only when the policy is updated can the transaction be completed.
    
  • The hedge accounting treatment for each individual transaction is determined -- and documented in writing -- before we enter into the transaction. And it cannot subsequently be changed.
    
  • On a daily basis all hedging activity is reported to our Controllers Office, which monitors hedge performance and accounts for the hedge.
    
  • On an annual basis Fannie Mae's internal audit department performs a comprehensive audit of our hedging activity to ensure compliance with our Hedge Accounting Guidelines and that strong internal controls are in place. Fannie Mae's internal audit department reports directly to the fully independent Audit Committee of our Board of Directors, which reviews its work -- including the derivatives audit -- every year.

It is because of our disciplined approach to accounting that we have experienced such large swings in our GAAP income over the past two years. In our use of derivatives, we look to execute the most efficient hedge for the business -- we don't approach our hedging with a specific accounting result in mind. We fully disclose the accounting implications of our decisions, and each quarter we report to investors both our core business earnings and our GAAP earnings, and reconcile the two.

To date, of the 14 housing GSEs (including the 12 Federal Home Loan Banks), Fannie Mae is the only one to have filed its fully audited -- and management certified -- financial statements with the SEC. The fully independent Audit Committee of our Board of Directors oversees our internal auditor, outside auditor, and our financial reporting. That gives us additional confidence in our financial statements, and should give investors confidence too.

Fannie Mae provides a comparison of our GAAP results to our non-GAAP financial measures.

In May of 2003, the Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The Statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133 --- http://www.fasb.org/news/nr043003.shtml 

Norwalk, CT, April 30, 2003—Today the Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The Statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133.

The new guidance amends Statement 133 for decisions made:

• as part of the Derivatives Implementation Group process that effectively required amendments to Statement 133,
• in connection with other Board projects dealing with financial instruments, and
• regarding implementation issues raised in relation to the application of the definition of a derivative, particularly regarding the meaning of an “underlying” and the characteristics of a derivative that contains financing components.

The amendments set forth in Statement 149 improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. In particular, this Statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative as discussed in Statement 133. In addition, it clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. Statement 149 amends certain other existing pronouncements. Those changes will result in more consistent reporting of contracts that are derivatives in their entirety or that contain embedded derivatives that warrant separate accounting.

October 1, 2003 Accounting Tutorial Provided to the Public by Fannie Mae --- http://www.fanniemae.com/ir/accountingtutorial.jhtml 

This virtual presentation is copyrighted material of Fannie Mae. No recording, broadcast, or other distribution of this virtual presentation, or any part of the virtual presentation, is permitted without Fannie Mae's permission. Your participation in this virtual presentation implies your consent.

October 29, 2003 Error Announcement:  FAS 133/149 Trips Up Fannie Mae

Statement by Jayne Shontell Fannie Mae Senior Vice President, Investor Relations October 30, 2003 --- http://www.fanniemae.com/ir/issues/financial/103003.jhtml 

As you know, yesterday Fannie Mae filed a Form 8-K/A with the SEC amending our third quarter press release to correct computational errors in that release. There were honest mistakes made in a spreadsheet used in the implementation of a new accounting standard.

As we also reported, we discovered the errors in the course of the standard review in preparation of the company's financial statements to be included in Form 10-Q for the third quarter, and were primarily made in conjunction with the implementation of FAS 149.

The bottom line is that the correction has no impact on our income statement, but resulted in increases to unrealized gains on securities, accumulated other comprehensive income, and total shareholder equity (of $1.279 billion, $1.136 billion, and $1.136 billion, respectively).

I would like to explain what happened yesterday regarding the release of the information.

We were preparing to file the Form 8-K/A as required, and to ensure the maximum disclosure, we also were preparing to issue a press release with a statement announcing the filing. We contacted the business service we use to distribute press releases to inform the service what we planned to do once the documents were finalized. Before we even sent the business service the documents to be disclosed, the service -- on its own and without our prior knowledge or authorization -- put forth a statement, attributed to Fannie Mae, "killing" our previously issued October 16 press release. Shortly thereafter, our stock began to trade down. We proceeded to file the 8-K/A and issued our statement as soon as we could.

Let me reiterate that the correction had to do with a computational error in performing complicated calculations required in the implementation of FAS 149.

FAS 149 was issued in April. It required Fannie Mae to mark to market the majority of mortgage commitments we had made, which were previously not part of our financial statements. The new requirement was effective July 1. In adopting a new accounting standard in a short period of time, Fannie Mae had to put in place a system and process to capture all open commitments and mark them to market. To implement this standard, Fannie Mae utilized information from its internal, automated systems in conjunction with spreadsheets that made additional calculations necessary under the new rule. Fannie Mae is already in the process of updating its automated systems to account for the mortgage commitments under FAS 149.

Our accounting team discovered the errors in the normal course of preparing our financial statements for inclusion in our 10-Q. They immediately notified management and our independent auditor, KPMG. Management in turn notified the Audit Committee of the Fannie Mae Board of Directors and our regulator.

We continue to be proud of our accounting processes and controls. Far from being a failure of our accounting system, this event demonstrates that our accounting processes and controls work as they should. While we would have obviously preferred the error did not occur in the October 16 press release, we are pleased that the error was corrected before we file our financial statements in our 10-Q.

October 31, 2003 Quotation from The Wall Street Journal

Fannie Mae had previously argued that it had a far better lock on its accounting than Freddie Mac, hoping to cast itself as a more responsible and sophisticated operation that didn't need much more scrutiny. Fannie Mae went so far as to hold an accounting "tutorial" earlier this month to explain derivatives accounting to investors, analysts and reporters. Yet it was in derivatives accounting that its stumble came.
Patrick Bartta and John D Mckinnon (See below)

Note from Bob Jensen
You can read Fannie Mae's Derivatives Accounting Tutorial at http://www.fanniemae.com/ir/pdf/tutorial10012003.pdf 

"Fannie Mae Made $1.1 Billion Error In Its Accounting:  Understatement of Equity Renews Calls For Oversight of Two Mortgage Giants," by Patrick Bartta and John D. McKinnon, The Wall Street Journal, October 31, 2003 --- http://online.wsj.com/article/0,,SB10674573311089700-search,00.html?collection=wsjie%2F30day&vql_string=Freddie%3Cin%3E%28article%2Dbody%29 

Fannie Mae, the mortgage-financing giant already facing a crescendo of criticism about its financial oversight, said it miscalculated the value of its mortgage commitments, forcing it to make a $1.1 billion restatement of its stockholder equity.

The government-chartered company, which bills itself as the world's largest nonbank financial institution, released a revised third-quarter financial statement Wednesday correcting what it called "computational errors" that appeared when the results were first reported earlier this month. The restated figures were higher and didn't alter the company's profit, which was $2.67 billion in the third quarter, up 168% from a year earlier.

But the episode instantly reinforced fears that Fannie Mae and its smaller sibling Freddie Mac lack the necessary skills to operate their massive and complex businesses, which some investors, rivals and political critics worry could pose risk to the nation's financial system if not properly managed. Though the companies are not formally backed by a government guarantee, investors generally assume the government would step in to bail the companies out in an emergency, given their critical importance to the housing and broader financial markets.

Spreads between most Fannie Mae debt issues and comparable Treasury securities widened Wednesday. Investors pummeled the stock after the news was announced, though the stock recovered some ground by the end of the day. In 4 p.m. New York Stock exchange composite trading, Fannie Mae's shares were down 2.4% at $73.10.

Lawmakers and Treasury officials were already debating whether to tighten oversight of Fannie and Freddie after Freddie Mac disclosed its own accounting problems earlier this year. Freddie Mac's problems, which involved understating income by at least $4.5 billion, led to a major management shake-up, including the ouster of two chief executive officers. Freddie Mac used financial transactions to shift excess earnings into the future and mask the company's volatility.

Both companies "have a credibility problem, and this only makes it worse," said James Bianco, president of Bianco Research LLC, a Chicago-based investment-research firm who has been critical of the two companies. He said it highlights how too few people have a firm grasp on Fannie Mae's arcane accounting and overall financial position, even as Wall Street analysts continue to tout the company's stock. "Investors look at this stuff, throw their arms up in the air [and say], 'We don't understand this stuff, you don't understand this stuff, and the companies don't understand this stuff, but it doesn't matter, because the government is going to back it anyway.' "

Fannie Mae had previously argued that it had a far better lock on its accounting than Freddie Mac, hoping to cast itself as a more responsible and sophisticated operation that didn't need much more scrutiny. Fannie Mae went so far as to hold an accounting "tutorial" earlier this month to explain derivatives accounting to investors, analysts and reporters. Yet it was in derivatives accounting that its stumble came.

Continued in the article.

Question
How can failure to book derivatives fair value of $1.1 billion not have any impact on earnings?  If this is the case, what's the big sweat over failure to book the derivatives?

Answer (I include the FAS 149 amendments of FAS 133 as being part and parcel to FAS 133 itself.)
If the unbooked $1.1  fair value of the derivatives had instead been properly booked according to FAS133/IAS39 rules, the balance sheet assets and liabilities would change by $1.1 billion.  If these derivatives had been speculations or did not otherwise qualify for special hedge accounting treatment under FAS133/IAS39 rules, they would have impacted earnings by $1.1 billion.  But these derivatives were apparently hedges, and Fannie Mae tries to imply that its accounting error is no big sweat.  The CEO of Fannie Mae asserts that derivatives are used primarily for two purposes:

... we use derivatives primarily for two purposes: as substitutes for notes and bonds we issue in the debt markets and to hedge against fluctuations in interest rates on planned debt issuances.
Statement from the CEO of Fannie Mae Regarding FAS 133 Reporting Prior to the October 29, 2003  Adverse News Report --- http://www.fanniemae.com/ceoanswers/derivativesaccounting.jhtml 

First I might note that when derivatives are used as substitutes for debt issuances, their changes in value would affect current earnings to the extent that they are not used for hedging purposes under FAS 133 rules.  However, I seriously doubt that Fannie Mae is allowed to speculate using derivatives?  As "hedges against fluctuations in interest rates" their changes in value would not affect current earnings to the extent that the hedges are effective.  The reason is that FAS 133 provides complex ways to avoid earnings impacts of changes in value of hedging derivatives.  This is complex in the sense how it is done varies with cash flow hedges versus fair value hedges of booked hedge items versus fair value hedges of unbooked hedge items such as "planned debt issuances."  In the case of forecasted transactions like "planned debt issuances," the hedges are most likely cash flow hedges of interest rate risk in forecasted transactions much like Example 5 in Appendix B of FAS 133.  See my video of Example 5:  

Video Tutorial:  Accounting for Interest Rate Swap Hedges and Valuation of Swaps --- 
030FAS133InterestRateSwapAccounting.wmv --- http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/  
Choose file 030FAS133InterestRateSwap.wmv

So where's the big sweat in FAS 133 and IAS reporting rules as they stand today?

The big sweat is that there are two types of hedges other than foreign currency hedges.  One type is a cash flow hedge and the other type is a fair value hedge.  What people often fail to realize is that you can't be hedged both ways.  If a company has cash flow risk and hedges that risk, it creates fair value risk.  If a company has fair value risk and hedges that risk, it creates cash flow risk.  If Fannie Mae hedged interest rate cash flow risk, then it created fair value risk on the combined fair value of its hedged items and hedging instruments.  If it hedged fair value, it created cash flow risk.

If Fannie Mae's erroneously unbooked derivatives qualified for special hedge accounting under FAS133/IAS39 rules, then the offset to changes in booked fair value would bypass earnings.   The ineffective portion of the hedge does impact current earnings.  However, since Fannie Mae primarily hedges interest rate movements (probably with interest rate swaps), the hedges most likely qualified for "The Shortcut Method" under FAS 133 (see Paragraph 132) and would be deemed to be perfectly effective at the beginning of the hedge.  

