Following the accounting practice in the Michigan area, you will be covering two things relating to the standards. You will give us an overview of the standards at about 12,000 feet. We have to go about 12,000 or 20,000 feet for this, because if you have seen the standard, it is 240 something pages long. It will give us an overview of the standard. In addition, we will be covering some key issues that lead to the controversy about the proposed accounting.

Are there any questions for Jim now?

No --- 470 pages! In the firm motto is; KPMG is "Time for Clarity." Thanks for that wonderful introduction Mr. Leisenring. It is a pleasure to be here. I'm charged with the task of trying to put in an example or two --- which you all understood Jim to say. I have two examples that I want to go through, a fair value hedge example and a cash flow hedge example, if we have time I will go through one more fair value hedge example.

But before I start I've got to share with you a story when I was flying down here, and this has happened to me before. When Tom and I were at the SEC, there was a lot of effort at that time put into asking registrants to be more robust in their disclosures about derivatives. And we participated in numerous calls, and the calls would go something like this. We'd call up and say, hello, Mr. Registrant or Ms. Registrant, I'm Steve Swad from the SEC, I'm here to help you. And this was before the IRS got a bunch of fresh recruits to do the same thing. We were cutting edge at the time. And the day after the registrants said, well what would you like? We'd say, well we notice you engage in a number of derivative activities. And you can't really tell that the disclosures about what you do are weak. And they'd say, well how can we help you? What do you want? We would just very kindly and gently say --- do a better job.

Well, flying down here, I ordered a cup of coffee on one of the major airlines, which happens to be a public company, and I got the little packet of cream. I don't know why my eyes glanced down, but I was reading the ingredients in the cream. And there was this real long ingredient, and I don't remember what it was. But it ended with 8. --- you know something like Luctose 8.. And then in parentheses it states that Luctose 8 is a milk derivative. Are these what they thought we meant by disclosures of derivatives? I got a charge out of that.

With that, why don't we talk a little bit about fair value, hedges? I'm going to give you a very common example that we've experienced. Just recap simply, fair value hedges. Jim said that the hedged item and hedging instrument get mark-to-market through income. That's about what he said. It gets a little more hairy than that, but if you pull away from that from this presentation I think that you are in good shape. That's what we are going to walk through. That's not that hard, that's a fair value-hedging concept if you will, and I find it interesting because normally when you think of hedge accounting, at least to me, I think of the derivative getting special accounting. In this case it's actually permission for the hedged item to get special accounting, that is the designated items gets mark to market when it otherwise wouldn't. And changes when that mark goes through income. So let's try one.

We've got a company with a fixed rate debt obligation of a million dollars, 8%. They borrowed from the market or they borrowed from the bank, it doesn’t matter. And they didn't like that interest rate, they didn't like that fixed interest rate. So they entered into an interest rate swap. And the terms of the swap are perfect --- perfectly offset the terms of the interest. So that the company under the data obligations is paying 8% under the interest rate swap, it's receiving 8%. And under the other leg of the interest rate swap, it's paying LIBOR plus 2. Very common!

Transactions have all the same critical terms. We are going to say for discussion purposes that LIBOR plus 2 starts out, or at March 31st at 10% and at June 30th is 9%. You need a little bit more than this. This is the meat of what you need. You need to know what the debts fair value was at the reporting dates and what the swap fair value was at the reporting dates. You also need to know any cash, cash interest payments that went out on the debt, net cash payments that went out on the swap. But let's just kind of forecast what these entries should look like before we go. I did debits and credits, I didn't know how else to communicate this other than through debits and credits. I had a fancy slide and then I figured I'd be more confusing than what it was worth. So I thought we just go through a simple journal entries.

So if we just take a blank sheet of paper, we know we have to mark up the hedged item to market through income. We know we've got to mark the hedged instrument to market through income. And we know changes in their market. So we should be able to say that as of March 31st when we are just doing the counting entries for the bond, we debit bond $50,000, take it from its million-par amount or proceeds amount down to its current fair value. And then we do an offsetting thing for the interest rate swap. We create an asset, $50,000 and credit income. So that at the end of the day in this perfect hedge, the gain you will on the debt obligation is offset by the loss on the interest rate swap. So I was never good at those parens. I want to redo that one more time.

