Derivatives! Hardly a day goes by without some major story appearing
in the business press on this subject. To the press, the word has
become virtually synonymous with bad investments and unexpected losses.
To the average person on Main Street, the word either means Spanish
for "evil" or the latest snake oil out of Wall Street. To
Congress and regulators, it represents a major financial area that
has somehow escaped direct regulation and that potentially threatens
the demise of the western world as we know it. To the investment bankers
and swap dealers, it represents a high-profit area, both in terms
of proprietary trading revenues and in terms of sales of products
to customers. To institutional investors, such as mutual funds, pension
plans, college endowments, and state and local governmental authorities,
it provides an intriguing yet potentially dangerous opportunity to
enhance portfolio returns. To treasurers and corporate risk managers,
derivatives provide a means to better manage a company's natural exposures
to interest rate, commodity, and foreign exchange risks. To the SEC
and the FASB, derivatives pose challenges both in terms of financial
statement disclosures and on how companies should account for hedging
and risk management activities. To boards of directors and external
auditors, it represents an area of growing concern and potential liability.
To the academic community, it represents -- well, we'll talk about
that later.
So it is that there are a variety of competing objectives and concerns
over derivatives at various levels. I call these the "derivatives
wars." It is not just one war but various skirmishes and battles
between opposing forces across a number of battle fronts, each seeking
to do the "right thing."
My objective tonight is to provide you with some personal observations
and views on the subject -- if you will, a battlefield report -- based
on my own involvement and experiences in this area over the years.
To put this in its proper context, let me give you an overview of
my areas of involvement.
As associate national director of Accounting and SEC at Coopers &
Lybrand, L.L.R, I am regularly involved in difficult accounting and
disclosure issues that arise from our practice relating to derivatives
and other financial instruments. My experience over the past few years
has been that often the accounting and disclosures issues are merely
the tip of the iceberg, with basic economic, financial, control, and
behavioral aspects lying beneath the surface.
As a member of the FASB's Financial Instruments Task Force and hedging
working group, I have also been involved in the accounting rule-setting
in this area. Of course, I have witnessed firsthand the often painfully
slow progress in dealing with what is a difficult and complex challenge
to the accounting model.
Until recently, I headed a group within our firm that deals with
the product developers on Wall Street, advising them on the accounting
and tax structuring of new derivatives and financing techniques. After
twelve years of involvement in that activity, I think I have gained
a pretty good understanding of the motivation and psyche of these
highly creative and very well-paid individuals.
I also count among my own audit clients several investment bankers
and swap dealers. As you can imagine, the audits of these active traders
of derivatives pose another set of challenges.
In the past year, I have also been involved in several control reviews
of end users of derivatives at the behest of senior management and/or
board of directors. While I am happy to report that in some of these
cases the review was initiated by the company on a proactive basis
and as a preventive measure, I have also been on the scene after the
fact of several "derivatives disasters," diagnosing the
sick, bayonetting the mortally wounded, and helping to heal the survivors.
Finally, I have over the years been and continue to be involved in
my firm's internal policies and training efforts related to financial
instruments in general and derivatives in particular.
I therefore liken my role to that of a platoon sergeant; that is,
leading the troops in the audit and accounting battles, reporting
up the line to the captains and colonels of senior management and
boards of directors and audit committees, and every so often being
given the opportunity to share my observations with the generals,
such as regulators and rule-setters like the SEC and the FASB.
I am going to cover a lot of ground tonight and will provide you
with my observations from the trenches on issues relating to regulation,
involvement of boards of directors and senior management, internal
controls, disclosure, accounting, and auditing of derivatives. I would
also like to briefly pass on my views on how you, the academic community,
should be involved in this area.
Please understand that I am more qualified to talk on certain of
these matters, such as accounting and disclosure, than I am on others,
such as regulation. That notwithstanding, I have never been accused
of being bashful and will offer my views on all these topics. I hope
you understand, however, that everything I say tonight are my own
personal views and not necessarily the views of Coopers & Lybrand.
Regulation of Derivatives
That having been said, I would like to talk briefly about my observations
on the debates about possible regulation of derivatives. Clearly,
this is a very broad topic, which in my view really relates to at
least the three following facets:
- Overall regulation of derivatives markets, both here in the
U.S. and globally.
- Possible regulation on the buy-side, that is, which types of
investors and users should be involved with which types of derivatives.
This is sometimes referred to as "suitability."
- Possible regulation on the sell-side, that is, what standards,
if any, ought to apply to those who market these products to potential
buyers -- what is often referred to on Wall Street as "sales
practices."
Let me talk briefly about each of these aspects.
