Accounting and FAS 133/138 Last revised: March 02, 2002
New at the William Margrabe Group: FAS 133 valuations have been a significant part of our business since September 2000, and are a large part of the reason we did not update "The Derivatives 'Zine" from July 2000 to July 2001. Over that time we have learned .... [more]
New, this month:
- Ask Dr. Risk!:
- Dr. Risk's Derivatives DictionaryTM:
- 8/28/00 Dr. Risk's Derivatives DigestTM:
- Dr. Risk's Links:
Table of Contents for this page:
Ask Dr. Risk! | Books | Derivatives DictionaryTM | Derivatives DigestTM | Essays | Links
Ask Dr. Risk!
- Free answers: Dr. Risk promises any correspondent from a business domain with a website (e.g., Mack@CSFB.com) at least a five-minute response to your important question, as soon as he has a free moment, probably within one month.
- Fast answers: If you absolutely, positively will have to have an answer overnight, set up your consulting account, ahead of time, with the William Margrabe Group, Inc.. Introductory offer: $300 / hour with one-minute granularity. If we can't provide the answer, we'll refer you to someone who can. If we can't refer you, we'll inform you fast for free.
- No answers: LDiablo@hotmail.com, Chris1492@aol.com, BillyG@MSN.com, and Desperate@Podunk.edu, etc. can no longer count on even brief answers, unless their questions are sufficiently intriguing. Sorry.
A question of sufficiently general interest to make it into the 'Zine, tends to generate a more comprehensive response. All questions and answers become the property of The William Margrabe Group, Inc
7/16/01 Volatility Reduction Measure (7/16/01)
Dear Dr. Risk
– Please explain the
term 'Volatility Reduction Measure' as used in reference to FAS 133
effectiveness testing. Thanks.
Dear Rob – FAS 133 requires corporations to mark all derivatives positions to market, but permits hedge accounting treatment for certain derivatives positions that qualify. A qualifying derivatives position must be a sufficiently good hedge for something else on the balance sheet, and the corporation must document this. The definition of a "sufficiently good hedge" is open to debate. This has good and bad implications. We hope that that debate does not end in the near future, because hedging effectiveness is an open issue. However, this opens the door for a certain amount of accounting manipulation -- perhaps whole truckloads.
Dr. Andrew Kalotay, President of Andrew Kalotay Associates, proposed (Andrew Kalotay, "Volatility Reduction Measure," Derivatives Strategy, 3/99) a measure of hedging effectiveness that has a bit of the flavor of R2. Namely, his Volatility Reduction Measure (VRM) equals one minus the ratio of the standard deviation of the "hedge package" -- the hedge and the item being hedged -- to the standard deviation of the item being hedged.
However, VRM is not R2. Before we explain why, we need to briefly review some aspects of regression. In a simple univariate regression, R2 is the percentage of the total sum of squares of the dependent variable that the independent variable explains, after one optimizes the intercept and the slope coefficient of the independent variable. In other words, R2 is the percentage by which volatility of a linear combination of the dependent and independent variables and a constant declines after choosing the optimal intercept and slope coefficient.
To approach Kalotay's VRM, consider a regression in which the hedge instrument's P&L is the independent variable in the regression and the P&L of the instrument to be hedged is the dependent variable. Now, constrain the regression intercept to be zero and the slope coefficient to be unity. The R2 in this constrained regression is related to, but different from VRM. Namely, VRM = 1 - Ö(1- R2).
See Kalotay's article for additional details. – Dr. Risk
Books
 |
"Not the last word in pricing and hedging energy products, but a good place to start the conversation. – Dr. Risk" |
Derivatives DictionaryTM Terms and definitions relating to currency. The main Derivatives DictionaryTM is here.
- 7/4/01 FASB
- Definition:
The acronym for Financial Accounting Standards Board. A self-governing
body that sets standards for financial accounting.
Comment: FASB's most obvious constituents are corporate financial accountants and the public accounting firms that audit the financial statements of public corporations. Officially, these persons have a responsibility to make sure that corporate financial statements reflect corporate reality accurately. However, board chairmen and CEOs have effective control over the hiring and firing of all accountants, which puts the chairmen and CEOs in a strong position to influence the accountants and FASB. The chairmen and CEOs want large compensation packages, which high share prices support, and they seem to believe that earnings volatility is a bad thing for compensation and job security. Consequently, they seek many ways of smoothing earnings, including "hedge accounting". - 7/28/00 BOJ
- The acronym for Bank of Japan (q.v.)`.
Derivatives DigestTM
7/4/00 "Life under FAS 133." CFO (2001 July) By Andrew Osterland.
"THE RULES OF ACCOUNTING ISSUED BY THE Financial Accounting Standards Board rarely generate enthusiasm in the corporate reporting community. But few have caused more outright resentment among business leaders than FAS 133, 'Accounting for Derivative Instruments and Hedging Activities.' "
"FASB 'could have achieved 98 percent of [the goals of FAS 133] at about 10 percent of the cost.' -- Philip Ameen, Controller, General Electric"
The initial FAS proposal in 1991 "was simply to mark all derivatives to market on a quarterly basis and recognize the gains and losses on the contracts, realized or not, through the income statement." That was simple and effective, except that it could create swings in income as the derivatives changed value.