So we've got a reduction in the liability that is resulting in a gain, last time I checked. And we've got this parenens debit on the asset that we are going to set up, we are going to set up a liability relating to the derivative and expenses. I should have not have leaped ahead because I got it wrong. And then you do the same thing at June 30th. The only thing that we haven't done is account for the interest rate pieces. And you are going to find in these perfect hedges that the cash monies paid out under the debt obligation and net monies received or paid out under the swap, just get dumped into the income statement.

So that at the end of the day the income statement looks like a LIBOR a plus 2 based loan, and the balance sheet looks like you've got a asset that you are re-measuring to market along with the derivative that you re-measured for market. Not too tough.! Actually, not much practice problem in this area other than trying to measure fair value. Which I think practice is going to get better at. So that's our first one. Setting up the bond, I think we could've got that. That first entry is resulting in interest expense $20,000 cash being paid out. And then we receive, this is the cash portion that I was talking about, we received on a net basis $5,000…we paid the $5,000 on the interest rate swap. So we charged P&L for $5,000. And that's just doing the fair value accounting on the balance sheet that we talked about. It's not hard.

Steve, we're going to stop and ask the audience a question.

That's a very common question. And the answer is that the markets may have an appetite for fixed rate debt when this debt is issued. And the company can lay off that risk very efficiently through the swap markets. So if the markets want fixed rates debt, the company will say fine, take it. And then if the company ultimately wants variable rates they will enter into a variable rate swap and execute and convert it to synthetic variable rate debt then.

Another, you could, in the swap market you can do a little more. You could switch this fixed rate debt into three years variable, two years fixed. Just by entering into a three-year swap. Or you could do the back three years if that is what you want. So even though we are keeping it simple and I encourage that we continue to do that, there's a lot of flexibility in the financial market that provide companies to tweak that they believe the appropriate type capital structure interest costs.

They do absorb or take on additional credit risks. But they've got to now swap counter party risks, and they are getting compensated for that in the swap price. But there is net, net, net I am told, real basis points that plus to the buyer. That's general.

Right. The accounting is the same, and the accounting focuses on changes in fair value of the hedge. Well, let me repeat the question first. Jim said, what if you enter into the hedge post debt issuance? So you enter into the debt on January 1st, you wait a quarter, and then you enter into an interest rate swap and do what my slide said you did. And the accountings the same, but the point Jim's highlighting, you do nothing with the change in the fair value of the debt from the date you issued it to the date you began hedging. And then you start marking to market changes in the value of the debt from the date you began hedging to the date you stop hedging. Yes.

It may not. In that case, the debt is not at fair value.

See Jim, I look at this fair value hedge accounting as a license to remeasure the hedged item once you meet the hedged criteria.

But note if it's late. If it's not at the same time and it's not hedging the full amount, the notional principle on the swap and the principle amount on the debt are not the same. That when we fair value the hedged item we are not getting all the way to fair value. It's sort of a mixed attribute measurement that we see in the hedged item.

Fair value hedge accounting may or may not result in fair value accounting, depending on when you enter into the hedge.

Most of the companies just do this. They simply chase in the cash flows of cash debts. And they do it in a simple manner; everything's the same. That's is the most common hedging strategy. Of course there are variations of it. But that becomes less common, much less common.

But of course that's important because your company assumes that is what happened, that's why it's ok.

Absolutely. The examples that I've put forth have very important element is that terms match. That's a very important assumption.

Yes, but not quite. Half piece, but not really?

Bifurcation would suggest that you split the debt into that part that is hedged and that's not. The carrying line item on the balance sheet's not going to likely to be split. It's going to be aggregated together and you're going to have the original carrying amount on the portion that's not hedged. And the new carrying amount reflecting the fair value in the portion that is hedged, added together.

He wasn't asking you a display question, though. It is the $5 million that you apply this to.