Hence Fannie Mae most likely is correct in contending that its failure to book the $1.1 billion in derivatives under FAS 133 would not have impacted earnings provided both the hedges and the hedged items were carried to maturity.  The risk in not booking the derivatives (in terms of earnings) lies in the likely case that the hedged items and the hedges might not be carried to maturity.  Failure to book the $1.1 billion hides the enormous risk of a hit on earnings if customers pay off loans early (as is likely the case if interest rates drop) or that Fannie Mae sells the loans before maturity (as is common with Fannie Mae).  

From The Wall Street Journal Accounting Educators' Reviews on November 7, 2003

TITLE: Fannie Mae Makes $1.1 Billion Error in Its Accounting 
REPORTER: Patrick Barta and John D. McKinnon 
DATE: Oct 30, 2003 
PAGE: A1 
LINK: http://online.wsj.com/article/0,,SB10674573311089700,00.html  
TOPICS: Advanced Financial Accounting, Audit Report, Auditing, Derivatives, Fair Value Accounting, Hedging

SUMMARY: Fannie Mae made an error in applying the new FAS149 requirements to mark loan commitments to market, in accordance with derivative accounting under FAS 133, that was required to be implemented in 3rd quarter reporting. Fannie Mae argues that this was not a systemic problem, but merely resulted from human error in manual systems that are being used temporarily in order to implement the new requirement quickly.

QUESTIONS: 
1.) The first paragraph describes the changes from revising their third quarter financial statements as a "restatement of stockholder equity"and the second paragraph indicates that "the restated figures...didn't alter the company's profit..." How is it possible to change total stockholders' equity and not affect net income? What measure of reported performance do you think was affected by this change? Support your answer and include definitions of appropriate terms in doing so.

2.) Cite statements from the article which characterize the reaction to Fannie Mae's announcement of the accounting error. Why has the reaction been so negative even though the impact of the accounting error on stockholders' equity was positive?

3.) At the end of the article, the author indicates that the problem giving rise to this restatement was "tied in part to an obscure accounting provision, known as Financial Accounting Standard No. 149." What is the subject of that standard? Do you think it is "obscure"? What do you think makes the popular business press use this description?

4.) The author describes the loan commitments that are the subject of this accounting error near the end of the article. What provision in FAS 49 requires that these commitments be marked to market value "and hence record any unrealized changes in value of those commitments despite whatever price the company agrees to pay for the loans"? What type of accounting treatment for such commitments could result in an impact on stockholders' equity, but not net income, as is the case at hand?

5.) The impact on stockholders' equity was positive--an unrealized gain on the value of the loan commitments undertaken by Fannie Mae. What does that say about the terms of these loan commitment contracts?

6.) Suppose you are an auditor and Fannie Mae is your client. What impact does this problem have on your plans for the year-end audit? Do you have any responsibility associated with the problematic third quarter report, even if that report was labeled "unaudited"?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

--- RELATED ARTICLES --- 
TITLE: Review & Outlook: Fannie's Black Box 
REPORTER: WSJ Editors 
PAGE: A12 
ISSUE: Oct 31, 2003 
LINK: http://online.wsj.com/article/0,,SB106755988050523700,00.html 

"Representative Stearn Calls for GAAP Overhaul," AccountingWeb, February 3, 2004 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=98662 

In the course of holding hearings into the accounting issues at Freddie Mac, Rep. Cliff Stearns (R-FL) said there are fundamental flaws in generally accepted accounting principles (GAAP) that need to be addressed to prevent future abuses.

"Specifically, GAAP should not allow companies to change the characterization of an asset and thereby change its accounting," said Stearns. "I applaud the Federal Accounting Standards Board (FASB) for its efforts to change and reform the system over the last two years. Nevertheless, I intend to offer legislation in the next few weeks concerning FASB that will reform accounting standards."

As part of the hearings, Stearns asked Armando Falcon, director of the Office of Federal Housing Enterprise Oversight (OFHEO), which oversees Freddie Mac and the larger Frannie Mae, to look into whether compensation of the two agency’s 20 top officials contributed to accounting problems.

"Through our past hearings we learned that Freddie Mac disregarded accounting rules, internal controls, and disclosure standards to maintain a reputation for steady earnings," stated Stearns, chairman of the Commerce, Trade & Consumer Protection Subcommittee. "I appreciate hearing from Freddie Mac about the new controls it is instituting to guard against improper accounting. Given that Freddie Mac hid billions of dollars in income in a way that complied with GAAP (Generally Accepted Accounting Principles), this Subcommittee has a responsibility to look at improving these accounting standards."

Stearns pointed to an anomaly that allows Freddie Mac and some other financial companies to engage in earnings arbitrage: "So Called 'mixed-attribute accounting' allows companies to decide whether financial assets are carried at current market price or at historic cost." Freddie Mac shifted assets between categories to manipulate earnings, without any change in the underlying economics of its performance. Said Stearns, "Taxpayers do not have the option of changing the characterization of assets to change the tax treatment; I think GAAP should not allow this either."

Martin Bauman, chief financial officer, Freddie Mac, testified, "While the restatement represented an important milestone, now that it has been completed, Freddie Mac is focused on bringing our financials up-to-date." In reacting to Stearns' concerns over the adequacy of current standards, Bauman stated, "Freddie Mac recognizes the importance of transparent accounting and reporting standards and we are committed to providing investors with the information they need to understand how we view and manage our business. We fully support the Subcommittee's efforts to move toward a principles-based accounting framework."

Hedging Paradox:  
In finance, there is no way to cover your Fannie without exposing your Fannie somewhere else.
Gypsy Rose Lee would've said her fan (hedge) can only cover one Fannie cheek at a time. 
Gypsy Rose Lee ( http://www.hollywoodlegends.com/gypsy-rose-lee.html ) decades ago was popular exotic dancer with high modesty tastes relative to today's riskier exposures.

The Word "Hedge" is the Most Misleading Term in Finance! FAS 133 and IAS 39 may be misleading the public into thinking that firm-wide risk is being accounted for when risk is merely being shifted about with hedging!

The FASB originally wanted (and still wants if the banking lobby will ever back off) FAS 133 to be simplified by requiring all changes in the value of booked derivatives to be charged directly to current earnings.  This is a simplistic solution that would have made Fannie Mae's error impact earnings by $1.1 billion.   The objection of the banking industry and other corporations to such current value accounting  is that current value accounting that takes changes in value directly into current earnings creates enormous volatility in reported earnings.  Earnings fluctuations, in turn, supposedly paint a picture of risk in stable companies that have in fact hedged risks.  The FASB compromised with bankers and other corporations in FAS 133 by requiring that all derivative financial instruments be booked at current value (including derivatives that were never before booked under previous rules) but allowing changes in current value be accounted for in a complicated way that does not affect current earnings when the derivatives qualify for special hedge accounting treatment under FAS 133.

An Illustration 

But the new FAS 133 rules (and the international IAS 39 counterparts) can be highly misleading in terms of risks that hedging itself causes.  By way of illustration, suppose XYZ company borrows $1 billion at variable interest rates to finance $1 billion in fixed-rate mortgage investments.  If the company wants to hedge all cash flows, it can enter into interest rate swaps to freeze the annual  interest expense cash flows on the $1 billion in debt.  Now the company and its investors sleep easy at night knowing that XYZ has locked in a net (interest revenue minus interest expense) fixed cash flow of say $50 million per year provided none of the investments or liabilities are settled prematurely.  Investors are supposed to breathe easier knowing that  XYZ has covered its backside with perfectly effective hedges.  But consider the risks that are not and cannot be hedged:

• When interest rates fall dramatically, XYZ's fixed-rate asset investments may be terminated prematurely by homeowners who want to refinance at lower fixed rates.  To simplify the illustration, suppose that XYZ simply refinances homeowner mortgages at the lower market rates.  XYZ thereby no longer enjoys the contracted "high" fixed rate interest revenue that would have kept flowing in if interest rates had not plunged.   
  
  
• If XYZ had not hedged its cash flow on the $1 billion in variable rate debt, the premature refinancings of its asset investments would not be so much of a problem, because XYZ's variable interest expense on debt might go down by roughly the same about that its interest revenue went down due to homeowner refinancing.  The current value of XYZ's variable rate debt is not impacted by changes in interest rates.  Only its interest expense is impacted, and when interest rates fall those expenses decline.  XYZ only hurts from unhedged variable rate debt when interest rates increase.  XYZ probably hedged its variable rate debt because it anticipated higher interest rates.  
  
  
• Risks may be hierarchical and obscure.  In the above XYZ example, the first level of hedging arises with the conversion of variable rate debt into fixed-rate debt much like is illustrated in FAS 133 Example 5 in Appendix B (See the 133ex05a.wmv video at http://www.cs.trinity.edu/~rjensen/video/acct5341/ ).  However, hedging the cash flow of interest expense for each debt item actually creates a higher level risk in terms of the entire portfolio of fixed-rate assets versus the portfolio of hedged variable rate debt.  Hedging each item of debt in the debt portfolio increases the aggregate level of risk in the combined asset and debt portfolios. The reason XYZ entered into a cash flow hedge of its variable rate debt is that it most likely anticipated increases in interest rates.  This locks in that $50 million in annual cash flow provided interest rates do not plunge.  However, if interest rates plunge, XYZ is stuck paying out far more in interest expense (on its debt and hedging instruments combined) than would otherwise be the case had it not hedged its debt cash flows.   The point is that hedging never eliminates all risks.  It merely substitutes one risk for another risk in accordance with what XYZ considers the most likely change in interest rates.  XYZ, however, cannot always forecast accurately since nobody can ever forecast interest rate fluctuations with 100% accuracy.  Hedging does not eliminate all risk even when the hedges are perfectly effective.
  
  

The bottom line here is that new FAS 133 and IAS 39 standards eliminated some very bad practices of companies, particularly banks, using derivative financial instruments for off-balance sheet accounting that hid enormous risks from the public even when derivative hedging instruments were used as hedging instruments.  However, these new and highly complicated standards do not go far enough in disclosing risk.  

An often overlooked issue in this entire debate is the problem of  disclosure rules that accompany the numbers.  Disclosures that accompany the FAS133/IAS39 numbers in financial reporting do not stress that hedging only changes the type of risk but never eliminates risk.  I propose that every company be required to make disclosures in a prescribed disclosure language that  more or less reads as follows for a company like Fannie Mae that lent money on mortgage notes held as assets and borrowed money to finance these investments:

In managing its assets and liabilities, XYZ must choose when to hedge cash flow risk and when to hedge fair value risk.   XYZ hedges both its investments and its debt in terms of forecasted trends in interest rates.  Investors should be aware, however, that hedging one type of risk exposes the company to the other type of risk and higher order portfolio levels of risk.  Even though reported earnings are not impacted by qualified hedges under FAS 133, there are risk exposures that remain and might affect future earnings.  Hedges of cash flow risk expose XYZ to current value risk of assets and liabilities.  Hedges of current value risk expose XYZ to cash flow risks from assets and liabilities.  Hedging entire portfolios may increase higher-order risks in terms of other portfolios.  It is prudent to nearly always hedge risks, but hedging does not imply elimination of higher order risk and risks other than those being explicitly hedges.  This is inherent in XYZ's line of business where risk management is a complicated process in which hedging changes risk exposures but never eliminates all risks.

