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The Impact of FAS 133 on the Risk Management Practices of End Users…
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Language: english
Created: Thu Sep 26 09:04:08 2002
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The Impact of FAS 133 on the Risk
Management Practices of End Users of
Derivatives
Report of Survey Results
September 2002
Introduction
Background
The Financial Accounting Standards Board (FASB) issued new accounting rules for derivatives
and hedging transactions (Financial Accounting Statement 133, or FAS 133) in June 1998 that
were effective on June 15, 2000. Most companies, however, did not implement the standard until
the first quarter of 2001. Because the transition from the previously accepted accounting treat-
ment was dramatic and controversial, many reporting entities -- along with FASB and the
Securities and Exchange Commission (SEC) -- were concerned about the impact that these new
rules might have on the hedging activities of corporations. To gain a clearer perspective on the
impact of FAS 133, the Association for Financial Professionals (AFP) surveyed its members in
January 2001.
This original survey had several major conclusions. First, two-thirds of respondents believed that
FAS 133 had imposed an "excessive burden" on reporting companies. Second, a quarter of
respondents indicated that they expected to apply regular derivatives accounting--as opposed to
applying special hedge accounting -- to a significant portion of their derivatives holdings. Third,
the new accounting requirements fostered a small reduction in hedging activity. Fourth, only a
quarter of respondents believed that FAS 133 imposed a beneficial discipline on risk manage-
ment activities.
The 2001 survey was conducted in early January, just a few months after companies started
complying with FAS 133 requirements, but since then, FAS 133 has continued to evolve. FASB
has posted additional guidance on its web site (http://www.fasb.org); and on May 1 2002,
released a new exposure draft containing proposed amendments to FAS 133. AFP decided to
survey its membership again, to see whether companies have altered their use of derivatives two
years after the effective date of FAS 133.
Survey Methodology
AFP mailed an eight-page questionnaire to select corporate practitioner members1 in May 2002
and received 175 valid responses. Respondents represented a wide variety of companies
throughout the United States, with respondents typically working for company with annual rev-
enues between $1 and $5 billion
Treasury and finance professionals of varying job titles completed the questionnaire. Most sur-
vey respondents identified themselves as treasurers (29 percent), assistant treasurers (25 per-
cent), CFOs (19 percent), and risk managers (10 percent). Respondents also identified the per-
son charged with overall responsibility for FAS 133 implementation as controller/comptrollers
(25 percent), CFOs (20 percent), treasurers (19 percent) and assistant treasurers (15 percent).
1
Surveys were sent to corporate members holding titles of CFO, treasurer, or controller and to members
who identified any of the following as one of their five primary job responsibilities: accounting/financial
reporting, hedging, risk management, and financial risk management.
Significantly fewer respondents identified financial reporting officers, assistant
controllers/comptrollers, risk managers and auditors as the key person tasked with carrying out
FAS 133 implementation.
Both the 2001 and 2002 surveys were conducted by AFP's research department with the assis-
tance of Ira Kawaller, under the direction and guidance of the Financial Accounting and Investor
Relations Task Force (FAIR) of AFP's Government Relations Committee. Dr. Kawaller devel-
oped the survey and performed the analysis for this report. He is the founder of Kawaller &
Company, LLC, which is a consulting organization that specializes in assisting commercial
enterprises in the use of derivatives instruments. He is also a member of FASB's Derivatives
Implementation Group (DIG), an advisory panel that offers guidance to FASB on FAS 133
implementation issues. He holds a Ph.D. in economics from Purdue University and is a frequent
contributing author to AFP Exchange and other AFP publications.
Executive Summary
The 2002 survey asked many detailed questions concerning the use of derivative tools and the
impact of FAS 133 on company behavior. The principal findings and conclusions are as follows:
q Sixty-three percent of companies report that they use derivatives to address interest rate and
currency exposures, respectively. However, only a third of responding companies indicate that
they hedge commodity or raw material price exposures.
q Respondents report lower levels of hedging activity for the vast majority of derivatives tools
and strategies, compared to levels reported in last year's survey.
q Despite this reduced hedging activity, seven out of 10 respondents claim that their company's
use of derivatives has not changed as a result of FAS 133.
q Some of the decline in hedging activity may be due to a perception that market conditions
have mitigated the need for hedging activities over the past year. This perception was likely
based on relatively lower interest rates, mild currency fluctuations and smaller commodity
price swings.
q Even after the process of initial implementation of FAS 133 accounting had been completed
-- a process that imposed special, one-time time start-up costs -- nearly half of the respon-
dents still report that complying with FAS 133 rules is "excessively burdensome." This result
is especially significant in that it comes despite an overwhelming reliance and preference for
the simplest, most plain vanilla derivatives.