This is the question for those in the back; can you hedge half of a hedged item? And the answer is yes. Let's move on to a cash flow hedge. But I'm not going to guess the entries, I think I've got it…caused more trouble that it was worth.

I tried to…this is another common example where a companies trying to hedge against a forecasted purchase of inventory and in my example this company makes gold watches. And so they need gold, they need gold for their gold watch manufacturing process. They need 10,000 ounces of gold, $310, and they expect to be buying gold in six months.

I'm measuring effectiveness based on changes in the forward price of this contract which becomes important if you get into the nuances of effectiveness.

That's a very good point. Because I…the question is why is it a cash flow hedge? I'm hedging this thought that I'm going to buy inventory six months from now. There's no contract for me to buy inventory; there's no obligation for me to buy inventory. It's just probable that I'm going to do so. When you're hedging a probable event, it likely falls into a cash flow hedge. It's a good point. Contrast that to my last example where we were hedging the debt obligation. That was a series of fixed payments that moved, its fair value moved. That's a fair value hedge.

The basic criterion to get into fair value hedging is you need a change in the fair value. That was a FASB concept and it's sound and it's easy. The notion in cash flow hedges is that you have no change in fair value, but instead you have a change in expected cash flows. --- inflows or outflows.

That's correct. This is part of our normal business activities; we buy 10,000 ounces of gold every six months or every nine months.

And the price might be different than $310.

Absolutely, in fact it's likely that the price is going to be different than $310. That's why we're hedging, that we are comfortable with that price today.

Right, excellent creating market value risk if you will, by where we are going long in goal of locking in that $310 price. Now we've created fair value risk on stand alone contract basis. But the company wants that. They feel comfortable that if they are able to buy gold at $310, they will be able to sell watches at $510 and make a couple of hundred bucks. Ok, I think these are the critical things.

Right, Jim's point is an economic-type point. Does the company really have to have risk on an enterprise basis or a hedge? The answer is no --- that the FASB models that reduced a transaction. So if you can identify a transaction with risk, and meet the other criteria, you may qualify for hedge accounts. We are going to get into a little bit later that this notion of risk and why there is something increase the risk or decrease of risk. So I'm not going to steal Tom's thunder. But, the answer to your question, Jim, is you need a transaction with risk that may or may not lend to enterprise risk.

All right, so let's just walk through a few of these things before I botch up these entries. I'm a concept guy, I'm not the details guy. We've got this forward that on January 1st the spot price was $300, the forward price was $310, it's fair value was zero. It was at market. March 31st both the spot and the forward price moved. Forward price moved positively by $5. It's fair value moved favorably and depreciated to $49,000. And then later depreciated to $200,000. So that's the hedging instrument, that's our derivative.

That is based on changes in the forward discount end, ok?

Is the question, how much would you pay me for $5, when this $5 of net appreciation when this contract expires? That should be the fair value. $5 appreciation times the notional on discount effects.

Question. You can deal with effectiveness on contract by contract basis, on all types of contracts, of the same type?

No, the question is can you deal with effectiveness on a contract by contract basis, or maybe you aggregate and deal with it in the aggregate. The standard's specific and it says it's a transaction-based standard; so it says that in order to qualify for hedged accounting, you must meet the transaction for which you are qualifying must be effective. And so it's a transaction-based effectiveness test. The standard permits aggregation in limited circumstances when you can combine transactions with similar risks you may hedge a group of transactions with similar risks.

But it goes through some criteria to what's similar, it's fairly rigorous in my view. So, if you had aggregations permitted in limited circumstances.

Ok, so I'm going to try not to make the same mistakes. We're in a cash flow hedge model; I want to forecast the forecast the entries. Remember, we marked both the hedged item and hedging instruments to market through income last night. That's because the hedged item was a recognized asset or liability or a firm commitment that had fair value movement. This is…I'm hedging the sales, I'm hedging the purchase of gold and its ultimate sale. That's not on the balance sheet. I have no contract to buy it. So my hedged item is this document and mind set that needs to be somewhere in the hedge accounting documentation.