Hence, Fannie Mae may have hedged in such a way that if it had correctly followed FAS 133/FAS149 rules there would have been no impact on Fannie Mae's reported earnings.  But the public should not be swayed to believe that Fannie Mae eliminates risks by hedging.  Fannie Mae merely substitutes one risk for another risk as some firms substitute cash flow risk with current value risk or vice versa.  

It should be noted in passing that both the FASB and the IASB are moving ever closer to requiring current value accounting for all financial instruments, such that many of the complications of FAS 133 and IAS 39 accounting will go away.  For example, the very complicated requirements for fair value hedge accounting virtually disappear.  What is important to note, however, is that current value accounting can still mask the problem of higher orders of risk.  Suppose that in the above XYZ example, the variable rate debt is not hedged for cash flows, i.e., there is increased cash flow risk but no fair value risk.  Further suppose that $1 billion in fixed-rate debt is hedged for fair value, thereby, having the hedged assets and the debt all frozen in terms of current value.  The assets and the debt thereby have no current value risk due to interest rate fluctuations.   This might be great if XYZ is going to be liquidated in the short term.  However, at the higher level of risk exposure of all assets and debt combined, the "hedged" XYZ firm is really exposed to cash flow and earnings risk.  Current value accounting, therefore, may be more misleading than helpful in disclosing "risk."

"FASB Proposes Improved Derivatives, Hedging Disclosures," SmartPros, December 11, 2006 --- http://accounting.smartpros.com/x55778.xml

The Financial Accounting Standards Board issued a proposal that would provide investors and others with better information about the effects of derivative and hedging activities on a company's financial statements.

The proposed statement specifically addresses constituents' concerns that existing disclosure requirements associated with FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, do not provide adequate information to financial statement users.

"The proposed disclosure requirements are intended to enhance understanding of how and why entities use derivatives, how they are accounted for in an entity's financial statements, and how they affect an entity's financial position, results of operations, and cash flows," said Kevin Stoklosa, FASB Project Manager.

The exposure draft would enhance the current disclosure framework by requiring that objectives and strategies for using derivative instruments be discussed in terms of underlying risk and accounting designation. The exposure draft would require tabular disclosure of notional and fair value amounts of derivatives instruments and the gains and losses on derivatives instruments and related hedged items. Additionally, the proposed statement would require disclosure of information about counterparty credit risk and the existence and nature of contingent features in derivative instruments.

The requirements of the proposed Statement would be effective for financial statements issued for fiscal years and interim periods ending after Dec. 15, 2007, with early application encouraged. The proposed statement would encourage but would not require disclosures for earlier periods at initial adoption. In years after initial adoption, the proposed statement would require disclosures for earlier periods.

The board is seeking written comments on the proposal by March 2, 2007.

From Lexis/Nexis
Credit Risk Management --- http://risk.lexisnexis.com/assess-customer-risk

For a short time you can download the proposed FAS 133 amendment from http://www.fasb.org/draft/ed_derivatives_disclosure.pdf

A slide show on FAS 133 and IAS 39 disclosure rules is available at http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/

Bob Jensen's PowerPoint Show on Derivative Financial Instrument Disclosure Requirements  --- http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/

But for Freddie Mac, the other pillar of the colossal U.S. mortgage market, Freddie Mac's restatement has only caused headaches and has even raised new questions about the quality of financial reporting.
Patrick Barta, "Restatement by Freddie Mac Puts Fannie on the Spot," The Wall Street Journal, January 12, 2004, Page C1.

The problem is the companies' (Freddie Mac versus Fannie Mae) business and financial statements have become so complex that they are effectively "unanalyzable" says James Bianco, president of Bianco Research, a Chicago-based fixed-income research firm that has been critical of Fannie and Freddie in the past.  He says the same is becoming true of other large financial institutions, particularly those that, like Fannie and Freddie, use large volumes of derivatives, which are investment contracts that can be used by companies to offset risk from interest rate shifts.
Ibid

Earnings (but not cash flow) Volatility Caused Largely by FAS 133
Freddie Mac and its main rival, Fannie Mae, are recovering from scandals several years ago in which they were found to have violated accounting rules to make their results look less choppy. Because they have adopted stricter practices, their results tend to fluctuate widely, as changes in interest rates and default expectations whipsaw the value of mortgage-related assets. Last year, for instance, Freddie had big losses in the third and fourth quarters but still managed to report net income of $2.21 billion for the year. In the latest quarter, "accounting developments exacerbated the appearance of some of these developments" in the mortgage market, said Richard Syron, Freddie's chairman and chief executive.
Damian Paletta and James R. Hagerty, "Freddie's Stricter Accounting Renders a Loss," The Wall Street Journal, June 15, 2007; Page A2 --- http://online.wsj.com/article/SB118182226301335242.html?mod=todays_us_page_one

Freddie Mac (Fannie Mae's Brother) Paves the Way With Risk Stress Tests and Then Fails on Macro Hedge Accounting

Macro hedge accounting is generally not allowed for financial reporting under FAS 133 (read that as in Freddie Mac), but it is frowned upon by the IRS (read that as in Freddie Mac).  In November 2003 we are still awaiting the long delayed Year 2002 annual report of Freddie Mac.  Freddie applied macro hedge accounting in a way that was not appropriate under FAS 133, and we've been waiting for new auditors to complete the work in revising prior-year statements and issuing Year 2002 financial statements.  

Freddie Mac named Richard Syron, a former head of the American Stock Exchange, the Boston Fed, and tech firm Thermo Electron, as its new chairman and CEO. The executive succeeds Greg Parseghian, who was asked to step down after federal regulators determined he played a role in a string of accounting misdeeds.
See "Freddie Mac Appoints New Chief:  Syron May Bring Stability To Beleaguered Company; Toughness Is Questioned," by Patrick Barta and John D. McKinnon, The Wall Street Journal, December 8, 2003 ---  http://online.wsj.com/article/0,,SB107081511244443300,00.html?mod=home_whats_news_us

Freddie Mac named Richard Syron, a former head of the American Stock Exchange, the Boston Fed, and tech firm Thermo Electron, as its new chairman and CEO. The executive succeeds Greg Parseghian, who was asked to step down after federal regulators determined he played a role in a string of accounting misdeeds.
See "Freddie Mac Appoints New Chief:  Syron May Bring Stability To Beleaguered Company; Toughness Is Questioned," by Patrick Barta and John D. McKinnon, The Wall Street Journal, December 8, 2003 ---  http://online.wsj.com/article/0,,SB107081511244443300,00.html?mod=home_whats_news_us 

Question
Do you want to learn more about derivative financial instruments accounting in action?

Answer
Although nobody has yet to write up a case on Freddie Mac, the Appendices at this Freddie Mac site are a derivatives accounting education in and of themselves --- .  The link with the appendices is at http://www.freddiemac.com/investors/restatement/

 The Investor Relations site is at http://www.freddiemac.com/investors/ 

"Freddie Mac hit with fine," by Marcy Gordon, The San Antonio Express News, December 11, 2003 --- http://news.mysanantonio.com/story.cfm?xla=saen&xlb=110&xlc=1097161&xld=110

Freddie Mac is paying a $125 million civil fine and is being threatened with possible curbs on its growth as federal regulators blame management misconduct for the mortgage giant's $5 billion misstatement of earnings. In a report issued Wednesday, regulators accused the government-sponsored company of violating its public trust.

A pliant board of directors and a system of compensating executives tied to annual earnings targets also contributed to the accounting crisis at Freddie Mac, which has brought the ouster of four top executives since early June, the Office of Federal Housing Enterprise Oversight found in its months-long investigation.

Freddie Mac agreed to pay the record fine in a settlement with the federal agency announced Wednesday.

The agency, which supervises Freddie Mac and its larger rival Fannie Mae in the multitrillion-dollar home mortgage market, cited "a pattern of inappropriate conduct and improper management of earnings" at the company and even "a disdain for appropriate disclosure standards" among former top executives.

The second-largest U.S. buyer of home mortgages "disregarded accounting rules, internal controls, disclosure standards, and ultimately, the public trust in pursuit of steady earnings growth," the agency's report found.

Its director, Armando Falcon, told reporters the agency already is considering imposing on both mortgage companies new requirements recommended in the report, including splitting the chairman and chief executive positions and limiting directors' terms.

Another recommendation is to restrain the growth of Freddie Mac's mortgage portfolio if it fails to disclose its financial situation more quickly and accurately — a prospect likely to unnerve shareholders.

Freddie Mac and Fannie Mae were created by Congress to pump money into the home mortgage market by buying home loans from banks and other lenders and bundling them into securities for sale on Wall Street.

The two corporations, whose stock is publicly traded, have grown explosively in recent years and are among the nation's largest financial institutions.

Freddie Mac's settlement with regulators still leaves to be resolved a criminal investigation by the Justice Department and a civil inquiry by the Securities and Exchange Commission.

Falcon said his agency's examination didn't find evidence of criminal misconduct. The report did cite evidence that one or more of the investment banks that engaged in transactions that Freddie Mac used to manipulate its earnings "may not have acted properly."

McLean, Va.-based Freddie Mac, with $40 billion revenue a year, has acknowledged understating its earnings by $5 billion for 2000-2002 to smooth out volatility in profits and uphold its image on Wall Street as a steady performer.

In addition, the company last month admitted inflating 2001 earnings by nearly $1 billion and said it may not be able to complete its accounting for 2003 until next June.

The company Sunday named Richard Syron, a Wall Street veteran and former Federal Reserve official, as chairman and chief executive. The board of directors in June forced out Freddie Mac's then-chairman and CEO, Leland Brendsel, and the company's president and chief financial officer.

In August, the federal regulators ordered the ouster of Brendsel's replacement, Gregory Parseghian — who had played a role in some of the company's questionable financial transactions, according to a report by attorneys hired by the board.

Parseghian earned $1 million in salary and $750,000 in bonuses in 2001.

The company didn't admit to or deny wrongdoing in the settlement, involving the first such fine in the agency's 10-year history. Freddie Mac also said it did not consent to any part of the agency's report and that it "strongly disagrees" with some of the findings.

The $125 million fine will be paid from the company's revenues, potentially reducing its bottom line.

The restatement by company auditors of Freddie Mac's 2000-2002 earnings, a massive project first announced in January and completed last month, cost the company $100 million.

Freddie Mac shares rose 25 cents to $54.25 in trading Wednesday on the New York Stock Exchange.

Under the settlement, Freddie Mac also agreed to strengthen its internal controls and accounting practices and to improve its disclosure of information to the investing public — steps the company already had undertaken after its accounting and management turmoil came to light in early June.

Also see The Wall Street Journal on December 11, 2003 --- http://online.wsj.com/article/0,,SB107106680095083900,00.html?mod=mkts_main_news_hs_h 

"Freddie Regulator Seeks $100 Million In Settlement Deal," by Patrick Barta and John D. McKinnon, The Wall Street Journal, December 9. 2003 --- http://online.wsj.com/article/0,,SB107092962387997400,00.html?mod=home_whats_news_us

Federal regulators looking into Freddie Mac's accounting woes are seeking $100 million or more from the company in settlement of possible civil charges stemming from its accounting misdeeds, people familiar with the matter said.

These people stressed that the negotiations between Freddie Mac and its regulator, the Office of Federal Housing Enterprise Oversight, are continuing, and that the final settlement could be far less. However, analysts who closely follow the mortgage-finance company believe that Freddie Mac officials are eager to reach a deal quickly. The payment likely would be in settlement of charges that the regulator could bring against the company for engaging in the accounting abuses.

The company already has taken several steps in its bid to restore credibility. Late last month, Freddie Mac completed a long-delayed restatement of past earnings, concluding that it understated results through 2002 by nearly $5 billion. And on Sunday, the company said it selected a new chief executive, former American Stock Exchange head Richard Syron.