Corporate managements tend to hate swings in income and smooth them out whenever the rules allow smoothing. Many managers cross the line and smooth earnings, even when that isn't kosher. Managers pressured the FAS to come up with a way that allowed them to smooth earnings.
The solution: "Hedge accounting" -- letting gains and losses of derivatives offset losses and gains on the hedged items -- allows corporations to reduce earnings volatility.
However, a corporation that wants hedge accounting treatment has to jump through various hoops:
- document each hedge, up front, explaining its business purpose
- mark their derivatives positions to market, each quarter
- "prove" that their hedges are effective
This doesn't come cheap, requiring systems and the personnel to operate them. GE spent about $8 million over two years to comply with FAS 13*3. The FASB "has effecively imposed a tax on companies to discourage the practice" of hedge accounting, according to Ira Kawaller, a sitting member of the Derivatives Implementation Group (DIG).
The controversy over accounting treatment for ESO's was also extraordinary.
7/6/01 "FASB Enacts Standards Prohibiting 'Pooling' in Mergers." The Wall Street Journal, 7/6/01.
FASB unanimously eliminated "pooling of interests" accounting treatment for mergers, leaving only "purchase" accounting treatment. This move is all about "goodwill" -- the excess of acquisition price over "fair value" -- and how to treat it.
"Pooling" allowed merging companies to combine their assets without recording, then amortizing "goodwill". Opponents of pooling believe that it inflates the reported the value of acquisitions.
"Purchasing" required companies to record goodwill, then amortize it some, each quarter. This reduced reported earnings, which management opposed.
FASB has crafted a compromise that allows acquisitive companies to halt the routine amortization of goodwill. Instead, the companies must determine if and when goodwill asset values exceed fair value, and then write them down to fair value.
Once more, we see the hand of corporate management
pulling the strings that control FASB. This old issue never goes away. The old
joke has more than a molecule of truth:
Manager: "How much is 2+2?"
Accountant: "How much do you want it to be?"
Manager: "You're hired."
In fairness to accountants, they are not the only professionals who must deal with a conflict between their purported missions and the agendas of those who pay them or can essentially hire or fire them. Others include schoolteachers, ministers, police, ...
Essays
7/16/01 FAS 133 (Dr. Risk, 7/16/01)
Some of our clients have shown keen interest in FAS 133 valuations since September 2000, and that is a large part of the reason we did not update "The Derivatives 'Zine" from July 2000 to July 2001. Over that time we have learned or seen more evidence for a few lessons.
-
FASB has once again touched a nerve with its efforts to require corporations to report fairly the results of their derivatives positions. We first noticed this in the early 1990s, when FASB addressed the reporting of executive stock options.
-
Financial reporting involves technical issues. None of them are no-brainers, some of them are difficult, and some may be too complex to resolve.
-
Financial reporting involves human issues. Accountants who strive for orderly financial statements are people. So are the corporate chairs and CEOs whose compensation and reputations rise and fall with reported income.
-
FASB is a political organization and much of the power lies with corporate management. Just for fun, visit www.FASB.org and see who are the board members. As of 9/1/01 the composition is three with Big Five backgrounds, three with corporate backgrounds, and one academic. Is this a coincidence? Something new? Or is it the result of efforts to deal with the political issues?
-
We would be willing to argue that top corporate managers call all the shots that are important to them. By such issues we mean where corporate managers have a consensus. The mechanism for exercising that influence is both relatively direct (through board members who represent the corporate world) and relatively indirect (through board members who represent accounts outside corporations, mainly Big Five auditors).
-
It will come as no surprise to students of business that corporate chairmen, CEOs, CFOs, etc. like to receive large compensation packages. Indeed, this will not come as a surprise to any but the densest or most naive.
-
Students of corporate finance are well aware that "agency issues" are a major reason why corporate governance is such a hot research topic. Basic corporate finance theory starts with the premise that the preferences of shareholders are of fundamental importance, and that corporate boards and top management act to maximize the wealth of shareholders. Sophisticated corporate finance recognizes that shareholders cannot always assure that managers and boards are their faithful agents. In egregious cases, clearly, management runs the corporation for the benefit of management and tramples the interests of shareholders. Barbarians at the Gates tells such a story about RJR Reynolds Corp.
....fairly lucrative for me, if not quite a “gold
mine”. FAS 133 requires breaking out some embedded derivatives, and accounting
separately for them and related loans. I’ve seen some doozies – some are
easy to describe, but extremely complicated to price. Then there’s the problem
breaking off-market swaps into par swaps and loans. Since I’ve been involved
with option pricing for nearly 30 years, a few people have dragged me into these
situations.
– a physically existing spark spread. – Dr. Risk
Links Links related to accounting and FAS 133 are below. Links related to other financial topics are here.
- 7/28/00 "A Central Bank Like No Other." The European Central Bank.
Our other web sites:
www.FreeOption
Pricing.com
Free option pricing calculators from here and around the world.
www.RiskManagement
Digest.com
Summaries
of the best articles
from the best publications
in the risk management trade press.
www.Derivatives
Digest.com
Summaries
of the best articles from the best publications
in the derivatives trade press.
www.AskDrRisk
.com
Answers to your questions about Investment,
Risk Management,
Derivatives, and
Financial Engineering