In regard to the overall market issues, the concern is that of so-called
systemic risk, that is, that one of the major financial institutions
that is a dealer in derivatives or a major user of derivatives might
fail, which in turn might cause a chain reaction that could jeopardize
the health of the whole financial system, a sort of "domino theory"
of derivatives. This is a concern that was first raised in early 1992
by the then-president of the New York Federal Reserve Bank, Gerald
Corrigan, and has since been argued from time to time by certain other
parties, most notably the GAO in its report to Congress on derivatives
last spring. The concern arises from the explosive growth of the derivatives
market, recently estimated at over $35 trillion in notional value,
most of which relates to the off-exchange or so-called over-the-counter
products such as interest rate swaps, currency swaps, and foreign
exchange contracts that are not subject to regulation in a way that
exchange-traded futures and options, or, for that matter, stocks and
bonds are. There have been congressional hearings on this topic and
certain members of Congress have proposed that either the SEC or a
new regulatory agency, a Federal Derivatives Commission, if you will,
formally regulate this area.
While I again apologize that I am not the best qualified to comment
on the merits of this concern, I believe that it is somewhat overblown.
To my knowledge, there has been much focus and guidance coming out
of such agencies as the OCC, the Fed, the FDIC, the NAIC, and others
over the past two years in this arena. For example, the SEC and CFTC
have instituted rules requiring securities and commodities trading
firms to provide extensive detail on the derivatives activities of
any affiliated entities that are not directly regulated by the SEC
or CFTC, with a goal of preventing a spillover of losses by such affiliates
to the regulated entities. Moreover, because of the global scope of
this issue, international groups such as the Basle Committee on Banking
Supervision, the Technical Committee of the International Organization
of Securities Commissioners, and the Group of Thirty have also promulgated
guidance in this arena. These efforts, which are aimed at dampening
such risks, have included not only guidance on the risk management
policies to be utilized by institutions that trade derivatives but
also the appropriate oversight by boards of directors and senior management,
as well as revised capital adequacy standards, proposed netting arrangements
between institutions, and expanded and improved disclosures of derivatives
positions. There is also a genuine concern, I believe, that overregulation
of U.S. derivatives markets could drive significant segments of the
market overseas.
While Congress is obviously mindful of all this, and even with a
pro-business, anti-regulation Republican majority in Congress, it
is always possible that, haunted by the specter of the S&L debacle
and in the wake of other recent events, such as the reported losses
on derivatives sustained by the government employees' credit unions,
many members of Congress would rather err on the side of increased
regulation lest the doomsayers prove correct. I am not one of the
"Chicken Littles," and in that regard it is noteworthy that
the derivatives and structured note markets seemed to have absorbed
the Orange County event without any significant market dislocations.
I therefore believe that the threat posed by derivatives lies less
to the system as a whole than with the profitability and the financial
viability of individual institutions and individual companies, investments
funds, and other entities that are the users of, investors in, or
traders of derivatives.
That, of course, brings me to the buy-side. I believe even a casual
observer of the scene over the last year would have to conclude that
some safeguards are needed. I'm sure that the stockholders of such
companies as Procter & Gamble and Gibson Greetings, to name a
few, as well as investors in mutual funds that suffered losses due
to derivatives would agree. Certain products are not appropriate for
certain users and there ought, in my view, to be clear speed limits
in this regard. This applies particularly to such entities as money
market and mutual funds, pension plans, college endowments, state
and local government funds, and credit unions, who are trusted with
the fiduciary duty of preserving capital. While he probably meant
it to apply only to corporate end users, I would take issue with a
former SEC Commissioner's statement in defense of managernent's prerogative
to utilize derivatives as they deem appropriate when he stated, and
I quote, "We must keep intact the inalienable right for individuals
to lose money. If we ever lose the right, making money will become
very hard indeed." Again, while this statement was probably aimed
at corporate end users, I would certainly take issue with it in regard
to the investment entities and funds where preserving invested capital
is paramount. I am sure you will agree that if it's your money were
talking about that is invested in a money market fund or a pension
plan, management should not have an inalienable right to lose it on
your behalf! Enough said.
It might well be asked how is it that all these so-called "surprise
losses" occurred. Was it that the buyers just did not realize
what they were buying, or was it that they did realize the potential
riskiness of these investments but chose to roll the dice? I think
there is some of both aspects. While it takes two to tango, it seems
clear from public reports that in certain cases -- for example, Procter
& Gamble and Gibson Greetings -- the buyers may have believed
they were dancing a slow waltz rather than a tango. And that brings
me to the sell-side.
Sales practice issues on Wall Street and across the country by other
securities firms are, of course, not a new issue. However, because
of the lack of specific regulation on derivatives as well as their
complexity and virtually infinite variety, it certainly has provided
a fertile area for product developers and marketers. By and large,
however, I believe that most major Wall Street firms have approached
this in a responsible manner. Indeed, many of them had instituted
clear sales practice controls even before the latest wave of problems.