"The settlement is another big piece" that Freddie Mac needs to put its woes behind it, said Howard Glaser, a Washington, D.C., mortgage-industry consultant who has done work for Freddie Mac.

Continued in the article.

"Freddie Mac Attack Critics are calling for greater oversight -- or even a breakup," Business Week, July 7, 2003 --- http://www.businessweek.com/magazine/content/03_27/b3840057.htm 

The improper use of hedge accounting to amortize gains -- and thus smooth ragged ups and downs in quarterly earnings -- was Freddie's downfall. As a June 25 press release deadpanned: "Certain capital market transactions and accounting policies had been implemented with a view to their effect on earnings in the context of Freddie Mac's goal of achieving steady earnings growth." Translation: Steady earnings help Freddie convince investors and lenders that management has its eye on the ball. They also help ward off politicians who might point to volatility as a reason to tighten regulation or even break Freddie up. 

The company's quest for smooth earnings, plus its admitted lack of accounting expertise and weak management controls, proved to be a fateful combination. That became clear to PricewaterhouseCoopers auditors soon after they replaced longtime Freddie auditor Andersen LLC in 2002. The new audit team soon discovered suspicious hedge accounting involving Treasury securities.

November 6, 2003
Freddie Mac, the nation's number two mortgage finance company, has estimated it will owe as much as $30 million in back taxes. That figure is just a fraction of the $4.5 billion the company expects to report in income when it restates earnings. http://www.accountingweb.com/item/98300 

Freddie Mac, the nation's number two mortgage finance company, has estimated it will owe as much as $30 million in back taxes. That figure is just a fraction of the $4.5 billion the company expects to report in income when it restates earnings. http://www.accountingweb.com/item/98300 

Mitchell Delk Senior Vice President Freddie Mac 
Written Statement Before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises of the Committee on Financial Services, U.S. House of Representatives 
July 11, 2001 (Note the Date) --- http://www.freddiemac.com/speeches/md071101.htm 

A pioneer in the use of risk-based stress tests, Freddie Mac believes that a well-implemented capital standard must produce specific and accurate determinations of required capital. Assigning too little capital or too much both have negative consequences. Too little capital could jeopardize our ability to withstand an extreme downturn in the economy. On the other hand, requiring too much capital would impose unnecessary costs on the nation’s families. Mortgage rates would rise, and mortgage products attractive to lower-income borrowers would become more expensive or unavailable.

Furthermore, it is critical that the test be operationally workable. For Freddie Mac to purchase mortgages on a daily basis, we must be able to calculate the amount of capital that will be required and incorporate it into our business planning and processes.

Finally, the stress test should recognize prudent risk management. For example, the test should not penalize the use of swaps and other securities contracts, the function of which is to manage interest-rate risk. This is an essential risk management strategy that we and other large, well-capitalized financial institutions use every day. A standard that ties capital to risk would appropriately recognize this strategy with a lower capital requirement. According to Chairman Greenspan, regulators must “develop ways to improve their tools while reinforcing incentives for sound risk management.”

Tripped Up by FAS 133
"Freddie Mac Overstated Results By as Much as $1 Billion in 2001," by Patrick Barta and John D. McKinnon, The Wall Street Journal, November 20, 2003 --- 

Freddie Mac is expected to report that it overstated earnings by as much as $1 billion in 2001 when it releases a much-anticipated restatement of past earnings in the next several days, people familiar with the situation said.

The mortgage-finance company, which has been embroiled in an accounting scandal since June, is still expected to conclude that it undercounted earnings by $4.5 billion or more during the entire three-year period of its restatement, which covers 2000, 2001 and 2002. But an overstatement during one of those years would be significant because it would further highlight the volatility of Freddie Mac's financial results, something the company had tried to hide. Freddie Mac initially reported that it earned $4.1 billion in 2001.

Some details of Freddie Mac's restatement remained in flux in advance of its release, and some people with knowledge of the situation cautioned that the numbers could change, although likely not enough to erase the troublesome overstatement. Some also believe that the overstatement could be limited to one quarter.

David Palombi, a spokesman for Freddie Mac, said he couldn't provide details on the restatement, though he noted that company officials have long stressed that it would reveal more volatile results. He said that the restatement is expected to significantly boost shareholder equity at the company.

Still, the possibility that Freddie Mac may have overstated its results in one of the years under review could make life harder for the company on Wall Street and in Washington, where legislators have been working to place Freddie Mac under stricter regulation. Companies that understate earnings are often treated more gingerly on Wall Street and elsewhere, analysts said, since correcting the errors results in more income for shareholders.

"They set up this belief that what they did was they understated earnings, and apparently they did on a cumulative basis, but it's not going to go over well that in one of the years they overstated earnings," said Mike McMahon, a financial-services industry analyst at Sandler O'Neill & Partners in San Francisco.

Freddie Mac is under investigation by several government agencies after it revealed that it used improper accounting tactics to smooth earnings to better please Wall Street. In some cases, the company pushed unwanted earnings into the future, or hid gains it thought would make the company appear to be too volatile. But an internal investigation revealed the company also used accounting gimmicks to mask some losses that resulted from accounting rules it thought were unfair.

The government-sponsored, publicly traded company exists to buy mortgages from lenders, providing needed capital to keep the U.S. mortgage market operating smoothly.

Freddie Mac's financial statements can be downloaded from http://www.freddiemac.com/investors/ 

Illustration of a Currency Swap
It costs Freddie Mac more to sell the euro debt than comparable bonds in dollars, but the agency gets to diversify its funding base. That benefit offsets the short-term pain of borrowing in euros and swapping back into dollars.
Margot Patrick and Henry J. Pulizzi, "Freddie Mac Returns to Europe To Diversify Debt," The Wall Street Journal, January 18, 2004 --- http://online.wsj.com/article/0,,SB107446591506604646,00.html?mod=mkts%5Fmain%5Fnews%5Fhs%5Fh 

Fannie Mae has a bigger brother named Freddie Mac whose failure to properly implement FAS 133 following a vigorous fight with the FASB to derail FAS 133 from becoming a standard.   It comes as no surprise that the external auditor for Freddie Mac was the infamous Arthur Andersen. 

"At Freddie Mac, It's Hard To Lay Claim to Innocence," by Jerry Knight, The Washington Post, 
July 28, 2003 (Note the Date) --- http://www.washingtonpost.com/ac2/wp-dyn/A51391-2003Jul26?language=printer 
"The intent was to deceive investors, and for that, everyone involved ought to take a fall."

When the accounting and management failures at Freddie Mac first surfaced last month, the board of directors proclaimed that it was throwing out all the executives tainted by the scandal and installing a new CEO.

Chief executive Leland C. Brendsel and Chief Financial Officer Vaughn A. Clark were allowed to resign. President David W. Glenn was fired.

Gregory J. Parseghian, 42, Freddie's chief investment officer, was promoted to president and chief executive. It was inferred that Parseghian had nothing to do with cooking the books and would restore the company's credibility.

As we now know, the idea that Parseghian is squeaky clean is tough to swallow after reading last week's report on the internal investigation of Freddie's phony financial reports.

The new chief executive's name turns up repeatedly in the investigative report detailing the dubious deals that Freddie Mac used to hide as much as $4.5 billion in profits.

According to the report of the internal investigation initiated by Freddie's board:

• Parseghian was directly involved with finding ways for Freddie Mac to circumvent new accounting industry rules that were written to help investors understand the impact on corporate finances of exotic transactions known as derivatives. James R. Doty, the lawyer who prepared the report, came to the conclusion that Parseghian was told by Freddie's auditors that the transactions the working groups recommended passed accounting muster, and were therefore completely above board.

• Parseghian was among several senior executives who approved a memo implementing a $700 million transaction known as the Coupon Trade-Up Giant, or CTUG, that was specifically designed to offset the impact of the new derivatives accounting rules.

• Parseghian, who was responsible for briefing the investment committee of Freddie's board of directors about major transactions, helped come up with a way to divide the CTUG into pieces small enough that the board wasn't required to be informed of them individually, even though all together they were part of one grand plan. "This division had the effect of avoiding the need for Board authorization," the report said. As a result, "the company failed to adhere to its own governance requirements."

• Parseghian participated in one meeting at which top Freddie Mac executives discussed five other ways in which they could get around the new derivatives accounting rules. He also supervised several junior executives who participated in two "working groups" that coordinated efforts to minimize the impact of the derivative accounting rules on the bottom line.

Freddie Mac won't say whether Parseghian was officially a member of those groups. Parseghian has declined to comment on the report.

Be that as it may, the report makes clear he was a central character in events that could lead to as much as $4.5 billion in restatements. It is hard to believe he can restore Freddie's credibility. The report portrays Freddie Mac as an organization that single-mindedly set out to circumvent new rules drafted by the accounting industry to demystify derivatives, the generic name for a menagerie of financial creations.

Dreamed up a couple of decades ago by mathematicians and PhD economists, derivatives offer clever ways for corporations to protect themselves against changes in interest rates and other unpredictable economic events.

They can also be used to cheat on income taxes, government prosecutors contend in a high-profile tax shelter trial now underway. They can and were used by Enron Corp. to create phantom profits. And at Freddie Mac they were used to hide profits, creating a convenient rainy-day fund that the company could tap whenever its operations failed to produce enough profit to satisfy Wall Street. Ever since derivatives were invented, people have struggled to figure out how they ought to be accounted for on a corporation's books. For years most companies simply pretended their dealings in derivatives didn't exist, making little or no mention of them in financial reports.

Finally the Financial Accounting Standards Board, which writes the official guidelines for keeping the books of U.S. corporations, came up with a rule that for lack of a simpler moniker will have to go by its official name: Statement of Financial Accounting Standard No. 133, known in colloquial accountants-speak as SFAS 133.

The basic rule is simple: Starting Jan. 1, 2001, companies must disclose the fair market value of their derivatives.

Freddie Mac fought that rule when it was being written, and when it was implemented the organization "devoted considerable resources to exploring strategies that would mitigate the effects of the rule change," the internal investigation found. Elsewhere, the report states simply, "Management believed that SFAS 133 should be 'transacted around.' " It's impossible to read the internal investigation report without being struck by Freddie Mac's arrogance. Nowhere in it is any evidence that anybody at Freddie Mac ever suggested the company ought to play by the same accounting rules as everybody else. The pervasive corporate value was that our business is different, these rules should not apply to us. So while other companies complied with the new rules and fairly disclosed the market value of their derivatives, Freddie devoted vast resources to a "transition" strategy designed to ensure that SFAS 133 would have as little impact as possible on the financial statements issued to investors.

That was no easy task, because in 2001, Freddie Mac was sitting on billions of dollars of gains in the market value of its derivative portfolio, a condition that would have ballooned its profit.

Freddie didn't want to report that windfall all at once, as accounting rules required, but wanted to move the "profit" into future quarters when it wouldn't just be seen as a fluke of accounting but real, sustained growth in the bottom line.

Investors wouldn't understand the one-time gain, Freddie feared. Somebody might see those billions and buy the stock, pushing up the price.

If the stock went up because of this windfall, it would fall when the derivatives profits evaporated, as they inevitably would under SFAS 133 accounting.

In dozens of pages, the report spells out how far Freddie went to avoid reporting a windfall when the new accounting rules kicked in. Elaborate deals were cooked up using "results-oriented, reverse engineering." In other words: Here's how much profit we want to report to shareholders, let's figure out how we can do it.

Some of the things that were done clearly violated accounting rules, and for that heads rolled -- Brendsel, Vaughn and Glenn. Other transactions were more creative, bending the rules without breaking them. But Parseghian was promoted.