So I don't have anything to do, no entry relating. The hedging instrument which is the [unsure of word] contract we've got to recognize as a natural liability and then to the extent that it qualifies for hedge accounting which this one does. You park gains and losses in comprehensive income. You take them out of comprehensive income and dribble them into income as the hedged item occurs. So I would expect to see us creating an asset for $49,000, debit asset, credit comprehensive income. And then bumping that asset $151,000.

No.

Good question. Question is does it make a difference whether it's intrinsic or time value. This 49,000 is for fair value, for fair value.

But it's time value, all of it.

No, I would say…

Well, $310 is the forward pricing, and $310 is the spot [faded].

You're making judgements on what intrinsic value is. I happen to agree with your judgement. But another judgement would be to the standard as silent as to what in terms of value on a forward. Another way of measuring intrinsic values is comparing forward to forward. And you can say I've got $5 of intrinsic value that way. But intrinsic value is an undefined term in the standard.

Our…this book that was made reference, footnotes method that you said [fades]

All right, lets see if I can get this thing to work. Debit; forward contracts, which is derivative. Credit it as comprehensive income. Yes.

Question. Can you clarify on that last question, if the company shows cost effectiveness using spot rates; can there be no entry on the statement end? [Too many voices, could not hear to finish question.]

But, the question is what if the company chose to measure effectiveness using changes in spot. Standards say you can only park in comprehensive income the effective portion of a derivative. So what it causes you to do is take the change in the fair value and put it into two buckets. You've got to [faded]. Only the effective gets special hedge accounting, the ineffective goes to income. Yes sir.

That's an excellent question. The question was what if this anticipated transaction does not work. This is a mind set thing. What if the transaction didn't work, how can you rationalize or justify work? How can you tell the difference between a hedging practice and a speculative practice? Couple of things. The standards says that in your mind when you are designating this hedged item as a forecast transaction, you've got to be explicit so that when the transaction occurs you are able to say yes, this is the hedged item. And so what you do is you'd say, the first 10,000 ounces of gold that I buy are designated, and let's say that I buy them…the first 10,000 ounces of gold that I buy in June are my hedged item. That would be your accounting policy. And so, if you didn't buy anything in June, the standards says if this forecasted transaction doesn't result, then you take this unrealized gain or loss or unrecognized gain, well, you take the gain or loss that has been recognized as comprehensive income and you flush it into earnings. The day that it is no longer probable that this anticipated transaction will not occur, that's when you remove the stock.

Right.

And the Board was equally concerned about coming out of comprehensive income. The Board didn't want somebody that’s short in a quarter saying I don't think I'm going to buy those things in June, and popping their earnings statement by $49,000. So your question of when is something speculating versus hedging is a very difficult question. The Board felt particularly uncomfortable with that question as it relates to these forecasted transactions. Because of their mind's set, you're hedging the mind, something that is in your mind. They try to put criteria on this, most of it focusing on documentation and effectiveness.

That's right, every reporting period you must access whether or not this gain or loss qualifies for hedge accounting. One of the criteria for hedging a forecasted transaction is that the forecasted transaction be probable. If it no longer becomes probable, take the amount out of comprehensive income and into retained earnings --- gain or loss.

Well, I don't know that I understand the question. If the same company had foreign currency risk…so let's say they paid for its gold in Deutsche marks. The accounting…so I'm going to pay $310…I wanted to lock in the cost of gold, the U.S. dollar cost of gold, even though I was going to pay in Deutsche marks. You can do that, that would be hedging your foreign currency risk inherent in the forecasted purchase of the gold, denominated in Deutsche marks. All right, have another question?

No, on April 30th. The days it's no longer probable that the event will occur.

That is why the Board was uncomfortable with this cash flow hedge accounting. This is hedging cash flows, hedging transactions in the future is hedging a mind set. That's what it is. It's deferring an income or in comprehensive income, real gains or losses, and hooking them up with this transaction that's going to occur in the future. Why? Because in my mind set. If I didn't have that mind set, those gains and losses would be in earnings.

Well, there are some fences that are established in the standards that say if you change your mind too often, there's going to be some scrutiny over permitting this special account, that the Board was uncomfortable with this permitting, gratuitously, deferral or non-recognition in earnings.