I think that there is a growing appreciation that in the absence of
such controls and codes of conduct, the institution runs the risk
of not only greatly displeasing particular clients, but more importantly,
it runs the risk of jeopardizing one of its most important assets,
that is, its reputation. That notwithstanding, I continue even to
this day to receive occasional calls from product developers and marketing
people at certain firms who (I will assume without the endorsement
of their employers) continue to seek loopholes in the accounting,
tax, and disclosure rules. Maybe I am getting older; while I used
to enjoy such conversations with these Rambo types, I now have little
patience for them. By and large, however, these calls are becoming
much less frequent. Clearly, it seems to me that most of the big Wall
Street firms that had not already done so have now made concerted
efforts to establish clear sales practices that will help potential
buyers more clearly understand the risks and rewards of a particular
product. In fact, I understand that, in something of an initiative
at self-regulation, the big product dealers, under the auspices of
the New York Fed, are developing a code of conduct in this area. All
this bodes well because, of course, as we know from reading the newspapers,
there have been some problems.
Again, going back to my analogy to dancing, I think one of my recent
experiences helps to bring home some of the thinking and motivations
on both the buy and sell sides, which underlie some of the fiascoes
we have been reading about in the newspapers.
While somewhat similar to the Procter & Gamble case, this was
not P&G, and, fortunately for the company involved in this particular
case, the degree of leverage embedded in the interest rate swap it
bought was nowhere near that in the P&G case. A few months ago,
I got involved in a situation of a Fortune 100 company whose senior
management, after reading about the P&G case and others, began
to question the company treasurer about a certain interest rate swap
the company had entered into. It turns out that the swap was indeed
a leveraged swap, which, depending on the velocity of interest rate
hikes during the particular reset period, could produce a leverage
factor of 2.5 to 3 times. That is, if short-term interest rates rose
by 100 basis points, the rate the company would pay would rise by
250 to 300 basis points. By the way, the P&G swaps reportedly
had a leverage factor of around 10 times. As I got involved in this
situation, it became clear to me that heretofore, while senior management
and the board had been generally informed by the treasurer that the
company had entered into a very sizable interest rate swap to change
fixed-rate debt to floating, no mention of the leverage feature had
been deemed worthy of communication up the line. Though I never got
him to admit it, it was clear to me that the treasurer did not fully
understand the product. In fact, in my view, and if I can use this
word, he had been "seduced" by the investment banker who,
back in August 1993, with interest rates at a modern low and with
the chief economist of his own firm predicting that rates would go
up over the next twelve to eighteen months, had convinced the treasurer
that it was the perfect time to swap most of the company's debt obligations
from fixed to floating and convinced him that the best way to do this
was to enter into this particular swap. Although paying the company
an above-market fixed rate, there was also what was described as a
very minor catch, that being that if interest rates rose, the impact
of such raises could be magnified. What the treasurer saw, I believe,
was a way, at least in the short term, to reduce his company's borrowing
costs because of the receipt of the above-market fixed rate, but did
not comprehend or did not choose to comprehend the potential damaging
impact that future rises in interest rates might have on this rosy
picture. So here we have it on both sides -- a willing but perhaps
not totally informed buyer and an eager salesman, both motivated by
short-term objectives, that is, the treasurer wishing to show his
board how he could minimize the company's borrowing costs, and the
investment banker wishing to maximize his own personal cash flow.
Overall, however, I think that things are headed in the right direction,
with the sellers of derivatives, in the wake of Bankers Trusts settlement
with the SEC over Gibson Greetings, having been sent a clear message
that they must take steps to ensure the risks and rewards inherent
in an instrument (that is, the behavior of the instrument across a
range of possible market scenarios is clearly highlighted) and with
buyers increasingly realizing that they must fully understand an instrument
and carefully consider the suitability of it for their needs before
they buy it.
Management and Boards of Directors
Most of the studies and releases by regulatory agencies and by study
groups such as the Group of Thirty and the GAO have pointed to the
key importance of active involvement of management, boards of directors,
and audit committees in the oversight and control of a company's derivatives
activities. With that in mind, let me give you some of my views on
this subject.
First, in terms of senior management involvement, while this of course
varies from company to company, I believe that there is now a clear
appreciation by most senior management, from the CEO down to the CFO
and controller, of the need to get up to speed and involved in this
area, and that in comparing this with the situation eighteen months
ago, there has been real progress. In the past, for the end users,
the subject of financial management, including the use of derivatives,
was often left to the treasurer and his group without much monitoring
by the CFO, the controller, internal auditor, etc. Often this whole
area was viewed as not only complex but not related to the company's
"real" business of manufacturing product, extracting oil,
or selling airline seats. Also --and I will talk about this further
in a few minutes -- the existing accounting rules, which quite honestly
are rather piecemeal, often are internally inconsistent and do not
cover many types of instruments and transactions, and often allow
hedge accounting or some form of deferral accounting to be applied,
thereby affording the treasurer the opportunity (often not malintentioned)
to mask the eroding value of the derivative until the point that cash
or additional collateral goes out the door. I think that this has
been changing, and changing quickly, in the corporate community in
the wake of Procter & Gamble, Gibson Greetings, et al., at mutual
funds, and no doubt will now begin to change -- and one assumes at
a fairly accelerated rate -- at state, county, and municipal organizations.