The report states that Parseghian was assured by Arthur Andersen, then Freddie's auditor, that the transactions were allowed, that they followed the letter of accounting standards. Within the rules or not, it doesn't make much difference. The intent was to deceive investors, and for that, everyone involved ought to take a fall.

Restoring Freddie's credibility ought to mean getting rid of everybody involved -- up to and including the board of directors. That's what WorldCom Inc. did, and it was a crucial step in that company clawing its way out of its own accounting scandals.

As Washington Post reporters Kathleen Day and David S. Hilzenrath have pointed out, the boards of Freddie Mac and its corporate cousin Fannie Mae each have five seats reserved for political appointments. Because the two giant mortgage companies were created by the government, the president himself gets to pick a batch of board members.

Over the years, some of the presidential appointees have been distinguished citizens, others have been distinguished by their political credentials.

For example, then-President Bill Clinton gave a seat on the Fannie board to Garry Mauro, who ran for governor of Texas and lost. President Bush gave one to Molly H. Bordonaro, who ran for Congress from Oregon and lost.

Lobbyists, loyalists, politicians and politicians' spouses have all been entrusted with overseeing the two biggest financial institutions in the United States. The non-political board members cover a similar range of résumés.

It would be fun to call up each of the Freddie Mac board members this morning and give them a pop quiz on the internal investigation that was completed last week.

1) Define CTUG, swaptions portfolio valuation and J-Deals.

2) Explain the key provisions of SFAS 133.

3) Compare and contrast the implied volatility of swaptions based on the Black Rock valuation model with the historical volatility model created by the company.

All Washington investors need to know is that No. 1 are transactions Freddie Mac officials used to get around No. 2.

All they need to know about No. 3 is that by switching from one valuation model to another, and then switching back 39 days later, Freddie conveniently managed to hide millions of dollar worth of profits.

Board members, on the other hand, ought to be able to expound on these topics in great detail. Doty told The Washington Post last week that the directors were not given enough information about the these matters to prompt questions at the time. A major transaction that was later found to be highly questionable "simply passed under the radar screen" of the board, Doty said.

Rather than a pop quiz , the board members ought to be called before Congress and examined in depth on their knowledge of how Freddie Mac does business, why this accounting scandal happened, what they knew and when they knew.

Bob Jensen's threads on other derivative financial instruments frauds --- http://faculty.trinity.edu/rjensen/fraud.htm

FREDDIE MAC 2001 INFORMATION STATEMENT PROVIDES ENHANCED DISCLOSURE OF USE OF DERIVATIVES, RISK MANAGEMENT PRACTICES McLean, VA --- http://www.freddiemac.com/news/archives2002/infostat_040102.htm 
APRIL 1, 2002 (Note the Date)
CONTACT: corprel@freddiemac.com
or (703) 903-3933

Freddie Mac (NYSE:FRE) today announced the publication of its 2001 financial Information Statement, which includes new, in-depth disclosures about the company's use of derivatives, risk-counterparties, and other risk management practices. The enhanced disclosures demonstrate that Freddie Mac is among the world's best-managed financial institutions.

The Information Statement for 2001, which meets or exceeds the Securities and Exchange Commission's disclosure requirements for publicly traded companies, provides shareholders, analysts, and the public with a detailed report on the company's financial condition. Freddie Mac's Information Statement is available at www.freddiemac.com .

Perhaps most important, the new Information Statement presents more clearly and comprehensively than ever before information about Freddie Mac's use of derivative financial instruments to manage interest rate risk on its portfolio of residential mortgages. The disclosure shows that Freddie Mac uses derivatives to manage its portfolio risk and not to speculate in the capital markets. It also contains important new information regarding how Freddie Mac effectively manages the credit risk associated with its derivatives counterparties.

For example, the Information Statement includes a new chart showing a summary by credit rating of the counterparties used in the company's derivative transactions, the notional balance of outstanding contracts, Freddie Mac's total counterparty credit risk exposure, and its exposure net of collateral.

It also shows that, as of the end of 2001, the simultaneous default by all of Freddie Mac's over-the-counter derivative counterparties would result in a loss of just $69 million—less than one week's worth of Freddie Mac's total earnings in 2001. This is an unusually low exposure, especially when compared to the risk exposures of other publicly traded financial institutions.

Other key disclosures being made for the first time in Freddie Mac's Information Statement for 2001 include:

A new table that shows the quantitative benefit of derivatives on the company's average level of portfolio market value sensitivity (a key measure of interest rate exposure) for 2001. A new section that provides an in-depth discussion of Freddie Mac's critical accounting policies in accordance with recent SEC guidance. Specifically, this section discusses policies that concern the establishment of loan loss reserves, the determination of the fair value of assets and liabilities (including derivatives), resecuritization transactions, and the application of SFAS 133 to Freddie Mac's hedging activities. A new section that significantly expands Freddie Mac's discussion of its principal hedging strategies, including its hedges of forecasted debt issuances, foreign currency exposure, existing long-term fixed rate debt, and embedded prepayment options in its retained pass-through mortgage securities. Today's announcement builds on the six voluntary commitments Freddie Mac made in October 2000 to ensure it remains in the vanguard of financial risk management and disclosure practice. These commitments include monthly interest rate risk disclosures, quarterly credit risk disclosures, obtaining and publicly disclosing a risk-to-the-government rating, and meeting the Basel Committee's principles for sound management of liquidity.

The 2001 Information Statement is available within our Shareholder Relations content area.

Freddie Mac is a stockholder-owned corporation established by Congress in support of homeownership and rental housing. Freddie Mac purchases single-family and multifamily residential mortgages and mortgage-related securities, which it finances primarily by issuing mortgage passthrough securities and debt instruments in the capital markets. Over the years, Freddie Mac has opened doors for one in six homebuyers and more than two million renters across America.

Risk stress testing at Freddie Mac preceded highly publicized controversies regarding the use of derivatives for speculation and risk management in Freddie Mac.  Between 2000 and 2001, Freddie Mac doubled its derivatives holding
to above $1 trillion, as it aggressively turned to derivatives --- http://www.larouchepub.com/pr/2003/030610freddie_mac.html 

Freddie Mac and Fannie Mae: Where the Domain of the Housing Bubble and the Domain of the Derivatives Bubble Intersect June 9, 2003 

Freddie and Fannie function to buy housing mortgages from mortgage lending institutions. By doing so, a mortgage lending institution, which has just issued a mortgage, can sell that mortgage to Freddie or Fannie for cash; it can then use the cash to make a new mortgage, and sell that mortgage to Freddie and Fannie, and so on, in the same manner several times over. During normal times, this activity would be merely liquefying the housing market; but since 1995, it has been used to allow mortgage lending institutions to make mortgages to finance the sale of houses priced up to the current limit of $310,000; the mortgage lending institutions sell the mortgage to Freddie or Fannie, and then make another mortgage loan for up to $310,000, etc.

This mechanism is crucial for the perpetuation of the housing bubble, providing lending institutions the vast scale of liquidity needed to provide households the financing to purchase vastly over-priced homes.

As a result of this process, Freddie and Fannie have become gigantic. In terms of asset size, the four largest financial institutions in America are: 1) Citigroup, $1.1 trillion in assets; 2) Fannie Mae, $822 billion in assets; 3) JP Morgan Chase, $720 billion in assets; and 4) Freddie Mac, $708 billion in assets. Thus Fannie and Freddie are two of the top 4 financial institutions in America.

As indicated in yesterday's briefing, Freddie and Fannie can carry out this operation by issuing three types of highly risky obligations:

 1. corporate bonds that Freddie and Fannie issue; 

2. Mortgage Backed Securities (MBS), in which Freddie and Fannie pool a group of mortgages together, put a guaranty on it (for which they earn a fee), and then they package these MBS to insurance companies, pension funds, international investors; etc; and 

3. outright derivatives, which Fannie and Freddie have.

Derivatives Holdings of Fannie and Freddie
($ billions)

	Fannie Mae	Freddie Mac
1997	161	96
1998	188	313
1999	275	424
2000	320	474
2001	533	1,052
2002	657	NA

The table shows the domain where the highly leveraged housing bubble and the highly leveraged bubble of derivatives intersect. Freddie and Fannie have turned to the use of derivatives to manage the housing bubble, to prevent it from exploding. Between 2000 and 2001, Freddie Mac doubled its derivatives holding to above $1 trillion, as it aggressively turned to derivatives. Freddie Mac has delayed the release of its 2002 annual report, but it is believed that its derivatives portfolio exceeds $1.3 trillion.

Federal Reserve Board chairman Alan Greenspan is the other key ingredient to the housing bubble: he has used his power at the Fed to lower interest rates so that the rate on a 30-year mortgage hit 5.32 percent, the lowest rate in four decades. However, the success of this whole scheme depends, among other things, upon continuing to keep interest rates low. Were interest rates to spike up, this would convulse the Mortgage-Backed Securities market, and the derivatives market of Freddie and Fannie. In 1994, a half percent increase in interest rates blew out the MBS market, which was then far smaller. Further, the derivatives market in general, is alreay producing instabilities. An interest rate increase would serve as a trigger to de-leverage the hypothecated $11.2 trillion U.S. housing bubble.

Derivative Financial Instruments

Derivative financial instruments ("derivatives") are financial instruments whose value is based upon an underlying asset, index or reference rate. Over-the-counter derivatives are privately negotiated contractual agreements that can be customized to meet specific needs. Exchange-traded derivatives are standardized contracts executed through organized exchanges. Freddie Mac enters into derivatives as an end user to obtain lower-cost financing, reduce risk and protect market value. Freddie Mac does not engage in such transactions for speculative purposes. By using derivatives, Freddie Mac is better able to match the expected cash flows of its assets and liabilities and reduce the corporation’s exposure to interest-rate and/or foreign-currency risk.

Accounting for Derivatives in 2001

On January 1, 2001, Freddie Mac implemented Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended ("SFAS 133"), which requires the corporation to recognize all derivatives on its balance sheet as either assets or liabilities measured at their fair value. The adoption of this standard did not affect the corporation’s previously issued financial statements up to and including the December 31, 2000 financial results. The one-time, net cumulative after-tax adjustments required upon adoption of SFAS 133 resulted in a $5 million increase to "Net income" and a $2.5 billion reduction to AOCI. The reduction to AOCI primarily resulted from SFAS 133’s requirement to recognize the derivatives designated as cash flow hedges, principally pay fixed swaps, on the balance sheet at fair value. Consistent with other GAAP-based equity valuation adjustments, changes in GAAP-based equity due to SFAS 133 AOCI adjustments do not affect Freddie Mac’s regulatory core capital, which is equal to "Stockholders’ equity," excluding AOCI.

When derivatives meet specific criteria, they are accounted for as either fair value hedges or cash flow hedges. Although Freddie Mac does not execute derivatives for trading or speculative purposes, in some cases, certain derivatives either do not satisfy SFAS 133’s hedge criteria or because hedge accounting has not been elected. Changes in fair value of those derivatives are reported in "Other income, net." The amortization of hedged item basis adjustments occurs over the life of the hedged item (for example, the estimated mortgage life in the case of hedged PCs), and must begin no later than when the hedge relationship terminates. A hedge relationship is deemed to be terminated when (i) the hedge no longer meets the SFAS 133 hedging criteria, (ii) hedge accounting is no longer elected, (iii) the derivative is sold or terminated, or (iv) the derivative is redesignated to another hedge relationship. Freddie Mac frequently redesignates derivatives from one hedge relationship to another or otherwise adjusts its hedging relationships in order to maximize the effectiveness of its hedging strategies in response to changing interest rates and other market factors, asset and liability paydowns, and changes in the composition of its derivatives, mortgage assets and debt obligations. Accordingly, the amortization of basis adjustments as a component of net interest income is begun each month for a substantial portion of Freddie Mac’s hedging relationships.