q Almost a quarter of the respondents say that their company has decided to forgo hedge
accounting on "significant portions" of derivative positions as a result of FAS 133.
q Companies generally use hedge accounting. However, when they decide to avoid hedge
accounting, it is because either they feel it is not necessary (i.e., the cost and effort outweigh
the benefits) or that the companies' exposures are not eligible for hedge accounting.
q Significant portions of companies who were eligible for special accounting treatments
described in DIG issues G20 and H15 -- treatments that would likely lead to less income
volatility -- choose not to avail themselves of this opportunity. This choice may reflect a per-
ception that more onerous documentation and valuation requirements are associated with
these treatments.
Overview of the Impact of FAS 133
General Attitudes About FAS 133 Implications
Companies tend to use derivatives to hedge their exposures in three major areas: interest rates,
currency exchange rates, and, to a lesser degree commodity/raw material prices. Sixty-five com-
panies (63 percent) report that they use derivatives to address interest rate and currency expo-
sures, respectively. However, only a third of responding companies indicate that they hedge com-
modity or raw material price exposures. The markedly lower usage of hedges for commodity risk
may be due, in part, to the fact that many of the respondents in the sample population incur little
or no commodity risk, but a higher proportion bear currency and interest rate risk.
FAS 133's Impact on Companies' Use of Derivatives
(Percentage Distribution)
Remained
Increased Decreased Don't know
the same
Use of derivatives for interest rate
exposures has... 7% 69% 21% 3%
Use of derivatives for currency
exposures has... 12 74 13 1
Use of derivatives for commodity or
raw material price exposures has... 7 71 15 7
Two years after its effective date, over a quarter of respondents claim that FAS 133 influ-
enced their company's use of derivatives. The effect, however, differs depending upon whether
the application was in connection interest rate, commodity, or currency risk. Respondents are
three times as likely to report lower use (versus higher use) of interest rate hedges with a two-to-
one ratio for commodity hedges. For currency hedgers, on the other hand, the response is more
balanced, with comparable numbers reporting lower and higher use, respectively. The larger
number of currency hedgers who indicate a greater reliance on derivatives can likely be attrib-
uted to the fact that FAS 133 allows for hedge accounting when forward contracts are applied to
uncommitted, anticipated foreign currency transactions, where pre-FAS 133, these applications
were not granted hedge accounting treatment.
Degree to Which Companies Agree that FAS 133 Has Imposed
an Excessive Burden on Reporting Companies
(Percentage Distribution)
Neither agree Strongly
Strongly agree Agree nor disagree Disagree disagree
16% 32% 34% 14% 5%
Nearly half of all respondents believe FAS 133 imposes an "excessive burden" on their com-
pany. This percentage is down significantly from the original survey results in 2001. In 2002,
48 percent of respondents believe that FAS 133 imposed an excessive burden on their company
compared to 67 percent of respondents from last year's survey. The decline might have been
expected given that the 2001 survey was conducted as companies were implementing FAS 133;
and implementation imposed a special, one-time "cost." Since the implementation phase is now
complete for most companies, this year's survey reflects a perception that the ongoing compli-
ance with FAS 133 remains burdensome.
A quarter of the respondents say their company forgoes hedge accounting on "significant
portions" of derivative positions as a result of FAS 133. Forgoing hedge accounting means
that many companies are prepared to show a higher level of income volatility that hedge
accounting would otherwise mitigate. This judgment reflects a view that the resulting income
volatility would be sufficiently small to be acceptable because (a) hedge positions are limited,
(b) underlying prices/interest rates/exchange rates are expected to be relatively stable over the
impending hedge horizon(s), and/or (c) the costs of complying with FAS 133 do not outweigh
the potential benefits of complying with the requirements.
Degree to Which Companies Agree that the Restrictions on Netting
Practices for Internal Derivatives Has Forced a Significant Change in Their
Risk Management Approach
(Percentage Distribution)
Neither agree Strongly
Strongly agree Agree nor disagree Disagree disagree
5% 6% 50% 27% 12%
Eleven percent of respondents believe that the restrictions on netting practices for internal
(inter-company) derivatives have forced a significant change in their risk management
approach. This issue is most relevant to companies that have associated international entities.
FAS 133 added very specific requirements for these firms to qualify for hedge accounting --
such as, rules that impose specific constraints on central treasuries that manage worldwide expo-
sures. These new requirements appear to have caused a relatively small number of companies to
modify their approach.
