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Two Teaching Cases Involving Southwest Airlines, Hedging, and Hedge Accounting Controversies
These are the two cases without answer teaching guides

These Scenario 1 and 2 Cases plus My Answer Teaching Guides are available at http://faculty.trinity.edu/rjensen/caseans/SoutwestAirlinesAnswers.htm

Bob Jensen at Trinity University

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 Glossary for FAS 133 and IAS 39 are at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

Bob Jensen's illustrations of hedge ineffectiveness testing and links to videos on ineffectiveness testing are at
 http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#Ineffectiveness

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.

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

The two Southwest Airlines cases below were inspired after series of messages between Bob Jensen and Tom Selling. The messages arose after Tom Selling initially proposed that both the FASB in FAS 133 and the IASB in IAS 39 ban hedge accounting such that accounting for derivative financial instruments makes no distinction whether derivative financial instruments are used for hedging or speculation purposes ---

Under Tom Selling's proposal, derivatives would simply be booked at fair value and adjusted for fair value at least quarterly with all changes in value going to current earnings. Under the present rules in FAS 133 in the U.S. and IAS 39 internationally, changes in the value of hedging derivatives instead go to an equity account (e.g., OCI as defined in FAS 130) other than current earnings (i.e., retained earnings) to the extent the hedge is still active and the extent that the hedge is effective.

Speculation derivative contract investments and "severely ineffective hedges" cannot get hedge accounting and all changes in their values must accordingly go to retained earnings. Value changes in ineffective portion of a "slightly ineffective hedge" goes to retained earnings while the effective portion goes to OCI. All this gets very complicated as defined and illustrated under the term "Ineffectiveness" at http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#Ineffectiveness


One Feature of the 2009 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!

Student Study Note
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

Hi Again Tom,

I think you are continuing to use terminology with a total lack of precision. I discuss a bit of this at the end of this message.

In this message I am going to present Hedge Accounting Scenario 1 (a true story) and Hedge Accounting Scenario 2 (a hypothetical story) for purposes of class presentation, analysis, and debate regarding hedge accounting under FAS 133 versus your proposal where hedge accounting is banned and there is no distinction between hedging and speculation when it comes to accounting for derivatives on the balance sheet and income statement.

I think these scenarios will be useful in various courses, including intermediate accounting, forensic accounting, and a PhD seminar.

Your main concern in banning hedge accounting in FAS 133 and IAS 39 seems to be to take away discretion of management in manipulating compensation with earnings management via hedge accounting rules in both the U.S. GAAP and international GAAP. I will deal with this issue in these two scenarios.


From The Wall Street Journal Accounting Weekly Review on January 29, 2010

Southwest Airlines Hedges Its Bets
by: Ann Keeton
Jan 22, 2010
Click here to view the full article on WSJ.com

TOPICS: Advanced Financial Accounting, Hedging

SUMMARY: "Southwest Airlines Co. Chairman and Chief Executive Gary Kelly, when asked recently to name the greatest risk for airlines in 2010 said: 'That's easy. It's energy prices.'...Southwest, whose fourth-quarter results were helped by lower-than-expected fuel costs, has cut back on some hedges to save money, while adding 'catastrophic' coverage to protect against a big price increase.....In 2008, the airline industry lost billions of dollars as fuel prices rose to record levels, accounting for one-third of the carriers' costs, up from an average of about 14%. That led airlines to add more hedges as they prepared for even more expensive fuel. But fuel prices declined during the recession, and many airlines...lost millions of dollars....Despite that loss, Delta plans to keep on hedging...'When something is that large a piece of your input costs, you can't abdicate the management of it,' [said chief executive Richard Anderson]."

CLASSROOM APPLICATION: The article can be used to introduce the purpose of hedging, particularly fuel cost and commodity hedging, in Advanced Financial Accounting courses.

QUESTIONS: 
1. (Introductory) What does Southwest Airlines executive Gary Kelly see as the greatest risk facing his company in 2010? What can the company's management due to cope with that risk?

2. (Introductory) What were the airlines' experiences with hedging fuel costs in 2008? Why will they again undertake hedging strategies even after this experience?

3. (Advanced) Given your understanding of hedging activities, explain how Southwest determines that it is "40% protected" if oil prices rise to more than $140 per barrel while the company is hedged for 50% of its purchases of oil if the price rises to $100 per barrel.

4. (Advanced) Consider the metric of "revenue per available seat mile" quote in the article. How do you think this ratio is determined? Why do you think this is "considered the best measure of revenue for airlines"?

Reviewed By: Judy Beckman, University of Rhode Island


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

 


Hedge Accounting Scenario 1 (True Story)

Out of the blue, so to speak, a Southwest Airlines Captain, who at the time was head of the Southwest Airlines Pilot Association (a union), contacted Bob Jensen (me) with an academic question with an academic question.

Captain A
"If any company that hedges extensively with derivatives and accounts for them under the highly complex FAS 133, how could this company manipulate (manage) earnings under FAS 133 to the detriment of a labor union in compensation contract negotiations?
"

My knee jerk reaction in general is that the first place to look is manipulation of fair value estimates of derivative financial instruments that have to be booked and maintained at fair values in both quarterly and annual financial statements. In the case of financial institutions hedging interest rate risk it is relatively easy to manipulate swap contract values by cherry picking yield curves --- http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

But this off-the-cuff answer really does not apply to Southwest Airlines. Note that Southwest Airlines hedges fuel prices big time and is, without question, the most successful airline in the world to date in terms of hedging outcomes in managing fuel price risk. During the 2007-2008 world crisis when oil prices hit record high levels, Southwest was still earning a profit when all of its competitors were contemplating declaring bankruptcy.

