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FAS 133 Surprises

By Robert Hunter

The fight over the Financial Accounting Standards Board's derivatives accounting and disclosure regulations is finally over. Now comes the hard part: actually implementing the new standard and making it work in specific transactions.

As Deidre Schiela, a partner at PricewaterhouseCoopers LLP and a member of the FASB Derivatives Implementation Group, notes, a number of surprises lie just beneath the surface of the FAS 133 that could reach up and bite unprepared derivatives practitioners where it hurts. Here are some of the most important:

1. Imperfect hedges

In today's environment, even if a hedge doesn't match an offset perfectly, as long as it falls within a band of 80 percent to 125 percent of the offset it can be deferred. Under FAS 133, any ineffectiveness in a hedge is immediately recognized in earnings. This will undoubtedly force firms to improve derivative product customization and efficiency.

2. Foreign-denominated entries

Today, foreign-denominated assets and liabilities, such as the issuance of foreign-denominated debt, can be designated as hedged items. Not so under FAS 133. The result: foreign debt issuance in many cases will create mismatches of derivative gains or losses vs. the transaction gains or losses on the issuance. For example, a U.S. corporate that today is free to issue debt overseas and swap it back to dollars will not be allowed to declare this a hedge under the new standard.

Moreover, the same applies to companies that use cross-currency interest rate swaps linked to their foreign-denominated debt to convert their fixed-rate foreign-denominated debt into a U.S. floating rate debt.

FAS 133 states that the premium on an at-the-money option must be marked-to-market through income—all the time, throughout its life.

Under FAS 133 they can no longer designate that debt to be hedged—it will now be remeasured against the spot rate. And the cross-currency interest rate swap will be marked-to-market against the forward rate. FAS 133 also stipulates that a compound derivative—an instrument with both currency and interest rate elements—cannot be separated into its constituent parts, meaning that a currency swap must be treated as a single item. The result: When you mark that swap to market, not only are you going to be reflecting changes in interest rates as well as exchange rates, but your debt is only being remeasured against the spot foreign exchange rate, which could lead to increased earnings volatility.

3. Foreign cash instruments

In general, FAS 133 declares that only derivatives can qualify for hedge accounting. But there are two exceptions in the foreign exchange area: hedging firm commitments and hedging net investments in foreign operations. Foreign-denominated assets or liabilities can be used to hedge those foreign-denominated firm commitments and net investments in foreign operations. So if you're hedging, say, available-for-sale securities, the Emerging Issues Task Force had said that you can use cash instruments to hedge those available-for-sale foreign-denominated securities. But FAS 133 says no.

4. Credit spreads

Today, companies anticipating the need for long-term debt issuance—whether for an acquisition, a purchase of plant and equipment, or simply normal borrowing needs—will lock in the current interest rate market using an interest rate forward known as a Treasury lock. FAS 133 stipulates that ineffectiveness on these contracts—such as a general change in corporate credit spreads—must be marked-to-market through income.

The FASB has said that market interest rate changes include not just the risk-free rate component of the interest rate of a corporate debt borrowing, but also the general credit-rating sector spread. What you can individually separate out is the credit risk or the changes in value of that fixed-rate loan, attributable to changes in the borrower's credit rating. The result: A corporate expecting to issue debt six months from now for 10 years that does nothing to improve its rate exposure reflects the market rate in its income for 10 years. But a company that thinks today's market is better than the market six months from now, and thus tries to lock in today's market, will have any spread changes reflected in its income for 10 years. “If you look at what's happened in the last two months,” says Robert Sullivan, partner at PricewaterhouseCoopers, “the 10-year Treasury has gone down to 480 basis points from 540 basis points. Corporate spreads have widened by 60 basis points. Corporates that locked in two months ago would have a 60 basis point charge to income for 10 years. Think of the present value of 60 basis points for 10 years.”

5. Options

Today's accounting for purchased options says that if you buy an option—such as a cap on interest rates, or an option on foreign currency—and you designate that as associated with an anticipated transaction or existing floating price obligation, you simply defer and amortize the premium on the option over time. If there are any cash flows from the option, they hit income when they accrue. FAS 133 states that under certain circumstances the premium on an at-the-money option must be marked-to-market through income—all the time, throughout its life. The intrinsic value—the value that you expect to receive eventually in cash flow—can be deferred, or can be offset against an existing asset or liability. But not the premium. Since option transactions are, for most companies, thought of as insurance policies, the result of FAS 133, in effect, is the marking-to-market of the insurance policy.

6. Hybrids

Companies that use hybrid instruments such as convertible debt and currently account for these instruments on something other than a mark-to-market basis are in for a surprise: While a typical corporate issuer of convertible debt doesn't have to perform any unusual accounting steps, whoever buys that convertible debt must mark-to-market the conversion feature through income. The result: Companies that have accrual-based accounting models may shy away from buying this sort of debt in the future. While they might come up with a short-term solution for their accounting, they may never come up with a longer-term technology solution.

Insurance companies are a case in point. Many insurance companies have on their liability side of the balance sheet annuity contracts and other kinds of investment-type contracts that might have embedded derivatives such as equity-indexed annuities. Under FAS 133, the equity feature would be considered different from or not related to the annuity feature, which is more like a debt contract. The equity feature, therefore, would have to be separated out and accounted for separately.

When To Apply FAS 133

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