The battle is a test of the IASB's (International Accounting Standards Board’s) ability to create standards that are broadly accepted by business -- and do it in time for European companies to adopt the rules in 2005.

The views of Mssrs. Chirac and Bolkestein matter because politicians have the power to derail international accounting standards -- supposed to be used by the 7,000 listed European companies -- because the European Union has retained the right to endorse individual rules that would apply within the 15-nation bloc.

Last month, the EU refused to do just that with two rules (in IAS 39) for derivatives, including an earlier version of the one being presented today, and Mr. Bolkestein warned of "growing unease concerning the standard-setting process itself."

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Silvia Ascarelli, “Accounting Panel Faces Another Test With Europe,”

The Wall Street Journal, August 21, 2003, Page C5

Introduction

For the IASB, a major political hurdle in becoming the world’s standard setting body is its decision to craft its international IAS 39 standard as close as possible to the extremely complex and highly controversial U.S. FAS 133 standard on Accounting for Derivative Financial Instruments and Hedging Activities. Like all Financial Accounting Standards Board (FASB) pronouncements, FAS 133 is required by the SEC for all registered companies in the U.S. This standard is comprised of over 500 pages of complicated rules and jargon on accounting for financial risk in derivative securities that now comprise trillions of dollars of financial speculation and hedging worldwide. After FAS 133 was issued by the FASB in the United States, the IASB issued its own international IAS 39 which closely conforms with FAS 133. IAS 39 is currently shaking the foundations of the future of harmonization of accounting standards in Europe and Asia. At the same time, FAS 133 is widely despised by most business firms and virtually all banking firms in the U.S.

In order to avoid wild fluctuations in earnings for financial hedges when implementing these standards, there are enormous incentives to qualify for hedge accounting under FAS 133 in the U.S. and IAS 39 elsewhere in the world. My leave proposal focuses upon the largest complaint of all about FAS 133 and IAS 39, i.e., the complaint that the new standards do not allow macro hedge accounting for most portfolios of hedged items. A macro hedge is a single hedge of multiple items in a portfolio as opposed to a separate hedge of each item.

Banks and other business firms are extremely vocal that the standards denying hedge accounting for most macro hedges just do not conform to how firms traditionally manage financial risk by macro hedging in practice. For example, a bank that invests in a variable rate loan can hedge interest rates by acquiring a derivative hedging instrument such as a swap that locks in the rate. However, banks tend not to hedge individual loans. Instead they hedge an entire portfolio of loans with a single “macro” hedging instrument. But, if that portfolio is not entirely homogeneous, advantageous hedge accounting under FAS 133 and IAS 39 is not allowed. For example, unless all loans in the portfolio have the same maturity date, a macro hedge is not given special accounting treatment that mitigates earnings fluctuations when the hedging instrument is adjusted daily to fair value. This has infuriated bankers and other corporations around the world. I plan to approach this problem on two fronts in research during my leave.

Ø First I plan to develop hedging models that will serve as a basis for amending FAS 133 and IAS 39 for purposes of allowing macro hedging for both cash flow and fair value risks. This will focus on alternatives not yet considered by the FASB and the IASB. I hope to extend the known state of the art in macro hedge accounting. Macro hedges exist in practice that nobody has yet figured out how to account for with hedge accounting.

Ø Second, I propose that macro hedging be disclosed online by business firms in pivot tables and charts modeled after Microsoft’s pivot table/chart “What if” forecasting innovations to the broader spectrum of “What if” financial reporting supplements to earnings forecasts. The purpose of online pivot table/chart reporting is to allow investors and analysts to perform sensitivity analysis to variations in assumptions and underlying parameters. The online sensitivity analysis should also help investors better understand that there is no theoretical basis for increasing or decreasing financial risk per se. Hedging to decrease cash flow risk must be accompanied by increases in fair value risk, and hedging to decrease fair value risk causes an increase in cash flow risk. Financial risk is not a single variable that can be optimized.