And, you have to document what your mind set is at the very start.

Yes.

It's my experience that cash flow hedge accounting is the most popular form of hedge accounting; that company's are relatively comfortable with the risk that’s recognized in their balance sheets. And a lot of times there's natural offset. It's that unknown that forecasted transaction, that expectation that they generally hedge and try to lock in. I'm going to run through, quickly, these, and then get into some changes, but the group is flushed out a lot of the changes, which is quite good. If you remember the contract depreciated so we create more of an asset.

We end up closing out that forward by getting cash. And we removed the asset, that derivative asset, and then we actually paid for the gold at the then spot. If you remember the spot I think was $330 an ounce. So we paid for the gold. We've got $200,000 in other comprehensive income that essentially will be used . . . that will stay in comprehensive income until that gold is sold. And after it's sold, it will bring down our cost of sales. So let's say, we sell all of that gold in one month. Our cost of goods sold would be 3.1 million.

This is hard; this accounting model is much different than what existed prior to SFAS 133. It takes into out of the footnotes the financial statements and brings into comprehensive income, changes in the fair value of derivatives that are used as cash flow hedges. And then, it links them with certain specific events and I'm going to get into that in a minute or so. Any other questions on the examples?

Good question. The question is why leave the $200,000 in comprehensive income? Why not net it against inventory? The Board had trouble with--well--trouble with moving a recognized asset or liability away from its fair value. So that adjustment would take this gold which is recorded at times zero at its fair value at $3.3 million, and moving it away to $3.1 million. They had trouble with that; and so it prohibited it.

It's also looking at…another way of thinking about it is, is the assets and liabilities on the balance sheet are not separate assets or liabilities for gold, are not going to be perturbed depending on whether or not you have a forward contract. On the balance sheet you want the forward contract duplications to be separate from the gold implications at the purchase date. Special accounting allows the income statement of facts to be aligned such that the forward contract's implications against cost of goods sold come together in the income statement. But still we privileged the balance sheet so that the asset and liabilities are comparable across entities.

Stays in other comprehensive income.

Other comprehensive income folds with that gain or loss until the gold is sold, or until there is impairment. There is an impairment standard that is layered on top of everything that says essentially, you can't sell that gold for $3.1 million then recognized rights down the $3.3 million, and take out of comprehensive income. There are impairment standards really that are just designed for assets. And then it says well if you are writing down the gold from $3.3 to $3.0 let's say, don't forget about the gain or loss, the derivatives gain or loss, that incomprehensive income that has some relationship. That gets hard, though.

[Reputive--unsure of word] to…it should special accounting and permitted for forecasted transactions Mike, that…your question is, what is the cost of goods sold? Let's say this company sold all of its watches. What words cost of goods sold? Was it $3.3 million, or was it $3.1? The hedge accounting model is for income statement purposes saying it's $3.1.

Right, I think that its correct that the offsetting…you offset the comprehensive income against the income [unsure of next words] you have our traditional lean towards [too many voices, could not make out rest].

Yes, you are absolutely right. The…getting into mainly this is good [unsure of word] to get into some of the key changes. But that's a key change that comprehensive income is now going to have some inventory-like features that you are going to have gains and losses for derivatives sitting in comprehensive income. And each one is going to have different characteristic depending on what it hedged. And the one I showed you hedged gold inventory, therefore it will move out of comprehensive income, into income, into earnings, the same way the inventory does. If instead your hedged item was variable rate debt, this gain or loss would move out of comprehensive income and into earnings as the interest payments on the debt were made.

Right, all right, I've got five minutes. I'd like to close up and hand back off to Tom. Most of you, hopefully all of you, received a handout that looks like this.

I don't think there are any more, if you give your business cards to Tom, he'll arrange to have them sent to you. For those of you that have one let's flip to page five. This should not take long, I'll try to do it in five minutes. This is an executive summary of KPMG's handbook on derivatives and hedging. And it summarizes the next 420 pages so there are some liberties that have been taken in order to distinctly put this information in both pages.

If you're interested in the book or have interest in this topic, contact your local KPMG office and they'll be able to arrange a course and help.