I can tell you that having spoken at many such seminars and invited
to speak at countless others, virtually every day in this fair city
there is a well-attended derivatives seminar. Senior management, including
CFOs, controllers, and internal and external auditors, are now eagerly
attempting to get up to speed in this area and when they do, sometimes
things do jump out of the woodwork. Let me give you an example. Following
a seminar at which I spoke, I got a call from the controller of an
oil and gas company who had attended the seminar and who, upon ordering
a review of his company's derivatives activities, discovered that
an internal derivatives trading group had been established in the
past six months, ostensibly to better manage the oil price risk inherent
in the company's business. In looking at the activities of this trading
group, however, it became clear that they were doing more than merely
hedging the commodity price risk in the business. In fact, the daily
positions now amounted to five to six times the underlying daily production.
Moreover, there was also active trading in and out of the positions.
To date, these had been accounted for using a deferral approach, even
though it seems the objectives were becoming more in line with earning
trading profits and the traders were being compensated based on these
trading profits. In fact, it seems the company, given this activity,
seemed more like a commodities dealer than an oil and gas producer.
My advice, with which the controller agreed and which he implemented,
was to adopt a mark-to-market approach, not only because this better
reflects the substance of the activity but, more importantly, because
of the discipline that mark-to-market accounting imposes.
With regard to boards of directors and audit committees, the topic
of derivatives has been on the agenda at most companies in the last
year. I have attended a number of such meetings. In some cases, the
discussion by board members has been substantive and probing. However,
in many other cases, unfortunately, while the board or audit committee
is quick to seek assurances from management and the external auditor
that everything is okay, they are often very reluctant to get into
any of the details or discuss in a substantive way any problems or
concerns that may be raised. While I'm not advocating that board members
get into all the nitty-gritty, this is not an area that is susceptible
to glossing over. Maybe the reluctance to get into the details is
due in part to the assumed and often actual complexity of the subject
matter. However, I believe it often also reflects board members' concerns
over potential exposure to unwanted liability; that is, on the advice
of counsel, they have been told not to delve too far into this area.
This, of course, runs counter to recommendations made by the many
studies that have come out in the past year that have urged boards
and audit committees to get more involved. The sad fact, I believe,
is that often because of the fear of litigation and liability, the
potential beneficial impact of boards and audit committees on this
and, indeed, on other issues is often not being achieved.
On a related subject, I would also note that the Advisory Panel to
the Public Oversight Board, headed by Don Kirk, in their report on
"Strengthening the Professionalism of the Independent Auditor,"
also pointed to the need for more effective oversight of management
by boards and audit committees. While I agree with most of what is
in the Panel's report, I am concerned that much of the onus was focused
on the auditor improving the level of interface with the board and
expanding the extent and quality of the discussion with audit committees.
While I would certainly agree that achieving greater board and audit
committee involvement in the company's controls and financial reporting
process and increasing and enhancing the level of discussion between
the external auditor and the audit committee and the board are highly
desirable objectives, I would question the attainability of these
goals without serious changes in corporate governance in this country,
a matter which the accounting profession can certainly encourage but
over which we may have little control. As a closing note on this whole
subject, I would also add that foreign companies looking to raise
capital often cite as their two main deterrents for coming to the
U.S. public markets the GAAP reconciliation that is required by the
SEC in such filings and also, increasingly, the whole environment
of litigation and its effect on corporate governance in this country.
The new Republican majority in Congress, as part of the "Contract
with America," has included litigation reform as one of their
priorities. Needless to say, I wish them well.
So those are my views on some of the areas about which, again, I
am not the most qualified to speak but on which, nonetheless, as a
participant and observer of the scene, I have, as you can tell by
now, some rather strong views.
Let me then turn, perhaps with a little less trepidation but nonetheless
with a number of strong views, to those areas about which I feel I
am better qualified to speak, that is, areas of accounting, disclosure,
and auditing of derivatives activities. With respect to the accounting
and disclosure issues, this has clearly been a long and winding road
for the FASB and the SEC. The issues relating to derivatives are part
of the FASB's broader financial instruments project, which is now
nearing a decade since its inception. In fact, I can remember attending
the first task force meeting some time after my 9-year-old daughter
was born, and I suspect I may see this activity into her college years.
You should all remember that when it comes to setting new accounting
standards, you can't rush genius. The Board attempted to tiptoe into
this area, first by improving disclosures relating to derivatives;
thus it issued Statement 105, which focused on disclosure of information
about financial instruments with off-balance-sheet credit risk, in
1990, and Statement 107, on disclosures on fair values of financial
instruments, at the end of 1991. It soon became clear, however, for
a variety of reasons, that the disclosures resulting from these two
standards did not do a complete job in properly informing the reader
of the extent of a company's use of derivatives; how that use related
to its overall financial risk management; and how it affected the
company's reported results, financial position, and overall risk profile.
Thus, in early 1994, the Board, after several strong suggestions from
the SEC and others, found it necessary to revisit the disclosure area
in order to address the many concerns expressed.