The Controversial Proposed Macro Hedging Compromise

To the IASB’s recent dismay, 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 is a serious political movement underway 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.

Unlike the IASB, the U.S.’s 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.

Paragraph 21(a)(1)
1) If similar assets or similar liabilities are aggregated and hedged as a portfolio, the individual assets or individual liabilities must share the risk exposure for which they are designated as being hedged. The change in fair value attributable to the hedged risk for each individual item in a hedged portfolio must be expected to respond in a generally proportionate manner to the overall change in fair value of the aggregate portfolio attributable to the hedged risk. That is, if the change in fair value of a hedged portfolio attributable to the hedged risk was 10 percent during a reporting period, the change in the fair values attributable to the hedged risk for each item constituting the portfolio should be expected to be within a fairly narrow range, such as 9 percent to 11 percent. In contrast, an expectation that the change in fair value attributable to the hedged risk for individual items in the portfolio would range from 7 percent to 13 percent would be inconsistent with this provision. In aggregating loans in a portfolio to be hedged, an entity may choose to consider some of the following characteristics, as appropriate: loan type, loan size, nature and location of collateral, interest rate type (fixed or variable) and the coupon interest rate (if fixed), scheduled maturity, prepayment history of the loans (if seasoned), and expected prepayment performance in varying interest rate scenarios. See Footnote 9

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Footnote 9
 Mortgage bankers and other servicers of financial assets that designate a hedged portfolio by aggregating servicing rights within one or more risk strata used under paragraph 37(g) of Statement 125 would not necessarily comply with the requirement in this paragraph for portfolios of similar assets. The risk stratum under paragraph 37(g) of Statement 125 can be based on any predominant risk characteristic, including date of origination or geographic location.

My Leave Proposal

My proposed research project entails investigation of how to improve macro hedge accounting both in the U.S. and in the international markets. The FASB’s blanket refusal to allow hedge accounting for macro hedges of non-homogeneous portfolios and hedges of more than one type of risk runs counter to both theory and practice. For example, it is extremely common for financial instruments such as loans to have combined interest rate risk and prepayment risk that arises from embedded options to settle before a maturity date. If multiple-risk items are being hedged for only one type of risk, usually price or interest rate risk, changes in the market value of the hedging derivative that hedges only one type of risk may not match changes in the market value of the hedged item whose value changes are impacted by multiple risks. The hedge of the price risk may be perfectly effective when in fact the FAS 133 mandated comparisons of the changes in hedged item and hedging instrument values make it appear to be an ineffective hedge that does not qualify for hedge accounting. The IASB recently made a small compromise for macro fair value hedge accounting of core deposits, but the compromise is very narrow in scope.

Put in another way, suppose the hedged item is an apple whose value is impacted by both the market price of apples and a significant likelihood that the apple will rot before being sold. The hedging derivative (say an apple price swap contract) is only impacted by changes in apple prices and is not subject to rotting before a contracted maturity date. Changes in the swap’s value may be highly ineffective in hedging the value change of any apple that becomes prematurely rotten. The same can be said about the hedge of a loan investment if the loan is paid off prematurely. Varying prepayment risks on loans held by banks typically prevent loan portfolios from being sufficiently homogeneous for purposes of macro hedging of interest rate risks under FAS 133 and IAS 39. The major macro hedging controversy boils down to the following controversies:

1. Individual item hedging is sometimes as absurdly impractical as writing a forward or swap contract for each apple held in a grocery chain’s inventory.

2. Not allowing multiple types of risk to be hedged with one hedging instrument fails to take into account that two or more risks may be highly correlated. The market value of a fixed-rate loan is greatly impacted by both risk of interest rate movements and risk of prepayment which, in turn, is also correlated with interest rate movements. The two risks are neither independent nor additive.

3. Businesses badly want accounting rules changed to allow macro hedge accounting for portfolios of assets and liabilities rather than individual items. They also want hedge accounting for “netting” hedges in portfolios containing both assets and liabilities. Managers often hedge net values even though netting is not allowed in the current hedge accounting standards.