Let's walk through some of the key changes and I am starting on Page 5. Just going to walk through a handful of these. Starting with the first one, by far the biggest change…old model. A lot of times derivatives weren't recognized on the balance sheet, new models, they all are. Big deal; that means all derivatives are recognized as assets or liabilities. It's kind of…increase balance sheets, add visibility…should add visibility to the derivative.

Going under scope, the first bullet there --- in the first box, well let's go down to the third box. Derivatives embedded in other contracts rarely were accounted for separately under the old model. Give [unsure of word] to this. This new model says, now look at things that are called derivatives by their contract that are stand alone swaps options forwards. But look inside on balance sheet instruments and in insurance contracts and in leases and see if you've got any derivatives. And if you do, separate that derivative component from the rest and account for the derivative in fair value. Account for the derivative the way the standard says account for.

Bunches of companies have convertible debts as an asset. The convertible securities, these securities pay interest at a fixed amount like debt would. And then gives the holder the option to convert into equity. Let's say I own Steve Swad's convertible debt. And if Steve Swad's stock price goes up this convertible debt behaves like equity would. Well, embedded in that convertible debt is an option of Steve Swad's stock. This standard requires separate accounting for that option. That's new, that's a big deal. Yes sir.

Good question. In a long-term lease if there were an inflation index, would that be an embedded derivative? The answer is no. One of the key tests is knowing whether you have…the answer is yes. There is an embedded derivative, but the standard's say that you don't have to account for all embedded derivatives, just those that are not clearly, closely related to the host. That's new, but that's key. It's the view of the Board that the derivative you described an indexed feature derivative of inflation index feature derivative is clearly and closely related to the lease, therefore it does not get separate accounting out of the standard. The one I described is not clearly, closely related. The equity component…the equity option is not like the debt host. Therefore, separate accounting is required.

There are bunches of examples of what is clearly and closely related and what isn't in the standard.

Question. Is that convertible embedded item accountable at the same by the issuer as by the investor?

Question is, does the same accounting toward the issuer as well as the investor and the answer is no, there's in inception for the issuer. Just the holder of the security has separate accounts.

Question. Doesn't that contradict the stake in claim 125 on average and then want to separate between the borrowers and lenders?

Well…

That's a good point.

Then you'll feel good about it, Hugo.

But you won't need two accounting will be different.

Could be.

Well, probably not. Let's just pay for your building in foreign currency. Buildings aren't going to be financial instruments…

Right, aren't going to be hedged items. That there, well, there's bunch of them…well, let's say that I…

If I buy, if I buy…say I have a manufacturing [unsure of word] and I need a specific piece of equipment that's made in Germany. And the German manufacturer says you can buy this equipment at its fair value, but you're going to have to pay me in Deutsche marks. And I want to do something to lock in the amount of Deutsche marks that I'm going to pay for this equipment. I would enter into a Deutsche mark-dollar foreign currency exchange contract; and add gains and losses in it. Park them into comprehensive income. When I buy the equipment I pay whatever Deutsche marks required to buy it and then that gain or loss that’s related to that Deutsche mark-dollar forward gets amortized in the income, over the life of the equipment.

All right, let's move through some of these…we've talked about the ineffective, I'm on Page 6 right above hedged items. We've talked about the ineffective portion of the derivative hit mark to market through earnings. That's a big deal. That's going to result in earnings volatility.

I'm on Page 8, top box. It used to be hedges of anticipated transactions denominated into foreign currency could only be hedged…the hedging instrument was limited to a purchased option. This standard eliminates that.

Let's summarize these issues on the front just about anywhere. I think there are four big changes.

• One is the balance sheet is going to be more volatile. That's because comprehensive income is going to go up and down with changes in the fair value of hedges that are used as cash flow hedges.

• Number two; the income statement is going to be more volatile. Gains and losses on the ineffective portion of derivatives is going to be recognized in earnings. That doesn't happen now, generally. So income statements are going to reflect the [noise--unsure of word] that is in vain in perfect hedging programs.