Southwest Airlines is also a poster child in terms of compliance with FAS 133 in its financial statements. However, it's extensive hedging derivative contracts are plain vanilla and easy to account for under FAS 133. The majority of its hedging contracts are jet fuel price purchase options where on a both long-term and short-term basis these derivatives lock in "strike" prices to avoid having to speculate in spot prices. The airline almost always takes a long position with these hedges such that, if oil prices rise, it can buy millions of gallons of jet fuel at below the current spot prices. If prices fall, the most the airline can lose is the price (premium)  it paid for the option. Ironically the airline would always like to lose the entire premium because that means it's buying fuel at cheaper spot prices.

I might add that Southwest does not hedge fuel prices at all times. Sometimes the premiums on purchased options for jet fuel have been so high that Southwest elected to not hedge fuel prices. But it is relatively uncommon for Southwest not to hedge fuel prices with purchased options. On occasion it will hedge with other contracts that have zero premium cost such as futures, forwards, or swaps, but these derivative financial instruments are trickier to manage due to potential risk of huge losses from partially ineffective hedges. Purchased options are preferred in Southwest Airlines because of the way potential losses are capped at the price paid for the hedging contract.

If Southwest tried (strictly hypothetically) to manipulate earnings via FAS 133 compliance it could not do so by the most popular way to manage earnings --- manipulating the fair value estimates of its derivative financial instruments. The reason subjective value estimation won’t work for Southwest is that the trading markets for jet fuel prices are wide and deep. The airline and its auditors can easily estimate contract values on any day by looking at the trading prices for particular options on that day.

So Southwest is not likely to be manipulating earnings by manipulating estimates of fair value of derivative financial instruments. Now suppose the Captain repeats his question:

Captain A
"If any company that hedges extensively with derivatives and accounts for them under the highly complex FAS 133 with perfectly accurate fair value estimates of derivative contracts, how could this company manipulate (manage) earnings under FAS 133 to the detriment of a labor union in compensation contract negotiations?
"

This Scenario 1 Case and My Answer Teaching Guide is available at http://faculty.trinity.edu/rjensen/caseans/SoutwestAirlinesAnswers.htm


Hedge Accounting Scenario 2 (Hypothetical Story)

In 2010, Tom Selling's proposal for banning all hedge accounting hit the world by storm --- Click Here
 
http://accountingonion.typepad.com/theaccountingonion/2009/06/regulate-derivatives-start-with-better-accounting.html

The FASB reduced FAS 133 and all of its amendments that now comprise Sections 330, 440, 815, and 840 of the FASB's Codification online database to less than 20 pages of text. Hedge accounting is now banned and there is no difference in accounting for hedging versus speculation derivative financial instruments. All such contracts are carried at fair value on the balance sheet and changes in fair value are taken into current earnings and eps metrics.

Out of the blue, so to speak, a Southwest Airlines Captain B, who is the new head of the Southwest Airlines Pilot Association (a union), contacts Bob Jensen (me) with an academic question with an academic question.

Captain B
"If any company that hedges extensively with derivatives and accounts for them under the highly simplified and streamlined Section 815 of the FASB's Codification database, how could this company manipulate (manage) earnings under Section 815 to the detriment of a labor union in compensation contract negotiations?
"

This Scenario 2 Case and My Answer Teaching Guide is available at http://faculty.trinity.edu/rjensen/caseans/SoutwestAirlinesAnswers.htm

 

 

PS to Tom Selling
I define insurance as risk management via actuary science. Actuaries only deal with data that has persistent and reliable linkage of the past with the future --- historical data that can be objectively extrapolated to future loss risks. Before using the term "insurance," think of whether there are actuary tables for the item you are calling insurance. Insurance companies then offer contracts that will spread actuary-determined risk among buyers subjected to such risks.

Hedging with derivative financial instruments scoped into FAS 133 never, at least virtually never, entails contracts for which there are actuarial tables that estimate risks. There is a huge gray zone between insurance and derivatives such as weather derivatives for which there are actuary tables. But these gray zone derivatives are not scoped into FAS 133 or IAS 39. There is also a gray zone of derivatives in wagering such as wagers on sporting events. These are not scoped into FAS 133.

Another indirect difference between insurance and derivatives entails how risk is managed and spread. With derivatives risk is managed between two parties --- the party and the counterparty to a derivative contract. The contracts can be, and often are, over-the-counter derivatives that are not traded on any exchange. With insurance risk is managed by spreading the risk among all buyers of a virtually identical contracts such as home and auto insurance sold by a particular company that is spreading the potential loss coverage among all buyers of the insurance.

If a Farmer A  contracts with his Neighbor B such that the Neighbor B agrees to reimburse Farmer A for weather-related damage to crops, this is not insurance as I define insurance. I think the term "insurance" should be restricted to instances where there are many buyers of protection who are spreading the risk with the actuarially-determined risk to the entire set of buyers. There are no actuarial tables for just Farmer A's plot of land. There are actuarial tables for hail, wind, fire, and flood damage for the entire state of Iowa.

These Scenario 1 and 2 Cases plus My Answer Teaching Guides are available at http://faculty.trinity.edu/rjensen/caseans/SoutwestAirlinesAnswers.htm

Bob Jensen's illustrations of hedge ineffectiveness testing and links to videos on ineffectiveness testing are at
 http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#Ineffectiveness

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.

 

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 Glossary for FAS 133 and IAS 39 are at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

Bob Jensen's illustrations of hedge ineffectiveness testing and links to videos on ineffectiveness testing are at
 http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#Ineffectiveness