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Derivatives

Statement Of Accounting Standard No. 33: The Impetus And Implications

The Institute of Certified Public Accountants of Singapore approved an accounting standard for derivatives similar to the ones introduced by the Financial Accounting Standards 133 in the U.S. and the International Accounting Standards 39. The statement was passed in July 2000 to become effective for financial periods beginning on or after July 2001.

All three standards are but a pit stop toward a fair value accounting model that the Joint Working Group has proposed But the standards are themselves significant and somewhat revolutionary in their departure from traditional accounting conventions. One thing is clear: SAS 33 is complex. The 172-paragraph standard raises many issues both in terms of practical issues of compliance and ramifications to earnings and the statement of financial position. This article will analyze the key changes arising from the standard, the impetus for the standard and possible implications on corporations and financial and derivative markets.

 

A Few Salient Features

Let's begin by taking a quick peek at the key features of SAS 33. At the risk of oversimplifying, this standard requires corporations to make the following changes to their financial reporting:

* Classify financial assets and liabilities into one of four categories - trading, available-for-sale, held-to-maturity and originated loans and receivables. Generally each category of asset or liability will initially be measured at the fair value of the consideration given up, changes in fair value on subsequent remeasurement would generally be recorded on the income statement or in equity;

* Recognize financial assets and liabilities which were traditionally kept off-balance-sheet, including futures, forwards, swaps, options and other derivatives, on the balance sheet at fair value; resulting changes in fair value on remeasurement dates would commonly be recorded on income statements;

* Disclose an enterprise's financial risk management objectives and policies and disclosure of various aspects of the hedge transaction;

* Meet the two conditions below prior to applying hedge accounting;

* Make available formal documentation of the risk management objective and strategy for each hedge undertaken including how hedge effectiveness will be assessed;

* Assess that the hedge is highly effective ­ the standard for an effective hedge is based on the correlation between gain/loss of the hedged item and the hedge instrument (in this regard, portfolio hedging or the use of a single hedge instrument to hedge a basket or group of hedged items is not generally considered effective hedging);

* Even where hedge accounting is possible, charge to earnings any imperfection of the hedge;

* Bifurcate hybrid financial instruments or those instruments that possess embedded derivatives and measure and account separately both the host and the derivative.

A key characteristic of the standard that often escapes corporations is that the standard applies from the very first day of the financial year in which it becomes effective. For a June 30 financial year, if conditions for hedge accounting in SAS 33 were not in place on July 1, 2001, hedge accounting cannot be applied to a hedge existing on that date. In this instance the gain/loss on the hedge instrument must be charged entirely to earnings. In other words, the standard does not permit hedge accounting to be applied retrospectively.

 

Why SAS 33?

Is compliance of the standard likely to be costly? Probably. Is it radical? Maybe. But is it necessary? Absolutely.

SAS 33 is a product of the changing world. Changes in financial markets and financial products innovation brought about a disconnect between the derivatives and other instruments used to manage risk and the financial reporting of such esoteric products. Certain high profile losses including the Barings Bank debacle in 1995 further propelled the need to develop consistent and comprehensive financial reporting for derivatives and other financial instruments. Without a standard that clearly sets out such a basis, there will be a lack of relevant and understandable information to assess an entity's investment decisions and financing strategies.

While SAS 33 is by no means the final answer in the reporting of financial instruments, it is a significant interim measure in the global move toward a fair value accounting model. The standard promotes visibility and transparency of financial instruments by forcing all entities to declare their hands on the income statement and statement of financial position instead of sneaking in a disclosure of financial derivatives in the footnote to the financial statements. Plus, it promotes a consistency of reporting that was hitherto absent.

 

Impact On Corporations

The immediate result of SAS 33 is clear. In the next reporting season, one can expect earnings volatility not previously encountered that will render the role of management, analysts and other financial professionals a tad more difficult in explaining the fluctuations. But even before that, the standard challenges the present skills of accounting professionals in that it calls for a higher degree of sophistication in terms of understanding financial instruments and in particular derivatives, in terms of valuing such instruments and understanding the business objectives of transactions and hedges that corporations enter.

* Additionally, corporations can expect some of the following experiences as a result of the standard:

* Corporations that adopted hedge accounting under the pre-SAS 33 regime will find a noticeable reduction on the number of instances they may do so. In many instances, while the economic objective of a hedge may not have changed, the gain/loss of the hedge instrument will need to be recorded partly or entirely on the income statement;

* The need to bifurcate hybrid instruments will throw into disarray carefully managed financial ratios, including leverage, asset and capital return ratios;

* Intuitively banks and financial institutions appear to be most affected by the introduction of the standard. However many financial institutions may be well placed to implement the standard as they already have the capability to mark their financial instruments to market and or have complex systems that would allow them to do so. On the other hand major corporations and in particular corporations with significant exposure to currencies, interest rates and other market variables which are actively managed through derivatives are likely to have to put in place systems to track and measure these instruments;

* Increase in compliance cost is expected from modifications to existing systems to allow tracking, measurement and valuation of derivatives and hedged items as well as the need to reconcile any differences between external financial reporting and regulatory returns.

Impact On Financial Markets

While the jury is still out on the effects that SAS 33 may have on financial markets and in particular, derivative markets, there is speculation that the standard will cause a move away from plain-vanilla hedge instruments toward more precise and customized hedge instruments that meet the stringent hedge effectiveness criteria. Potentially part of this adjustment of existing hedges will take place just before the effective date of SAS 33. This speculation presupposes that corporations will change their hedging behavior in response to an accounting rule change in order to avoid volatility. Alternately there are views that given that the economics and cash flows of corporations do not change as a result of the standard SAS 33 should not change corporate preferences to certain financial instruments.

Thus far, an Association for Financial Professionals survey on the impact of FAS 133 in the U.S. indicated that initial reactions appear to suggest a small reduction in hedging activities. Nonetheless, a significant number of respondents to the survey who do not currently use derivatives for hedging plan to do so in the future--possibly due to increased awareness over risk management activities arising from the standard.

 

Conclusion

SAS 33 is probably the most significant accounting standard introduced in Singapore in the last decade. Its ramifications wide and far ranging in terms of promoting transparency in the reporting of financial instruments and in particular derivatives and in limiting the application of hedge accounting. In respect of the latter, corporations can and may well choose the default solution--mark to market all financial instruments on the books and accept the volatility rather than incur the cost to apply hedge accounting. This proposition is supported by the fact that the requirements of SAS 33 do not affect the underlying reason for entering into a hedge. However the optics of highly volatile earnings and the prospect of explaining fluctuating earnings to investors and analysts are likely to dissuade all but the most hardened management. With its one-year headstart FAS 133 will serve as a useful bellwether for corporations applying SAS 133 or its equivalent. But it is early days yet.

 

This week's Learning Curve was written by Leong Kok Keong, partner and head of financial services industry in the assurance practice of Andersen Singapore.

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