Fasb Grows New Fangs

A new rule forces companies to shed light on their derivatives

Skittish investors, who now hammer stocks if quarterly earnings are off as little as a penny a share, may soon be in for a shock. Earnings for much of Corporate America will soon become less predictable--maybe a lot less so--because of an accounting rule about derivatives that takes effect for some outfits as early as July 1. "We're in a different world," says Ira G. Kawaller, a consultant and a member of the derivatives implementation group of the Financial Accounting Standards Board (FASB). "It's a virtually foregone conclusion that there will be more earnings surprises."

FASB's Statement No. 133, which has been battled over for half a decade, requires that nearly all derivatives--financial instruments such as futures, options, or swap contracts whose prices are derived from some other commodity or security--must be "marked to market" every quarter. That means if the derivative is lower than its cost at the end of the quarter, the company may have to account for that loss in the earnings report, even though the derivative has not expired and may well rise in price later. Conversely, an upward move could make earnings higher than expected. Because derivatives can fluctuate sharply from day to day, earnings may be almost impossible to predict precisely until very late in each quarter.

BIG LOSSES. Many companies use derivatives routinely to protect themselves against adverse price movements in currencies, interest rates, or commodity prices. Up until now, many of the derivative gains and losses were commonly deferred or treated as off-balance-sheet items. The new rule was born out of concerns in the mid-1990s that companies were using derivatives for speculative purposes and blindsiding investors with big losses when the companies were wrong. The best-known case: Procter & Gamble Co., which took a $157 million pretax charge in 1994, the result of losses in derivatives trading. In effect, P&G had entered into derivatives contracts that would have paid off if interest rates declined. Instead, rates rose.

The rule, although aimed at making the effects of derivatives clearer to investors, will cause confusion. Critics say that reported earnings could fluctuate by as much as several cents a share each quarter based on how companies use these financial tools. The rule is "forcing firms to rethink how they hedge," says Bruce Domash, a director in the audit and financial surveillance unit of the Chicago Board of Trade. He expects companies to move away from such exchange-traded vehicles as futures contracts and switch to more customized forward contracts, which are purchased directly from banks and securities firms. The rule takes effect on July 1 for companies with fiscal years ending this June 30, and on Jan. 1, 2001, for outfits operating on calendar years.

The new rule will do some good. It will let investors clearly see each quarter which derivatives strategies are being used and how well they are working. And it will regularly shine a light on instruments that now are commonly left out of financial reports until they have run their courses. An interest-rate-swap contract, for instance, may change sharply in value each quarter but, until now, only the interest payments of these devices--which could be tiny--have been recognized in current earnings. Now the full gain or loss of the entire contract will be transparent. "You will be able to see who is effectively hedging and who is not," says Paige B. Grumulaitis, a senior director at Enron Corp.

Indeed, corporate-finance officials will be held to account when their hedging strategies miss their targets. Suppose a food processor wants to protect himself against a rise in wheat prices. He buys a futures contract at an exchange, but the wheat specified in the contract doesn't precisely match up in price or quality with the wheat he'll eventually purchase. His hedge turns out to be "imperfect," and he must log part of the loss or gain into earnings at the end of each quarter, not just when the contract expires--the old way of accounting for derivatives.

If the hedge is perfect--it matches up with what's being hedged--the treatment is different. The entire gain or loss is recorded as "other comprehensive income" in the shareholder equity portion of the balance sheet. Right now most hedges are imperfect, and part of their quarterly gains and losses would flow through to the earnings statement.

The new accounting treatment raises another issue. The same corporate officials who are responsible for the hedging will be the ones who decide how perfect or imperfect their hedges are, and thus determine if the gains or losses go to the income statement or only the balance sheet.

Critics say that the rule will drive up the cost of hedging, and perhaps discourage companies from even trying. A forward contract tailored to a buyer of grain, for instance, could prove more costly than a futures contract or an option traded publicly on a commodities exchange. And yet, a big commodity buyer may not want to take the risk that an option will perform poorly in one quarter--even if it then does well the following quarter, when the grain is delivered--because of the earnings volatility it will cause. "It's death for options," says Kevin R. Holme, a managing director for Bank of Montreal's global financial products.

It's more than options at stake. Liquidity at futures markets like the Chicago Board of Trade and the Chicago Mercantile Exchange could be diminished as big hedgers move to customized contracts. And tailor-made deals have their drawbacks, too: There are fewer players in that game, and hedgers can't easily undo a hedge if their needs change.

FASB has tried to respond to critics by developing some key exemptions. Under a normal purchases-and-sales exemption, for instance, forward contracts for goods that companies use in their business--such as grain or fuel oil--will not be treated as reportable derivatives so long as the goods are actually delivered. Similarly, foreign-currency transactions between different divisions of companies will escape the quarterly markup but will still have to be reported when the contracts end. Such moves have gladdened some critics who worried about the initial rules FASB proposed. "We're pleased with the outcome," says John A. Papa, treasurer for Johnson & Johnson, one of the initial objectors to the new rule. "They made the appropriate amendments."

Some companies that have used the new standard for a couple of years even find parts of it helpful. Northwest Airlines Corp., an early adopter in 1998, has found the foreign-currency rules more workable than prior approaches. But even Northwest says the standard requires more administrative work to keep track of the effects of each hedge.

Indeed, the administrative burden may grow sharply for many outfits because the rule also broadens the definition of derivatives. For example, leases that tie rental payments to such things as commodity prices--farmland rentals pegged to the price of corn, for instance--could be regarded as derivatives. A host of financial instruments that build in schedules where an underlying asset can rise or fall in value will have to be analyzed, with detailed documentation, to determine what kind of accounting is required. "They've laid out such detailed criteria [that] it's very, very onerous," complains Michael S. Joseph, a partner at Ernst & Young who is one of the dissident members of the FASB's derivatives implementation group. "It's more bad than good."

HARDER JOB. The rule may also have an impact on how investors value companies. Net income, for instance, may be more volatile because of the derivative adjustments. Cash-flow measures, unaffected by interim bookkeeping charges, may be more useful. Profitability measures such as return on equity will be more difficult to use since the new rule will also have an impact on the balance sheet's shareholder equity account. "Analysts are going to have to come up with new ways to evaluate companies," says Joseph. "For ordinary investors, it means their job is going to be a lot harder."

That may be so. But the new rule will open up companies' use of derivatives to public scrutiny. That alone should make it worth the extra effort.

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