• Number three, the scope of derivatives, the scope of what a derivative is, is expanded. They include, often will include commodity contracts. And if they include energy-type contracts that are settled net per cap, is a big deal. Last--it's a big deal in that it's unusual, it's new. It's going to take time to digest.

• Last, we've talked about separate accounting for embedded derivatives. You are going to have to hunt for derivatives in leases and insurance contracts in on balance sheet items and that's new, that's unusual.

Then there's a consequence of all of this. And that's going to be a little bit of a drain on systems that systems have to be modified to account for all of these changes. We've talked about this cash flow hedging, I think that is where a bi --- a lot of energy is going to be spent. Think about, let's say that a company has a gold hedging program and buys a machine in Germany. In comprehensive income they are going to have some gains and losses that get recognized in a certain period, and others that get recognized over many periods.

So you are going to have this big pot of gains and losses and a bunch of different ways that this pot is going to get out of comprehensive income and into earnings. And that's going to be a big systems effort. With that, I'll pass back to Tom and Jim.

And as I move up to the front, Jim wants to weigh in a little bit.

But the Board states in SFAS 133 about why they don't like cash flow hedge accounting; is when we think about hedge accounting your original reason we are hedge accounting is because there are recognition in measurement anomalies in our current accounting model. The measurement anomalies are that certain instruments are measured at one measurement attribute, for instance fair value, and another set of instruments that may be related in this exposure are measured at a different measurement attribute. Cost amortized cost lower cost to market.

And because of those differences, the timing of the changes in those values or earnings occur in different periods. That's a measurement anomaly. A recognition anomaly in the Board sense is, when we think about firm commitments. Firm commitments are fully executory contracts; both parties have not behaved in any way. But other than that, it meets the definition of an asset. But it's not recognized because of the recognition issue that we're used to. And that also can cause timing differences in when the earnings the facts of the firm commitment and the related instrument flow through earnings. And the Board is very positive about saying they don’t really mind thinking about hedged accounting in that setting.

But now let's talk about a cash flow exposure. Do we EVER recognize or consider recognizing cash flows that are going to occur in another period in this [jury--unsure of word]? And so there is no novelty in the accounting model about wanting to delay the recognition of changes in the relating hedging instrument to another time period, because we are not going to fix future events in cash flows into the current period. It's the Board…foreshadows a dislike of cash flow hedge accounting within Statement 133 saying the only reason why they allowed it was to accommodate the people who are already getting cash flow hedge accounting on a political basis. But also hints that they may not, when they [reduces--not sure of word] this later, they may want to take away cash flow hedge accounting, because it's not an anomalous accounting situation.

Well, in earnings there's a real debate over what the cost of gold was in my example. That's a…in the companies' mind and it's only the mind, there cost of goods was $3.1 million and in Jim's mind it was $3.3 million. It's the amount you paid to the vendor. But it is a debate, there is a valid debate that exists about what the gold costs were…what the foreign currency equipment, the German equipment that I bought was. What it's cost bases was. And that's where the issues are. That is the most popular and common type of hedging that exits, this cash flow hedging.

So, in summary let's go through Mr. Linsmeier's views, not any official views of the potential advantages and disadvantages of this statement and where we might see the accounting model moving in the future. But first the advantages. This is a very complex statement; that's going to be a disadvantage. But relatively speaking comparing…compared to the existing accounting model it's a big improvement. It's a big improvement because it increases the transparency of derivatives and financial things.

I guarantee you that Proctor and Gamble's investors in Spring 1994 would've liked to have known that Proctor and Gamble was investing on one derivatives contract that a minor twist in the yield curve caused a $57 million loss. Those investors without having derivatives being transparent in the financial statements thought they were only buying Proctor and Gamble's ability to do mouthwash and toothpaste, not give the asset twists in the yield curve. So that transparency is something that will be a positive thing in terms of letting investors understand what the company's doing. It's also going to provide the practitioners that want to do the right job a consistent and complete model that they can apply on a regular basis.