There are many other sections of the Year 2001 annual report that are too extensive to quote here.

As of November 2, 2003, the Year 2002 Annual Report of Freddie Mac is not yet available at http://www.freddiemac.com/investors/ar/ 

Also see http://www.freddiemac.com/investors/reports.html 

Improper Use of Hedge Accounting for Portfolios In a Manner Not Allowed in FAS 133

"Freddie Mac Attack Critics are calling for greater oversight -- or even a breakup," Business Week, July 7, 2003 --- http://www.businessweek.com/magazine/content/03_27/b3840057.htm 

Mistakes were made -- lots of them. Management controls were weak, disclosures were misleading, and accounting in many cases was flat-out wrong. Despite all that, the company's future is rosy. That was the message from Freddie Mac (FRE ) on June 25, when it announced that an upcoming restatement could total $4.5 billion. "The company remains safe and sound," Freddie Mac Chairman Shaun F. O'Malley declared.

The market, too, focused on the good news: The restatement, expected in September, will boost Freddie's past earnings and increase surplus capital. That raises the possibility of bigger dividend payouts or even a share repurchase to reward stockholders. Freddie's shares rose 1.6%, to $50.83.

But no matter how hard Freddie tries to spin billion-dollar accounting errors, the housing-finance agency's admissions are fueling critics. Freddie made so many mistakes in applying derivative accounting rules that "a majority of the corporation's derivatives in 2001 and 2002 will not qualify as accounting hedges," the company said. And while Freddie Mac will correct financial statements back to 2000, the errors date from the mid-'90s, says new Chief Financial Officer Martin F. Baumann.

Not everyone is as sanguine as the stock market, however. What, for instance, would have happened had Freddie bet the wrong way on interest-rate movements, or if banks, fearing further problems, refused to buy its debt? Freddie's problems reveal just how little is known about its inner workings -- and highlight the risks should the markets lose confidence in its ability to manage its huge derivatives portfolio."  Even if they're not trying to cook their books," says Michigan State University accounting professor Thomas J. Linsmeier, Freddie's mistakes show that "there could be a systemic problem requiring a taxpayer bailout."

That's exactly why a small but vocal group of banks, politicians, and academics for years have argued that Freddie and its larger cousin, Fannie Mae (FNM ), be subject to tougher regulation, including Securities & Exchange Commission oversight. Now, Freddie's revelations will make it harder -- though not impossible -- for either of the two government-sponsored enterprises to block reforms. They have also raised anew the question of whether these giants should be split up or even privatized.

Freddie and Fannie are crucial cogs in the housing market because they buy mortgages from commercial banks and other lenders and resell them to investors as mortgage-backed securities. That frees lenders to lend again. And thanks to the three-year-old housing boom, Fannie and Freddie now carry an astronomical $1.6 trillion in assets on their balance sheets, up from $962 billion in 1999. But as Freddie has shown, what lies behind those numbers is often a mystery.

The reason, in a word, is derivatives. The root of Freddie's problems can be found in a dense document called Statement of Financial Accounting Standards 133, which determines accounting rules when derivatives are used as hedges. The rules require companies to assign current market values to the interest-rate swaps, options, and other derivatives they hold and to reflect any changes in their value on the balance sheet. FAS 133 also contains a sweetener: Companies can offset any gains (or losses) on an asset with a similar loss (or gain) on the derivative used as a hedge. And here's the real grabber: Any changes in a derivative's value can be recognized over the life of the hedge, allowing companies to avoid the volatility that market-value accounting creates.

The improper use of hedge accounting to amortize gains -- and thus smooth ragged ups and downs in quarterly earnings -- was Freddie's downfall. As a June 25 press release deadpanned: "Certain capital market transactions and accounting policies had been implemented with a view to their effect on earnings in the context of Freddie Mac's goal of achieving steady earnings growth." Translation: Steady earnings help Freddie convince investors and lenders that management has its eye on the ball. They also help ward off politicians who might point to volatility as a reason to tighten regulation or even break Freddie up.

The company's quest for smooth earnings, plus its admitted lack of accounting expertise and weak management controls, proved to be a fateful combination. That became clear to PricewaterhouseCoopers auditors soon after they replaced longtime Freddie auditor Andersen LLC in 2002. The new audit team soon discovered suspicious hedge accounting involving Treasury securities.

Freddie, it turns out, had sought to lock in favorable spreads between the lower interest rate it pays to holders of its debt and the higher rate it gets for the home mortgages in its portfolio. Typically, financial institutions lock in such spreads with standard interest-rate swaps. But in an attempt to lower hedging costs, Freddie used Treasury securities instead of swaps. At the end of 2002, Freddie held some $16 billion in Treasuries on its books as debt hedges.

The net effect was the same -- holding Treasuries can protect against interest-rate changes as well as an interest-rate swap. There the similarities end. Because Treasuries are cash instruments, they aren't eligible for hedge accounting under FAS 133. So by designating Treasuries as derivatives and accounting for them as hedges, Freddie violated FAS 133 and now must reverse that treatment by recognizing gains in past years. Although Freddie at the time tried to document the transactions as true hedges, and even got Andersen's O.K., Baumann says: "The accounting was wrong. It just didn't qualify" for hedge treatment.

Once the new auditors dove deeper, they found a disturbing pattern: Most of the derivatives were incorrectly accounted for. Another big error concerns what are called "held-to-maturity," or HTM, securities. Freddie's portfolio includes $260 billion worth of mortgage securities that it classifies as HTM. As long as companies promise not to sell such securities before they mature, they can record them on the balance sheet at their original cost instead of revaluing them each quarter.

But Freddie used some of its HTM securities as collateral for short-term borrowings. It later repurchased the securities, and in doing so, tried to classify the sale and repurchase as a simple repurchase. But once sold, HTM securities do not qualify for hedge accounting. By selling a portion of the HTM portfolio, Freddie tainted its entire $260 billion portfolio. That means Freddie must record any value changes on more than 100,000 securities in either the income statement or shareholders' equity.

Freddie's board and new management team -- besides O'Malley and Baumann, it includes former Chief Investment Officer Gregory J. Parseghian as CEO and President -- have vowed to put the books in order. They are adding to Freddie's accounting staff and increasing the level of internal oversight. Executives overseeing risk-management functions now report directly to Baumann.

But that won't be enough to mollify critics. Longtime Fannie and Freddie foe Representative Richard H. Baker (R-La.) on June 24 unveiled a measure to move their regulator, the Office of Federal Housing Enterprise Oversight, from the Housing & Urban Development Dept. to the Treasury Dept. and to expand its powers. Treasury Secretary John W. Snow refuses to comment on any specific proposal, but he may be warming to the idea. "[We want] a regime of greater transparency so the investment community will know what's going on," says Snow. Freddie's effort to come clean may be just the start of hard times ahead for the GSEs.

Prepared Remarks
Greg Parseghian
CEO and President of Freddie Mac
Equity Lunch/Debt Dinner
Boston, MA
August 20, 2003 (Note the Date)

Good evening, and thanks to all of you for joining me here in Boston.

It's been over two months since the Board of Directors of Freddie Mac asked me to be CEO. At that time, I promised to keep you updated on our progress. As part of that commitment, I have been on the "road" a lot in the past few weeks.

At each event, I have described my vision for Freddie Mac – and how we are going to achieve it.

Simply put, we aspire to be the premier financial institution in the world.

The reason for this bold vision is the critical importance of our mission to lower costs and increase access to quality housing for more of America's families. Our mission has never been more relevant or important-and we can only achieve it by being the best at everything we do.

Now let me describe my top priorities for becoming the premier financial institution. They are:

• Get our financial statements right;
• Build long-term shareholder value;
• Communicate effectively so that the public understands our business and results; and
• Foster an open culture

Get Our Financial Statements Right

When I took this job, I told you that "Job One is getting our financial statements right." But that is only the beginning. Several months ago, we embarked on a remediation plan to address the issues that led to the need to restate earnings.

My goal is for Freddie Mac to be recognized as the best in class for accounting, reporting, controls and financial disclosures.

We have recently sharpened the focus of this plan in light of the review conducted by Baker Botts. The report raised serious concerns about the company's past accounting, controls and disclosure processes and practices.

In response, I directed CFO Marty Baumann to expand his remediation effort to ensure that each issue identified in the report is addressed with an action plan to correct the deficiency.

In addition, we have retained the immediate past Director of the SEC's Division of Corporation Finance to benchmark the disclosure processes and practices of high-quality reporting firms – and replicate them at Freddie Mac.

These steps will enable us to make a seamless transition to an SEC reporting company. I reaffirmed our commitment to SEC registration in a letter to Treasury Secretary Snow in July.

Build Long-Term Shareholder Value

My second priority is to build long-term shareholder value.

Three core competencies are critical to our ability to do this: asset selection, risk management and low-cost financing.

First, asset selection is critical to maintaining a high-quality mortgage portfolio in both our investment and securitization businesses. It ensures we are well positioned to participate in the broad array of products that characterize mortgage debt outstanding.

Second, risk management has been - and will continue to be – a core competency at Freddie Mac.

When I arrived in 1996, I was determined to develop an interest-rate risk management framework that would allow us to grow in a safe and sound manner and fulfill our mission – regardless of where interest rates happened to be.

Since 1998, we have managed through six cycles where interest rates moved between 150 and 250 basis points in a relatively short period of time. Throughout these extreme interest-rate moves, Freddie Mac's risk profile remained low.

This is not news to investors because of the frequency of our interest-rate disclosures.

Freddie Mac is one of only two financial institutions that disclose duration gap on a monthly basis. And to my knowledge, Freddie Mac is the only financial institution that discloses both duration gap and portfolio market value sensitivity – or PMVS – on a monthly basis.

PMVS is important because it considers the potential loss of market value due to both duration and optionality risk.

In the fall of 2001, rates rose by about 100 basis points in a one-month period – similar to the move we experienced in July.

Because we were extremely well hedged, our duration gap moved by only one month and our PMVS averaged 4 percent during that time period.

Experiences like these give me great confidence in Freddie Mac's ability to weather significant market volatility. When we release our monthly volume summary for July, you will see that – despite the tremendous rise in interest rates – Freddie Mac continued to maintain a low risk profile.

In sum, we strive to maximize shareholder value while taking the lowest possible risk.

Very few institutions can claim such a strong risk position – one that I am determined to maintain.

Our third core competency is low-cost financing. Freddie Mac's ability to lower the cost of homeownership is a direct consequence of our charter, our disciplined approach to risk management and the superior performance of our mortgage-backed and debt securities.

Every day we strive to be the premier global non-sovereign credit, attracting low-cost funds from around the world to support homeownership in America.

By bringing Wall Street to Main Street, we enable homeowners to compete alongside the largest and most creditworthy institutions in the world for financing.

I want to emphasize that we are focused on creating long-term shareholder value, and not on short-term objectives, such as earnings targets. As CEO, I will not compromise long-term value objectives for the sake of reducing volatility in short-term earnings results.

Communicate Effectively So that the Public Understands Our Business and Results

My next priority is to ensure that investors fully understand whether we are fulfilling our objective of building shareholder value and operating in a safe and sound manner.

To enhance investor understanding, we will provide three sets of results: GAAP, a non-GAAP supplemental measure and fair value. Since I look at all three of these measures in evaluating Freddie Mac's performance – I believe you should have them, too.

GAAP will be the primary measure of our financial results.

GAAP is important because it is the gold standard mandated for all public reporting companies, as well as the basis of our regulatory capital requirements.