All this coincided with increasing revelations by companies of surprise
losses from derivatives, as well as an ever-loudening chorus of demands
by Congress and various regulators for more transparent disclosures
of derivatives by companies. I was one of those in that chorus. Clearly,
many companies had taken a minimalist approach to disclosing information
under Statements 105 and 107, the biggest problem, in my view, being
that while disclosing the rather sterile quantitative information,
they did not try to put these in the context of the company's over-all
financial risk management policies, leaving the reader often baffled
as to what the disclosures meant. I can remember, for example, a reporter
calling me up regarding a certain computer company that, according
to a major Wall Street analyst, was using derivatives to speculate
on foreign currency on a large scale. The reporter sent me the analyst's
report as well as the company's annual report and recent 10-Qs and
asked me to read them to see if there were any violations of GAAP
and any failure to disclose the extent of its use of foreign currency
derivatives. I dutifully read all the material sent to me by the reporter,
but, alas, I could not find any violations of GAAP or any failure
to report anything that was required under Statements 105 and 107.
However, it was difficult to tell from the footnotes and MD&A
what the company was doing. Thus, I had to call back the reporter,
tell him that, unfortunately, I could not find any direct violations
of the rules, to which he asked if there was anything I could say
on the subject. I told him that I guess that it would have been nice
for the shareholders of the company and any prospective investors
in the company to know that they are investing in a company that was
more like a foreign currency dealer than a computer company since,
based on the analyst's report, the company was speculating on foreign
currency way beyond the natural needs of its business.
Does Statement 119 cure all this? The answer is probably not, but
it does go a long way toward expanding and enhancing the disclosures.
These now cover all freestanding derivatives, with the exception of
commodity futures and other commodity-based derivatives contracts,
which the FASB decided to exclude because they do not have to be cash-settled.
Because of the extent of the required disclosures under Statement
119, I believe that most companies will feel it is necessary to relate
the disclosures to their overall financial risk and risk management
activities. Further, though not required, Statement 119 encourages
additional disclosures, such as those related to how a company assesses
and manages financial risk, i.e., an interest rate GAAP analysis for
a bank and value-at-risk calculations for trading institutions. (In
regard to value-at-risk, I would like to make some comments in a few
minutes.) Moreover, the SEC has, through the review of filings for
some 500 registrants, already required a number of companies to significantly
expand and enhance their disclosures related to the financial risks
faced by the company and how it manages those risks and how its use
of derivatives relates to this risk management. It has also required
disclosure of a company's specific accounting policies relating to
different derivatives, as well as detailed disclosures on a company's
derivatives activities during the year.
My fellow partner and former chairman of the SEC, Richard Breeden,
has said that the best regulation of derivatives lies in improved
market disciplines, which in turn depends on full and transparent
disclosure of a company's derivatives activities to the market. I
believe that we will see vastly improved disclosures in the current
round of annual reports and agree that this is very healthy. Clearly,
sunlight is the best disinfectant. It can also act on a company as
a vaccine; that is, in order to make the disclosures, a company needs
to both gather the information and to understand what it is doing.
And, as I have previously noted, when a company does so, it sometimes
finds things it may not have been fully aware of before.
Now, let me move on to the accounting. This has been a most vexing
area because it not only highlights some of the core concerns with
the historical cost model but also has surfaced some of the practical
and conceptual problems that arise as we move from the historical
cost model to a more market- or fair value-based accounting.
The Board has now been reconsidering the accounting for derivatives
in earnest for some three years and has during that period changed
direction a number of times. This has been a difficult project for
the Board. The Board seemed headed for a possible speedier conclusion
to this project back in June 1993 when it issued a document entitled
"A Report on Deliberations Including Tentative Conclusions on
Certain Issues Related to Accounting and Hedging and Other Risk-Adjusting
Activities." While certain of the tentative conclusions in the
Report on Deliberations contemplated potentially significant changes
in the rules on accounting for derivatives and synthetics, the Board,
at least at that point in time, continued to embrace the concepts
of hedge accounting and synthetic instrument accounting. For example,
while it was proposed that all freestanding derivatives be carried
at market or fair value, hedge accounting would have been permitted
for qualifying hedges of existing assets and liabilities and for firm
commitments. Whether or not hedge accounting should be permitted for
hedges of anticipated or forecasted transactions was left undecided,
with several Board members sharing the concerns voiced by the chief
accountant of the SEC over both the conceptual propriety of permitting
deferral of gains and losses on such transactions and the practical
concern over the ability to develop workable rules that would prevent
companies from deferring losses in situations where the expected transactions
might never materialize. The tentative conclusions also proposed a
new method of hedge accounting, termed the "partial effectiveness
method." Under this method, a hedge is considered effective to
the extent that cumulative changes in the fair value of the hedging
instrument do not exceed the (inverse) cumulative changes in the fair
value of the item being hedged with any excess change in the fair
value of the hedging instrument over the (inverse) change in the value
of the hedged item being recognized currently in earnings. For financial
institutions and other entities that manage net interest rate or currency
risk of their over-all asset/liability position, the Report on Deliberations
proposed an elective mark-to-market pool approach under which all
components of a dynamically managed portfolio (i.e., assets, liabilities,
commitments, and related derivatives) would be measured at market
or fair value with the resulting gains and losses reported in current
period earnings. Finally, with regard to synthetics, the Report on
Deliberations described an approach under which a company would combine
and initially measure the separate financial instruments used to create
the synthetic as a single financial instrument measured at the net
proceeds received or paid. In subsequent financial reporting periods,
the company would recognize in current period earnings any difference
between the combined fair values of the separate instruments and the
fair value of the "prototype" instrument that the company
was trying to synthetically create.