4. It may be possible for firms to provide online supplementary pivot tables for investor dynamic analysis of hedges much like Microsoft provides online “What if” pivot tables to supplement its earnings forecasts. See http://www.microsoft.com/msft/history.mspx

My proposed research has the following stages:

1. Design a new macro hedging model that is somewhat similar to how Microsoft Corporation currently provides supplemental pivot tables (spreadsheets) and charts online that allow investors and analysts to adjust Microsoft’s reporting earnings and financial forecasts for different assumptions. Although Microsoft does not provide such pivoting alternatives for derivative instruments reporting, I think that the concept of pivot reporting can be extended to macro hedge reporting. Microsoft’s current “What if” pivot reporting spreadsheets and charts can be downloaded online from http://www.microsoft.com/msft/history.mspx

2. Prepare a simulated macro hedge set of “What if” pivot tables and charts that are realistic in terms of actual macro hedges taking place in banks.

3. Conduct interviews with CFOs of banks, security analysts, and academic experts to explain how my proposed pivot reporting of macro hedges work and elicit their opinions regarding how this type of reporting might improve upon the highly controversial FAS 133 rule that does not make allowances for macro hedges versus the equally controversial IAS 39 proposed compromise that fails to show the extent of financial risk in a macro hedge. I have made initial contacts with three academic experts. I intend to formally interview these experts along with three CFOs of banks and three security analysts. These interviews and follow-up interviews are intended to both aid me in developing my macro hedging models and in having experts evaluate the relevance of my findings.

4. Conduct interviews with standard setters in both the IASB and the FASB in an effort to both explain my proposed pivot reporting compromise and try to help these standard setters overcome that impasse that is heatedly dividing companies (especially banks) and standard setters at this point in time. My goal is to propose a new macro hedging standard to both the FASB and the IASB.

This proposal entails pivot table reporting that might some day extend to other controversial new and proposed standards for reporting of financial instruments and derivative financial instruments. Pivot tables allow for greater flexibility in financial reporting over ranges of risk and multiple risks. The envisioned time table for this research is as follows:

October 2003-June 2004
Conduct interviews with a number of banks to find a good example of a controversial macro hedge of interest rate risk. I will attempt to model realistic macro hedges in pivot tables.

August 2004-October 2004

Conduct interviews with at least three large banks, three large corporations, three security analysts, and three academic experts to both demonstrate my pivot reporting alternatives to a macro hedge and elicit their reactions and suggestions for improvements. My models and proposed amendments to FAS 133 and IAS 39 will be revised according to the best feedback I can obtain in these interviews.

November 2004

Conduct interviews with standard setters in the FASB, the SEC, and the IASB to demonstrate the pivot reporting approach and to elicit their reactions to this approach as a way to overcome the current rift caused by the differences in opinion on how best to report fair value and financial risk of macro hedges.

December 2004

Write up the final outcomes for submission to a research journal. My hope is that my efforts will motivate the FASB and the IASB to revise the standards for macro hedge accounting.

Personal and Professional Enhancements from This Research

My recent awards and qualifications to conduct this research are listed in the Appendix. What I hope to personally achieve from this research is to be on the leading edge of emerging value and risk accountancy and accountancy education. I hope to inspire my students and my audiences to look to the future trends of accountancy and see beyond traditions rooted in the mathematical writings of Luca Pacioli in 1494. Pacioli’s elegant algebraic accounting system is analogous to the theorems of Pathagoris that serve us well but are not sufficient for modern navigational systems in outer space. Similarly, under the globalization of business and capital flows and the complexities of international transactions, traditional accountancy is becoming increasingly inadequate. What a thrill it is to be on the leading edge of newer networking communications and computing technologies.

History of Academic Leaves at Trinity University

Since joining the faculty at Trinity University, I have had three academic leaves. The first was in 1988 and the second was spent mostly in Europe in 1993, where I was also the British Accounting Association’s “Distinguished Visiting Foreign Scholar.” The third was spent mostly in New Zealand in 1998 courtesy of three universities in New Zealand. My work from these leaves resulted in invitations to present my research outcomes at various universities in Finland, Sweden, Canada, China, England, Germany, Mexico, Taiwan, and the United States.