Investors also need to understand the drivers of our GAAP results. Because of the different accounting treatment of economically similar instruments like callable debt and option-based derivatives, we expect to provide a supplemental, non-GAAP book-based measure.

We will round out the picture by providing a quarterly fair value balance sheet.

Fair value represents the net marked-to-market value of all financial instruments. Over the long term, fair value closely reflects the underlying economics of our business. It will be particularly helpful in understanding our performance during – and immediately following – the restatement period.

Although all these measures are important, long-term value creation is the touchstone of our business philosophy. That's why we want to provide you fair value metrics more frequently than required by the FASB.

If we are successful at generating world-class risk adjusted returns (and I am confident we will), we will maximize earnings over the long term regardless of how they are measured.

Foster an Open Culture

My fourth priority is to foster an open culture at Freddie Mac. I hope that many of you believe as I do, that our June 25 press release marked the beginning of a new era of open communication. As difficult as it was, I am proud that, when there was bad news to communicate, you heard it from me first.

Going forward, we intend to be more outward facing in the way we do business. We're going to talk to and – more importantly – listen to our investors, customers, business partners and employees.

In the brief time I have been CEO, I have been very pleased with the response I have received by simply picking up the phone and talking to people. I am confident that we have a huge opportunity to build profitable business partnerships that will enhance our ability to serve homeowners and renters.

Conclusion

In closing, let me say that Freddie Mac has a bright future. Freddie Mac is a great American company with a great mission. I am determined to lead our company to be the best at everything we do. And we will do it in a manner marked by openness, transparency and candor. On behalf of the Freddie Mac employees and myself, we are committed to achieving the mission and vision I described today.

This concludes my formal remarks. Let me now open the floor to questions. I'll ask the first one: "Why are you the right person to lead Freddie Mac?"

The IASB opens a very small crack in the door for Macro Hedging --- http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#M-Terms 

To the IASB’s dismay in the summer of 2003, certain key aspects of FAS 133 incorporated in the international IAS 39 standard have riled European banks and other EU businesses to a point where, for the first time, there was a serious political movement underway in Europe to veto acceptance of a portion of an IASB standard in the EU.  A news article in the August 21, 2003 edition of The Wall Street Journal on Page C5 reads as follows:

This accounting battle centers on the IASB's insistence that derivatives should be valued at their fair value, rather than at cost, which is generally immaterial or even zero and is often how European companies treat them. Banks have argued that the outcome of the IASB's plan would be unnecessary volatility in their earnings and net worth, a point echoed by Mr. Chirac.

IASB Vice Chairman Tom Jones argued that the current system merely pretends that the earnings volatility doesn't exist. Trying to smooth earnings is what got Freddie Mac into trouble in the U.S., he said.

"Bank results in Europe are a fiction: No volatility, and derivatives are nonexistent (at least appearing to be nonexistent in financial statements)," he said.

The new IASB proposal (compromise) would now make it easier for banks to lump bundles of securities or loans together and hedge a fraction of the overall risk, a process known in the industry as macro hedging. This isn't allowed in the U.S., which requires (in FAS 133) companies to show the individual items being hedged. The original IASB draft had taken a similar stance.

But the body didn't give in on two other bones of contention: when banks should take a charge to earnings because hedge strategies are ineffective and whether banks can include money deposited in bank accounts that is available on demand in accounting for their hedges. The IASB argues that the money has to be treated for accounting purposes as if it could all be withdrawn the next day, although that doesn't happen in practice. It also argues that its concessions on macro hedging should help the banks accomplish similar results, and its board members have shown little willingness to budge.

The IASB’s Exposure Draft of the macro hedging compromise is entitled “Amendments to IAS 39:  Recognition and Measurement Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate” and for a short time can be downloaded free from http://www.iasc.org.uk/docs/ed-ias39mh/ed-ias39mh.pdf

It should be noted that this compromise does not apply to cash flow hedging or other types of hedging other than interest rate hedges.

It’s highly unfortunate that the proposed macro hedging compromise of IAS 39 mentioned above puts the IASB international standard on a somewhat non-divergent course with the FASB/SEC in the United States .   The FASB currently shows no interest to date in compromising FAS 133 with respect to macro hedging, although the complaints of the European companies apply to U.S. firms as well.  Two paragraphs from FAS 133 from the FASB are quoted below:

Paragraph 448.
The Board (FASB) considered alternative approaches that would require amortizing the hedge accounting adjustments to earnings based on the average holding period, average maturity or duration of the items in the hedged portfolio, or in some other manner that would not allocate adjustments to the individual items in the hedged portfolio. The Board rejected those approaches because determining the carrying amount for an individual item when it is (a) impaired or (b) sold, settled, or otherwise removed from the hedged portfolio would ignore its related hedge accounting adjustment, if any. Additionally, it was not clear how those approaches would work for certain portfolios, such as a portfolio of equity securities.

Paragraph 449.
Advocates of macro hedging generally believe that it is a more effective and efficient way of managing an entity's risk than hedging on an individual-item basis. Macro hedging seems to imply a notion of entity-wide risk reduction. The Board also believes that permitting hedge accounting for a portfolio of dissimilar items would be appropriate only if risk were required to be assessed on an entity-wide basis. As discussed in paragraph 357, the Board decided not to
include entity-wide risk reduction as a criterion for hedge accounting.

For more details, go to http://faculty.trinity.edu/rjensen/acct5341/speakers/133macro.htm 

October 29, 2003 question from Dennis Ratliff

-----Original Message----- 
From: Ratliff, Dennis J [mailto:dratlif@ju.edu]  
Sent: Wednesday, October 29, 2003 10:16 PM 
To: Jensen, Robert 
Subject: SFAS 133

Bob, I know you are real familiar with SFAS 133, do you think the standard has had much effect on business decisions?? thanks. 
Dennis.

Hi Dennis,

FAS 133 is hands down the least neutral FASB standard ever issued, as is IAS 39 in the international scene.  FAS 133 has had an enormous impact upon decisions, particularly in banks where newer types of hedging instruments had to be devised in order to conform to FAS 133 accounting rules.  For example, companies used to hedge with cross-currency derivatives that were not eligible for hedge accounting under FAS 133.  They then had to hedge with more complicated concatenations of instruments (FAS 138 relieved this somewhat).  In particular you might listen to the audio laments of Mike Kogler (Chase Bank) who absolutely despises FAS 133 --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm

Probably the most significant impact, however, is the loss of many former off-balance-sheet financing (OBSF) ploys.  Derivatives, particularly swaps, were among the most popular OBSF ploys used by corporations until FAS 133 went into effect.  After FAS 133, companies either could look to other on-balance sheet financing alternatives (other than derivatives) since derivatives could not be OBSF or they could seek alternate OBSF ploys, particularly SPVs --- http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm

You might also be interested in the following message from Ira Kawaller (a member of the DIG) that I keep posted at http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

Message from Ira Kawaller on August 4, 2002

*********************************
Hi Bob,

I posted a new article on the Kawaller & Company website: “What’s ‘ Normal ’ in Derivatives Accounting,” originally published in Financial Executive, July / August 2002. It is most relevant for financial managers of non-financial companies, who seek to avoid FAS 133 treatment for their purchase and sales contracts. The point of the article is that this treatment may mask some pertinent risks and opportunities. To view the article, click on http://www.kawaller.com/pdf/FE.pdf   .

I ' d be happy to hear from you if you have any questions or comments.

Thanks for your consideration.

Ira Kawaller Kawaller & Company, LLC http://www.kawaller.com 
kawaller@kawaller.com  717-694-6270

********************************************

Hope this helps!

Bob Jensen

Huge Growth in Derivatives Trading

March 21, 2003 message from Risk Waters Group [RiskWaters@lb.bcentral.com]

**************
The OTC derivatives market continued to grow strongly in the first half of the year, according to the International Swaps and Derivatives Association. The credit derivatives market grew 37%, with total notional outstandings reaching $2.15 trillion during the first half of 2002, the trade body said. Notional outstanding volume in interest rate and currency derivatives increased 20%, to $99.83 trillion, in the first half, while equity derivatives outstanding volumes rose to $2.45 trillion - up 6%. "The continued pace of growth in the over-the-counter derivatives markets during times of economic and political uncertainty demonstrates their importance as a mechanism for mitigation and dispersion of the risks our members encounter in the course of their business," said Bob Pickel, Isda chief executive. "The acceleration in use of credit derivatives in particular is testimony to the effectiveness of this product set in the redistribution of credit exposures to those firms desirous of adopting them."
**************

But Warren Buffett and others warn of looming disasters in the enormous derivatives markets!
See http://faculty.trinity.edu/rjensen/fraud033103.htm#DerivativesUpdate

My response to an inquiry about FAS 133 tutorials:

Angela asked me to reply to your message. In the late 1990s there were quite a few alternatives for FAS 133 training around the nation. I was asked to chair several of these myself and have some audio modules that I captured from speakers that I lined up for these various training workshops. See http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm 

Since then the momentum for such training workshops has died down, although some accounting firms are still providing some workshops. For live workshop information, I suggest that you contact Ira Kawaller --- http://www.kawaller.com/

I have a tutorial guide section near the top of my glossary on derivatives and FAS 133 terminology --- http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm 

I also have my own free tutorials and cases at http://faculty.trinity.edu/rjensen/caseans/000index.htm 

In particular, you might note the 133ex01a.xls and other Excel workbooks at http://www.cs.trinity.edu/~rjensen/ 

Hope this helps!

Bob Jensen

"How FAS 133 Cost Sears $270 Million:  How many more companies will get nailed by the new derivatives accounting rule?" 
CFO.com, March 23, 2001 --- http://www.cfo.com/article/1%2C5309%2C2374||A|7|7%2C00.html 

The $270 million charge against earnings that Sears, Roebuck reported this week in its 10-K filing with the Securities and Exchange Commission stems from the 1997 termination of an interest rate swap in its credit card portfolio, a company spokeswoman said.

But precise details on the terms of the swap or why Sears canceled it were not immediately available. The spokeswoman said Jeffrey Boyer, Sears' senior vice president and CFO, was not available for comment.

The spokeswoman also said that Sears did not view the $270 million as a material loss, but rather a "balance sheet reclassification."

Some accounting experts familiar with the Financial Accounting Standards Board Statement 133 said the Sears situation underscores exactly why the ruling was adopted in the first place.

Despite the opposition of many auditors and financial executives, both FASB and the SEC argued that the rule was necessary to protect investors.

Jim Leisenring, the FASB staff member who chairs the Derivatives Implementation Group and oversaw the drafting of FAS 133, says, "People said the disclosures were already accurate, and a lot of people said there were no surprises."

But if there are no unwelcome surprises buried in corporate financial statements, then companies won't be harmed by spelling out their exposure under FAS 133, Leisenring reasons. If there are losses, then companies have an obligation to alert shareholders.

It's entirely probable that Sears' management already had a good grasp of its derivatives' exposure, but the reclassifying of the hedging write-off makes the extent of the loss transparent to investors.

Jeff Wallace, managing partner for Greenwich Treasury Advisors in Greenwich, Connecticut, says the huge derivatives losses in the mid- 1990s by Orange County and Procter & Gamble spurred the initial movement to draft 133 in the first place. The fact that companies are identifying the true size of their derivatives losses is a sign that the rule is working as planned.

What's more, Sears is not likely to be the last company to report a large charge stemming from the rule. Last year, Microsoft reported that it had a charge of $375 million, Wallace says.

But Microsoft is on a June fiscal year, and Sears, like most of the rest of corporate America is on a calendar year. As more 10-Ks for 2000 are submitted to the SEC in the next few weeks, more derivatives losses will be revealed.

"We haven't seen an end to the surprises," Wallace says.