Since June 1993, when the Report on Deliberations was issued, the
Board has continued its discussions on this topic. As evidenced by
these discussions, the Report on Deliberations, though a noteworthy
and interesting document, represented a very preliminary set of thoughts,
and, as I mentioned before, the Board has since changed direction
several times. While this may be due in part to the fact that two
of the seven FASB members at the time of the Report on Deliberations
retired and were replaced by new Board members, the heightened focus
on derivatives in general and on the accounting for derivatives in
particular by Congress, the GAO, the SEC, and others, together with
the wave of reported losses and "busts" involving derivatives,
has undoubtedly impacted on Board members' thinking. Critics of the
current rules argue that not only are they incomplete and internally
inconsistent, but moreover, any type of deferral accounting, whether
it be in the guise of hedge accounting or synthetic instrument accounting,
is harmful because it often masks the extent of a company's involvement
with derivatives as well as the potential losses the company may suffer
from using these instruments. An accounting method is needed, it is
argued, that is not only less complex and that leaves less room for
subjective judgments, but that also gives greater visibility to a
company's use of derivatives by making sure they are captured on the
balance sheet. Mark-to-market accounting, it is argued, will achieve
all these objectives.
Thus it was that during 1994, while continuing to explore various
hedge accounting methods, the Board also began to examine possible
alternative mark-to-market approaches. As part of this effort, the
Board considered a number of models that, while measuring all free-standing
derivatives at market or fair value, also attempted to provide some
sort of special or hedge accounting for a broad array of hedging and
risk management techniques, including dynamic portfolio management,
hedging forecasted transactions, and managing exposures to changes
in cash flows and market values. In each case, however, Board members
found that the methods proposed were either too complex and/or yielded
results that were conceptually difficult to justify. Accordingly,
in November 1994, the Board, in an effort to move the project ahead,
instructed the FASB staff to develop a model under which a company
would classify all freestanding derivatives into two categories --
"trading" and "other than trading." Derivatives
classified as trading (which would include derivatives used to manage
risk in a trading portfolio) would be measured at market or fair value
with all gains and losses, realized and unrealized, recognized currently
in earnings. Derivatives classified as other than trading would also
be measured at market or fair value. However, the unrealized gains
and losses would be included in a separate component of stockholders'
equity until realized, at which point the realized gain or loss would
be transferred from stock-holders' equity and recognized in earnings.
Since November 1994, the Board has been continuing down the path of
developing this approach, having also tentatively decided that commodity
futures and other commodity-based derivatives that entitle the holder
to settle in cash or via receipt or delivery of the commodity, as
well as certain other instruments that have derivative-like characteristics,
such as interest-only strips and some structured notes, should also
be encompassed by this proposed accounting approach. The Board has
also tentatively decided that with regard to regulated futures, the
daily settlement for changes in value via variation margin should
be treated as an event of realization requiring immediate recognition
of the value change in earnings.
The proposed approach, which is similar to the one adopted by the
Board for debt and marketable equity securities in Statement No. 115,
would effectively eliminate hedge accounting and synthetic instrument
accounting as they are now known. Proponents of this approach argue
that it has a number of advantages, including the following:
It captures on the balance sheet the fair value of all derivatives
used by a company. As a result, it may provide the reader with in
"early warning" of any major adverse changes in such fair
values. Thus, it over-comes the weakness of current hedge accounting
practices that have sometimes masked major potential adverse changes
by keeping them off-balance-sheet.
Accounting will not depend on the type of instrument used or the
type of risk hedged. The proposed approach is broad and consistent
for a wide range of instruments and a wide range of hedging, risk
management, and risk selection strategies.
The approach and the resulting accounting procedures are simple
and easy to understand. As a result, it should be much less costly
to implement than the current rules.
If the maturities of the hedged items and the hedging instruments
are matched, the proposed approach still provides for appropriate
offsetting of gains and losses in the income statement. The wide
array of available over-the-counter and customized derivatives should
permit entities to choose those instruments that will enable them
to accomplish this objective.
Entities would have the flexibility to decide when derivative-related
gains or losses would be reported in the income statement because
the timing of realizing those gains or losses would be within their
control.