Appendix
My Qualifications for This Research

I have specialized in the highly technical portions of the complex FAS 133 and IAS 39 standards. As a result the KPMG Accounting Firm, GE Capital, IBC of Boston, and Strategic Research, Inc. have invited me to conduct training seminars for employees and clients in New York, Boston, and Chicago. In addition, I have conducted seminars on this topic in numerous universities in the U.S., Canada, England, Sweden, Finland, Germany, Taiwan, and Hong Kong.

I teach the ACCT 5341 graduate Accounting Theory course that focuses upon reporting of value and risk. Firms both speculate and hedge using complex derivative contracts that, in many instances such as Enron, are used to get around accounting reporting rules. I have written a number of papers on these issues and have made numerous technical presentations at other universities and research conferences on accounting for derivatives and hedging activities. I also have conducted training courses and do consulting on FAS 133 accounting standards for such firms as GE Capital. My Website on FAS 133 and IAS 39 is used extensively by accounting firms and investment analysts. See http://www.trinity.edu/rjensen/caseans/000index.htm

The above Website on derivatives accounting combined with my international presentations in the U.S., Asia, Canada, Mexico, and Europe were among the primary reasons I was chosen recently for two major awards from the American Accounting Association:

In August 2003 in Honolulu, I received the AI/ET Section Outstanding Educator Award for 2002-2003 Year. The AI/ET Section is the Artificial Intelligence/Emerging Technologies Section of the American Accounting Association. Only one person is selected each year. http://accounting.rutgers.edu/raw/aaa/aiet/aiethome.htm

On August 15, 2002, I received Accounting Association's Outstanding Accounting Educator Award at the Annual Meetings of the American Accounting Association and an accompanying $10,000 gift from the PricewaterhouseCoopers Foundation --- http://accounting.rutgers.edu/raw/aaa/awards/award4.htm

Some recent publications in this area include the following:

“A Theory of Interest Rate Swap Overhedging,” (with Angela L.J. Huang), forthcoming in Managerial Finance. The Editor of the journal invited me to write a paper on this topic.

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

“Customized Financial Reporting, Networked Databases and Distributed File Sharing," by Robert E. Jensen and Jason Zezhong Xiao, Emerging Practices in Cost Management (Warren, Gorham, & Lamont Professional Publishing Division, Research Institute of America Inc., Forthcoming).  This is a reprint of an article appearing in Accounting Horizons, September 2001

"Implementation of SFAS 138 Amendments to SFAS 133," The CPA Journal, November 2001. (With Angela L.J. Huang and John S. Putoubas), pp. 54-56 --- http://www.nysscpa.org/cpajournal/2001/1100/dept/d115401.htm

“Customized Financial Reporting, Networked Databases and Distributed File Sharing," Accounting Horizons, September 2001, pp. 209-222.

"FAS 133 As Amended and "DIGGED":  Highlights of FAS 138 and Some Key DIG Issues," Derivatives Report, September 2000, pp. 8-17.  

”An Explanation of Example 5, Cash Flow Hedge of Variable-Rate Interest Bearing Asset in SFAS 133,” by Carl M. Hubbard and Robert E. Jensen, Derivatives Report, April 2000, pp. 8-13.
http://www.trinity.edu/rjensen/caseans/133ex05.htm
The Excel workbook is at http://www.cs.trinity.edu/~rjensen/133ex05a.xls

”The Receive Fixed/Pay Variable Interest-Rate Swap in SFAS 133, Example 2, Needs An Explanation: Here It Is,” by Carl M. Hubbard and Robert E. Jensen, Derivatives Report, November 1999, pp. 6-11.
http://www.trinity.edu/rjensen/caseans/294wp.doc
The Excel workbook is at http://www.cs.trinity.edu/~rjensen/133ex02a.xls