But Wallace also says it's also important to keep the loss in perspective. While $270 million is a large number by any standard, it amounts to barely 1 percent of Sears' $26 billion credit card portfolio. The loss, while painful, is not catastrophic by that measure.

The spokeswoman said that when Sears terminated the interest-rate swap in 1997, it began amortizing the $270 million write-off on a 20-year schedule. The adoption of FAS 133 this year forced Sears to accelerate the charge-off and recognize the entire amount still outstanding in the first quarter.

According to Sears' 10-K, the "transition adjustment includes the effect of recording an existing cash flow hedging relationship on the balance sheet and reclassifying deferred losses from previously terminated interest rate swaps from other assets to other comprehensive income." The hedge caused a pre-tax charge of $56 million, or $34 million after taxes. The terminated swap had a pre-tax charge $389 million, or $236 million after taxes.

Sears' filing said it will write off the derivative losses over the next 17 years "as a yield adjustment of the hedged debt obligations."

Ira Kawaller, a Brooklyn, NY, consultant who specializes in derivatives, says, that although he's not familiar with the specifics of the Sears' charge-off, the company's classification of the impact of the swap as other comprehensive income, or OCI, suggests that it funded some of its credit card portfolio with a variable-rate liability and hedged it with a fixed-rate contract. As the market moved against it in 1997, the retailer decided to unwind the contract rather than expose itself to further losses.

Continued in the article.

Question:  How should Southwest Airlines account for these derivatives?
"Trying to Make Fuel Prices Less of a Wartime Gamble," by Daniel Altman, The New York Times, March 23, 2003 --- http://www.nytimes.com/2003/03/23/business/yourmoney/23HEDG.html 

Now that the war in Iraq has begun, oil prices could go $10 a barrel higher — or lower — by this time next month. How can a company that uses a lot of oil or its byproducts protect itself?

Because the risks run in both directions, businesses in several industries face a complex task: guarding against a price spike while staying open to the benefits of falling prices.

The companies' methods run the gamut. Some have been actively hedging, using complex financial instruments, while others have preferred to manage fuel inventories or pass along costs to consumers.

Last September, Southwest Airlines decided to prepare for the possibility of war in the Persian Gulf. The company bought financial derivatives to ensure that it would never pay much more than 70 cents a gallon for jet fuel — the equivalent of a bit more than $23 for a barrel of crude oil, compared with the price of $28.80 today — for its fuel supply this quarter. More than 75 percent of its fuel needs for the remainder of 2003 and all of 2004 are similarly protected, and some of its hedges extend all the way to 2008.

Southwest's hedges mostly take the form of common but sophisticated derivatives called collars and swaps, said Gary C. Kelly, the airline's chief financial officer. In the near term, about two-thirds of the derivatives are based on prices for heating oil, which follow rates for jet fuel more closely than those for crude oil.

The cost of price protection amounts to about 1 or 2 cents for each gallon of jet fuel, Mr. Kelly said. With jet fuel being traded for more than $1 a gallon lately, he added, "it's obviously a very substantial saving."

Southwest, though, may be the exception rather than the rule.

"It varies tremendously from firm to firm," said Edward N. Krapels, an expert on risk management at Energy Security Analysis, a research firm in Wakefield, Mass. "In the airline industry, you'll find some who are quite aggressive hedgers, and others who are not."

Mr. Krapels said some companies might have become wary of hedging after buying derivatives to protect themselves, only to find that oil prices would fall. In the Persian Gulf war of 1991, for example, the sudden drop in prices that accompanied the build-up of coalition forces and their early victories took many companies by surprise.

As a result, Mr. Krapels explained, "most large consumers are underhedged, with some very significant exceptions." He added, "The impact of an oil price increase on these guys will be very significant."

Companies that routinely engage in hedging tend to be in the middle of the petroleum supply chain, said Neal L. Wolkoff, the chief operating officer of the New York Mercantile Exchange, where energy derivatives are traded. "The greatest participation tends not to be from the ultimate consumer," he said. "It's more either merchants and refiners or integrated oil companies."

The Valero Energy Corporation, a top refiner, contracts in advance for cargoes of oil from China, Russia and other countries. The company uses simple mechanisms to guarantee oil prices into the near future. Because of the uncertainty about oil prices in the next few months, Valero has tried to insure itself in case market rates fall below those in its long-term contracts.

"We are concerned that prices are going to fall off after this whole Iraqi thing is resolved, so any extra barrels we have, we hedge them," said Gene Edwards, Valero's senior vice president for supply and trading.

 
ATHER than buying options to sell oil at fixed prices, as protection against prices falling, Valero sells future contracts for oil. For example, it might buy oil at $35 a barrel today and promise to sell oil at $32 a barrel next month. If the price of oil next month falls below $32, then Valero can buy oil from the market and sell it at a profit.

Mr. Edwards said that investment banks often approach Valero with more complicated derivatives, but that the futures generally offer a less expensive solution.

In addition to buying and selling futures, Valero has been engaging in a more tangible form of hedging — limiting its own stocks of oil so it can take advantage of prices if they fall. "You try to keep inventories low, because you don't want to be sitting on extra barrels," Mr. Edwards said.

That kind of activity has kept volume on the New York Mercantile Exchange near normal levels, Mr. Wolkoff said. "A lot of companies are, in effect, hedging through their physical business," he said. "That means there appears to be a reticence to hold inventory. That's one way of hedging, simply by reducing your exposure."

Some companies that use a lot of fuel have an even simpler way of dealing with high and low prices. The Roadway Corporation, the trucking-line operator, passes along the high cost of fuel to customers through a surcharge. Each week, the company updates the surcharge automatically, using the Energy Department's diesel price index.

"It makes fuel a pass-through for us," said John M. Hyre, a spokesman for Roadway. "We don't benefit by it, and we're not negatively impacted by it. We do have concern for the impact that rising fuel costs have on our customers, though."

The company can benefit, however, when fuel prices drop steeply. "If we encounter good pricing, we will work on getting long-term contracts under that good pricing," Mr. Hyre said.

If the war in Iraq does not go as the Pentagon has planned, any sudden spike in oil prices could have the harshest effects on some people who have little use for petroleum products, except on the drive to work. Hedge-fund managers and other speculators who sell financial protection to companies like Valero could be at risk, Mr. Krapels said.

"If the war goes badly, and the oil price goes significantly higher than it is today, how well can the people who took the short side of that bet withstand it?" he asked. "There could be some very big credit exposures." 

The dangers of derivatives abuse and the excessive amounts of derivatives now in the markets --- http://faculty.trinity.edu/rjensen/fraud.htm#DerivativesFraud 

"The Impact of FAS 133 on the Risk Management Practices of End Users of Derivatives," Association for Financial Professionals, September 2002 --- http://www.kawaller.com/pdf/AFP_2002.pdf 

The Financial Accounting Standards Board (FASB) issued new accounting rules for derivatives and hedging transactions (Financial Accounting Statement 133, or FAS 133) in June 1998 that were effective on June 15, 2000. Most companies, however, did not implement the standard until the first quarter of 2001. Because the transition from the previously accepted accounting treatment was dramatic and controversial, many reporting entities — along with FASB and the Securities and Exchange Commission (SEC) — were concerned about the impact that these new rules might have on the hedging activities of corporations. To gain a clearer perspective on the impact of FAS 133, the Association for Financial Professionals (AFP) surveyed its members in January 2001.

This original survey had several major conclusions.

• First, two-thirds of respondents believed that FAS 133 had imposed an "excessive burden" on reporting companies.
  
  
• Second, a quarter of respondents indicated that they expected to apply regular derivatives accounting—as opposed to applying special hedge accounting — to a significant portion of their derivatives holdings.
  
  
• Third, the new accounting requirements fostered a small reduction in hedging activity.
  
  
• Fourth, only a quarter of respondents believed that FAS 133 imposed a beneficial discipline on risk management activities.

The 2001 survey was conducted in early January, just a few months after companies started complying with FAS 133 requirements, but since then, FAS 133 has continued to evolve. FASB has posted additional guidance on its web site ( http://www.fasb.org ); and on May 1 2002, released a new exposure draft containing proposed amendments to FAS 133. AFP decided to survey its membership again, to see whether companies have altered their use of derivatives two years after the effective date of FAS 133.

Survey Methodology

AFP mailed an eight-page questionnaire to select corporate practitioner members¹ in May 2002 and received 175 valid responses. Respondents represented a wide variety of companies throughout the United States, with respondents typically working for company with annual revenues between $1 and $5 billion Treasury and finance professionals of varying job titles completed the questionnaire. Most survey respondents identified themselves as treasurers (29 percent), assistant treasurers (25 per-cent), CFOs (19 percent), and risk managers (10 percent). Respondents also identified the person charged with overall responsibility for FAS 133 implementation as controller/comptrollers (25 percent), CFOs (20 percent), treasurers (19 percent) and assistant treasurers (15 percent).

Footnote 1 
Surveys were sent to corporate members holding titles of CFO, treasurer, or controller and to members who identified any of the following as one of their five primary job responsibilities: accounting/financial reporting, hedging, risk management, and financial risk management.

Executive Summary 

The 2002 survey asked many detailed questions concerning the use of derivative tools and the impact of FAS 133 on company behavior. The principal findings and conclusions are as follows: 

• Sixty-three percent of companies report that they use derivatives to address interest rate and currency exposures, respectively. However, only a third of responding companies indicate that they hedge commodity or raw material price exposures. 
  
• Respondents report lower levels of hedging activity for the vast majority of derivatives tools and strategies, compared to levels reported in last year’s survey. 
  
• Despite this reduced hedging activity, seven out of 10 respondents claim that their company’s use of derivatives has not changed as a result of FAS 133. 
  
• Some of the decline in hedging activity may be due to a perception that market conditions have mitigated the need for hedging activities over the past year. This perception was likely based on relatively lower interest rates, mild currency fluctuations and smaller commodity price swings. 
  
• Even after the process of initial implementation of FAS 133 accounting had been completed — a process that imposed special, one-time time start-up costs — nearly half of the respondents still report that complying with FAS 133 rules is “excessively burdensome.” This result is especially significant in that it comes despite an overwhelming reliance and preference for the simplest, most plain vanilla derivatives. 
  
• Almost a quarter of the respondents say that their company has decided to forgo hedge accounting on “significant portions” of derivative positions as a result of FAS 133. 
  
• Companies generally use hedge accounting. However, when they decide to avoid hedge accounting, it is because either they feel it is not necessary (i.e., the cost and effort outweigh the benefits) or that the companies’ exposures are not eligible for hedge accounting. 
  
• Significant portions of companies who were eligible for special accounting treatments described in DIG issues G20 and H15 — treatments that would likely lead to less income volatility — choose not to avail themselves of this opportunity. This choice may reflect a per-ception that more onerous documentation and valuation requirements are associated with these treatments.

Bob Jensen’s documents (including audio and video) on FAS 133 are at http://www.cs.trinity.edu/~rjensen/000overview/mp3/133intro.htm 

Update on Derivative Financial Instruments and FAS 133

Letters to the Editor
An Eye on Derivatives
The New York Times
March 10, 2002

To the Editor:

Re: "Contracts So Complex They Imperil the System", NY Times, February 24, 2002

To characterize derivatives as not being transparent is a mistake. Derivatives are transparent. They are carried on the balance sheet at their market value, and changes in value are explicitly recorded in financial statements. If derivatives are used in special purpose vehicles or by subsidiaries, however, they won t be apparent at the consolidated statement level. This lack of transparency is not a function of the derivative. Rather, it s a function of the consolidation process.

Ira Kawaller --- http://www.kawaller.com/pdf/Times.pdf