On the other hand, opponents of the proposed approach believe that
the proposal's focus on the balance sheet treatment of derivatives
will result in an inappropriate portrayal of hedging activities in
the income statement. In effect, the traditional hedge accounting
and "matching" concepts have been ignored by this proposal.
For example:
Entities would not be able to fix the U.S. dollar cost of commitments
to purchase fixed assets from foreign suppliers. The gains or losses
on the forward-exchange contracts entered for this purpose would
be included initially in stockholders' equity and transferred to
earnings when the contract matures or is sold prior to maturity.
They cannot be part of the basis of the fixed asset purchased.
Derivatives that hedge inventory or any other assets or liabilities
that are carried at cost would cause changes in equity but the offsetting
gains or losses on the hedged items would not be reflected on the
balance sheet.
The use of derivatives to permanently hedge translation adjustments
reported in equity (e.g., on hedges of a net investment in a foreign
subsidiary) would be effectively eliminated.
The proposed approach would eliminate synthetic instrument accounting,
even for "plain vanilla" interest rate swaps that synthetically
change fixed-rate debt into floating and vice versa.
It would increase volatility of stockholders' equity. Under the
current accounting model, certain assets and most liabilities are
carried on an historical cost basis. However, the derivatives that
were acquired to hedge these items will be measured at fair value,
with unrealized gains and losses, immediately impacting stockholders'
equity. Thus, even if the change in the value of the derivative
perfectly offsets the change in value in the hedged item, stockholders'
equity will only reflect the change in the value of the former.
As a result, the proposed approach treats stockholders' equity as
a "dumpster" by adding unrealized derivative-related gains
and losses to the list of other items recorded in equity under current
GAAP, e.g., foreign currency translation adjustments and unrealized
gains and losses on available-for-sale securities. The Board has
severely clouded what constitutes "income" and has not
adequately explained why the expanded stockholders' equity section
would now be better for the financial statement users. Whatever
happened to the "clean" surplus theory?
In an effort to properly match the timing of recognition in earnings
of gains and losses on derivatives with the related gains or losses
on the items being hedged, companies may, of necessity, increasingly
have to turn to over-the-counter instruments that may be more risky
than exchange-traded futures and options. This would seem particularly
true in the case of futures, where the daily settlement would be
treated as a realized gain or loss.
Clearly, entities in different industries would be affected differently
by this proposal. Companies sensitive to fluctuations in capital,
such as banks and other regulated entities, would probably oppose
the proposal. On the other hand, many commercial entities may welcome
the freedom and flexibility offered by the proposal to hedge any type
of risk with any type of derivative. This is particularly relevant
in the area of hedging forecasted transactions because current hedge
accounting rules require that if a hedging instrument does not meet
specified criteria, it should be marked-to-market with the changes
recorded in the income statement.
Whichever the case, companies will certainly need to carefully reassess
and appropriately modify their hedging and risk management approaches
should this proposed approach be enacted by the Board.
What do I think about the Board's current direction? I must confess
I am somewhat schizophrenic on this proposal. The practitioner in
me, tired of the daily debates related to the current rules and the
lack of clarity and subjectivity, says to himself, at least this approach
is simple, uniform, and objective. On the other hand, the theoretical
accountant in me, perhaps too used to the "matching" concept
and the notion that a meaningful portrayal of earnings is the keystone
of financial reporting, is troubled by this proposal. While it would
now capture all derivatives on the balance sheet, it would do so,
in my view, at a high cost. In further expanding the use of stockholders'
equity as a dumping ground, it, in my view, further dilutes the meaning
of earnings and net income. All this is at a time when, according
to the Jenkins Committee and the AIMR study "Financial Reporting
in the 1990s and Beyond," the analysts are looking for a return
to the clean surplus approach with an ability to capture and distinguish
within net income the results of all activities.
Overall, it seems to me that the approach that the Board seemed headed
toward in its June 1993 Report on Deliberations was more promising.
That is an approach that would recognize that one size does not fit
all in terms of accounting for derivatives. For financial institutions
and other entities that manage portfolios of both on- and off-financial
instruments, it seems to me that the right answer in the end is mark-to-market
or fair value for all financial instruments, including derivatives.
However, when you get to hedging of other exposures that are not yet
recorded on the balance sheet or are related to assets or liabilities
that are not carried at fair value, then a more traditional hedge
accounting model should be permitted. However, its use should be circumscribed
to those situations where the intent and effect is clear and virtually
certain.