And finally the last advantage, is that much of the guidance within this document, if it is consistent with the conceptual [framework--unsure of word], they're certainly more consistent with the conceptual [framework--unsure of word], than the existing accounting model or deferred assets and deferred liabilities. The losses were called assets; deferred losses were called assets. And deferred gains were called liabilities, amongst other things. Those I think are the primary advantages of Statement 133.

In terms of disadvantages, this is an extremely complex standard. Now we only touched the surface today. It took the Board 270 thinner pages to issue Statement 133 and it is very hard to follow. So it's complex, a very complex fix. For firm value hedges we talked about that. The hedged item is going to be…what is the attribute we are going to measure the hedged item at? If the hedging meets [unsure of word] the derivative is not a hedge of the full fair value change of the hedged item, remember that hedged item is going to come from it's original measurement attribute and by a partial change in the fair value. What is that measurement attribute? I think of it as a mutt attribute, ok. A mixed mutt dog attribute.

Yes, that's true.

That's the same thing…

That's true, that's true. But that's not a complete fix conceptually in the mind. When we think about a firm commitment, the only amount of the firm commitment we are going to call an asset or a liability is the amount of the gain or loss. The measurement attribute is the amount of the gain or loss on a firm commitment. That's something that is probably not real appealing that in terms of thinking of a measurement attribute.

Thinking it more importantly if we think about this standard. The Board for a long time attempted to do hedge accounting at an enterprise, thought about it at a enterprise risk reduction level. And then it became obvious over time that it's very difficult to measure the exposure of enterprise risk in these settings and ask whether derivatives litigate or change or matters to those risks. So we see in this model a transactions' based sub-derivative accounting rules. That should promote transaction based hedges that may have earned over hedging. It's possible that if you've got a fixed rate asset and a fixed rate liability of the debt variety, that you're perfectly hedged to the interest rates. But it's possible to try to go to someone and say if we only looked at that fixed rate asset site, maybe you want to be able to manage the exposure of that interest rate. And there may be more derivatives being sold because of the transactions' nature of--the transaction level nature of this accounting. On concentrating on transactions, people may not concentrate on risk as a whole.

And lastly, only derivatives are hedging instruments in this model. The Board says we are not going to think about it a little bit because we are trying think about going all the way to fair value accounting for all financial instruments and that will take care of some of the problems. But in reality, if we are thinking about hedging interest risk exposure at fixed rate assets, fixed rate liabilities of the matched terms isn't a very effective hedge. And it promotes thinking about risked management only in a derivatives fashion. Those are some of the disadvantages of this statement.

Look to the future. I already talked about the last two bullet points. The Board in Statement 133 previously recognizes that there is a lot of complexity in fair value hedges. All this documentation effectiveness, ineffectiveness, is such a [cuckold--unsure of word] way for fair value--for financial instrument fair value hedges if all financial instruments were fair value. And they made a commitment that recognized conceptually that that might be an appealing, much more appealing solution. So the Board's committed to do that, but they need to resolve some key issues related to the reliability of fair value next series of reliability issues. So they foreshadowed that, and they've also foreshadowed the discontinuation of a cash flow hedge.

Well, I want to go back in the last point something that Rashad brought up earlier. Why did you build? Why was it built, this really complicated hedging model? Because somehow we believed that in a hedging activities, risks have been reduced, or risks…I always use the term risks have been managed. Let's think about something. You have got to think about the difference between speculative items, ok. But we probably all agree that changes in fair value should flow through income immediately. Trading securities, debt securities. And what we do when there is hedging relationships between a hedging instrument and a hedged item.

When we buy a debt security that is a fixed rate debt security, what are we doing in that process besides getting fixed rate interest flows? We may also win if it's an asset, if rates go down. And we're going to loose if rates go up. So in a speculative setting, we're taking a view that in speculation we like risk go down and that may be our cue. That what causes us--we've got risk exposure that we think about this as being speculation. Now let's turn around to see this first example.

Borrow a fixed rate debt. Why didn't they say borrow a fixed rate debt? Why did they go to cash flow? What did they think, what must they have thought about the change in interest rates? So it's going to go down, right? And they wanted to partake in the gain of it going down. Let's say they sought the variable now and interest rates went up. Do they win or loose?