Some of my more recent presentations on hedge accounting include the following:

"Update on Financial Accounting Standards," Southern Gas Association Accounting & Financial Executives Conference, April 28, 2003 in San Antonio, Texas.  Host:  Bruce Narzissenfeld

"The Crisis in Accountancy," Kent State University and the Ohio Council of the Institute of Management, April 18, 2003 in Kent, Ohio.  Host:  Norman Meonske

"Accounting for Intangibles and Internet Reporting," Pre-Conference Workshop, 14th Asian Pacific Conference on International Accounting Issues, November 22, 2002 in Los Angeles.  Host:  Ali Peyvandi --- http://www.craig.csufresno.edu/apc/

"The Future of the Accounting Profession:  Part 2," Virginia Institute of CPAs Educator Conference in Virginia Beach, Virginia Polytechnic Institute and State University, November 20, 2002.  Host:  Konrad Kubin

"Advances in Accounting for Derivative Financial Instruments," Florida Institute of CPAs Educator Conference, The University of South Florida, October 24-25, 2002 in Tampa.  Host: Gary Holstrum

"The Future of the Accounting Profession:  Part 1," Virginia Institute of CPAs Educator Conference in Roanoke, Virginia Polytechnic Institute and State University, September 30, 2002.  Host:  Konrad Kubin 

"Accounting Scandals in the United States:  Impacts on the World," The University of Augsburg, Augsburg, Germany, June 18, 2002.  Host:  Dr. Adolph Coenenberg

"Accountancy Profession in a Crisis: Worldwide Trends and Options for the Future," The 2002 European Applied Business Research Conference: Rothenburg ob der Tauber, Germany, June 17, 2002.  Host:  Ron Clute

"Educational Issues in FAS 133:  Accounting for Derivative Financial Instruments and Hedging Activities," Texas Society of CPAs Educator Seminar," Airport Hilton Hotel, Austin, Texas, October 19, 2001:  Host:  Roselyn Morris

"10 Lectures in Accounting and Finance," Monterrey Tech University and The Virtual University of Monterrey Tech, Monterrey, Mexico, March 18-23, 2001.  Host:  Oscar Tamez

Plenary session and panel speaker at the Year 2000 Taiwan Accounting Association's Annual Conference, Nov. 11-12 in Taipei, Taiwan. Host:  Dr. Chan-Jane Lin, National Taiwan University

"Cases for Implementing FAS 133 and IAS 39," Eight-Hour Module in the KPMG FAS 133 Implementation Workshop, October 12-13, 2000,  Chicago. Host:  Ira Kawaller

An Eight Hour Workshop on Implementing FAS 133 and IAS 39 Standards for Accounting for Derivative Financial Instruments and Hedging Activities, Controller's Office of General Electric Corporation, White Plains, NY, June 29, 2000:  Host:  David Brain

"Workshop on Accounting for Derivative Instruments and Hedging Activities," Kent State University, April 27, 2000.  Host:  Norman Meonske

A Real World Case of the Controversial Accounting for a Copper Swap that Challenges the Theory of IAS 39 and FAS 133, 23rd Annual Congress of the European Accounting Association, Ludwig-Maximilian University, Munich, Germany, March 30, 2000:  Hosts:  Professors Wolfgang Ballwieser and Hans-Ulrich Kupper

"Issues and Strategies for Financial Services Companies" sponsored by IBC of Boston at the web site http://www.ibcusa.com/2489/ December 13-14, 1999, ·Millennium Broadway Conference Center, New York, NY.  Host:  Claire Roderick

"Accounting for Derivatives and Hedging Activities:  The Mexcobre Case," World Research Group, Key Bridge Marriott in Chicago, September 29-October 1, 1999.  Host:  Pallavi Dalvi

"Accounting for Derivatives and Hedging Activities:  The Mexcobre Case," World Research Group, Key Bridge Marriott, Washington DC, October 27-29, 1999.  Host:  Pallavi Dalvi