Before leaving the subject of accounting and disclosure, I think
it is important to realize that while added detailed disclosures and
a better and more comprehensive set of accounting rules are clearly
necessary and desirable, they are not the only and maybe even not
the best way of conveying information on a company's use of derivatives
and on its over-all financial risk profile. In that regard, we should
remember that over the past five to seven years there has sprung up
the discipline of financial risk management, involving highly quantitative
techniques that are designed to quantify in a standardized way the
extent of market risk inherent in a particular portfolio of financial
instruments and related derivatives, and, indeed, the financial risk
across all the portfolios in an institution. Out of this has come
a concept of value-at-risk, which is a measure of the potential loss
resulting from hypothetical changes in market factors such as interest
rates and foreign exchange rates for a given time period. For example,
a particular institution might define its value-at-risk as the potential
daily loss across all the financial instruments in its portfolio that
would result from adverse market movements within, say, a 95 percent
confidence level. By providing this sort of benchmark, the company
is not only providing a measure of the riskiness of its portfolio
but is also indirectly conveying information about the extent to which
it hedges or speculates. Now, a number of major financial institutions
are already providing this type of disclosure, and its use is being
increasingly endorsed by the SEC and other regulators. In this regard,
I think an analogy can be made between the development of this kind
of quantitative discipline and its possible use as a benchmark disclosure
with the development many years ago of actuarial techniques and their
subsequent use in pension accounting and disclosures.
Let me move briefly now to some of the auditing issues relating to
derivatives and how these have, for example, impacted our practice.
We, of course, audit a wide spectrum of entities across all industry
sectors. Ten years ago it was largely only the securities firms where
we had to worry to any great extent about auditing derivatives. This
is no longer the case. And thus, we have had to meet this challenge
by training our people, by developing new tools, including, for example,
derivatives controls questionnaires, and by developing or purchasing
our own valuation models. It has also opened up major new service
areas for us, such as financial risk management consulting and internal
control-related services. For example, starting about three to four
years ago, we decided to create a global financial risk management
practice consisting of professional financial risk managers, and we
now have core groups in New York, London, and Tokyo that can go into
a company or institution, map and quantify its financial risks, and
advise on risk management strategies' and related systems, procedures,
and controls. Often, in more complex situations, we use these individuals
as part of our audit evaluation of a particular company. I noted that
we have created or purchased a variety of derivatives valuation models
and have trained many of our staff on these. In certain circumstances,
however, a client -- most notably a derivatives product dealer --
may have certain very complex or long-dated instruments in its portfolio
(for example, a 40-year Swedish krona swap containing a series of
embedded caps and floors). In such circumstances, we have turned to
outside specialists to help us assess the reasonableness of the client's
valuation procedures, methodologies, and end results. A number of
these outside specialists come from academia, such names as Hull and
White, and Gifford Fong, to name a few.
Finally, I would like to leave you with a few thoughts and perhaps
suggestions regarding how all this may impact on your activities.
First, of course, there are curriculum issues. Just as we have had
to train our people to understand derivatives, how companies use them,
and what the audit, accounting, and disclosure implications are, I
believe that this subject matter needs, as appropriate, to be built
into your accounting and auditing courses. In today's world, I believe
this would be a serious omission. Enough said. Secondly, with regard
to academic research, this whole area provides very fertile ground.
With all the fuss in the past year, with new disclosures and with
likely changes in the accounting rules, there would seem to be a whole
host of opportunities for academic research on, for example, how each
of these things has impacted stock prices overall, particular industries,
particular companies, and how new regulations, new disclosures, and
new accounting rules impact companies' approaches to risk management.
I hope that my comments here tonight may have stimulated your thoughts
on other areas for research.
In closing, I would just say that derivatives are clearly here to
stay and that it is important that we all understand that, if used
properly, they can be extremely valuable financial tools, but that,
as events of the past year have shown, if not properly understood
or controlled, they can be extremely dangerous to a particular entity.
I am optimistic that recent events, while certainly sobering, are
already beginning to have a very salutary effect on the various participants
in the market. That is good, because I would not mind a respite from
the battlefield duty.
QUESTIONS AND ANSWERS
Question:
Sometimes these transactions really aren't as bad as they seem. It's
a general image that companies that engage in derivative transactions
are doing something terrible, and it may not really be terrible. Assume
someone wanted to buy a house and needed to have a mortgage for $100,000
and would have preferred a fixed rate of 9 percent. And assume he
was able to get a variable rate, and then actually entered into an
interest rate swap, and at the end of the day converted that transaction
into a fixed rate of 8-1/2 percent. So if he just went to a bank and
borrowed $100, 000 and paid 9 but because he is high-techish had managed
to end up paying 8-1/2, that would be deemed to be smart and prudent
and not particularly unusual -- he accomplished something good. But
on the other hand, if someone said that my neighbor is entering into
derivatives and interest rate swaps, it would sound fantastically
complicated and risky.
Answer:
That's a very good observation: put it all in balance. Recently, somebody
tabulated the reported losses. I think the number for publicly reported
losses may have added up to approximately 15 billion dollars. We are
talking about a market that some have estimated at 35 trillion. So
we are talking about the losses being a very small segment. Most companies
are using these in a healthy way, the way they are meant to be used,
without getting too exotic or beyond the natural exposures of the
company. But there is that temptation out there to increase yield
by using things like debt to reduce borrowing costs and be the instant
hero. These are some of the things I talked about. Thank you.