Risk Management Practices
Hedging Activity by Risk Exposures
(Percent of Respondents)
2002 Survey 2001 Survey
Interest Rate Exposures
Recognized variable rate assets 17% 31%
Recognized variable rate liabilities 46 52
Recognized fixed rate assets 15 27
Recognized fixed rate liabilities 26 38
Prospective investment purchases 11 25
Prospective debt issuances 18 35
Currency Exposures
Expenses or revenues denominated in a
16 34
non-functional currency
Prospective purchases or sales (no firm
28 30
commitment involved)
Prospective purchases or sales (a firm
43 52
commitment is involved)
Recognized assets denominated in a currency
32 46
other than the functional currency
Borrowing or lending in a currency other than the
25 39
functional currency
Raw Material Exposures
Net investment in foreign operations 15 24
Prospective purchases or sales 19 39
Inventory price risk 6 19
Over the past year, hedging activity for all types of risk exposures declined across-the-
board. Still, the most frequently hedged exposures continue to be those relating to variable
interest rate liabilities and prospective currency transactions (when firm commitments are in
place). In the 2001 survey, both of these exposures were hedged by just over half of the respon-
dents; in the 2002 survey the percentages dropped to somewhat under half.
There are several potential reasons for the decline in reported hedging activity. One is that FAS
133 itself has led to a decline in the use of derivatives. As reported above, nearly half of all
respondents agree with the assessment that implementing FAS 133 puts an excessive burden on
companies and that a sizeable minority of companies report choosing to forgo hedging activity.
Still, since both surveys were conducted after the effective date for FAS 133, all of the reported
reductions in hedging activity may not necessarily be attributable to the accounting standard, per se.
Another possible explanation for the declines may be that some companies believe that
market conditions over the past year lessen the perceived need for hedging. This perception
of reduced risk exposure is based on relatively lower interest rates, mild currency fluctuations
and smaller commodity price swings. Additionally, although some companies may have respond-
ed to both surveys, the reported decline in hedging activity might be due -- in some part -- to
differences in the characteristics of the companies responding to the survey.
Risk Management Tools
Top Three Derivatives Tools Used by Companies
(Ranking by Exposures)
Commodity and/or raw
Interest rate exposures Currency rate exposures
material prices
1. Swaps
1. Forwards 1. Forwards
(forward rate agreements)
2. Caps or floors 2. Plain vanilla options 2. Futures
3. Futures 3. Collars or corridors 3. Plain vanilla options
This year's survey reveals similar preferences of derivative tools as those found in last year's sur-
vey: Companies tend to prefer "plain vanilla" derivatives tools over those that are more sophisti-
cated or complicated.
Interest rate swaps continue to be the most popular derivative tool for companies that hedge
interest rate exposures. Independent caps and/or floors (not in combination) run a distant sec-
ond, while the other alternatives are used by a very small percentage of hedgers. Among curren-
cy exposures, forward contracts are the favored derivative tool. Plain vanilla options (akin to
caps or floors for interest rate exposures) are a distant second, while option combinations (such
as collars, corridors, or options with other, more exotic features) are the third most widely cited
tool.
For commodity and raw material exposures, forward contracts again are the favored vehicle.
Additionally, futures contracts seem to be used with a greater frequency for managing commodi-
ty exposures than they are for risks associated with interest rates or currencies.
The Use of Hedge Accounting
Application of Hedge Accounting -- Most Widely Hedged Exposures
(Percent of Respondents)
Exposure Derivative Tools Usage2
Interest Rate Recognized variable rate liabilities 83%
Recognized fixed rate liabilities 82
Interest rate expenses or revenues dominated
in non-functional currency 74
Currency exchanges for prospective purchas-
Currency Rate 75
es/sales, with firm commitment
Currency exchanges for prospective purchas-
es/sales, with no firm commitment 72
Recognized assets or liabilities denominated in
a currency other that the functional currency 65
Commodity/Raw
Prospective purchases or sales 85
Materials
Inventory values 79
As might be expected, a high proportion of companies that qualify for hedge accounting elect to
opt for this treatment for at least most -- but not all -- of their exposures. For interest rate expo-
sures, more than eighty percent of companies that hedge such exposures use hedge accounting
for hedges of their fixed and variable liabilities. A slightly lower percentage of companies with
exposures in prospective purchases or sales of commodities and raw materials use hedge
accounting.
Not all companies, however, make this election. The most widely reason cited for eschewing
hedge accounting is that respondents feel the special hedge treatment is not necessary. This
response could be interpreted to mean that the effort to apply hedge accounting is too great for
the benefit that would be derived. Presumably, companies that come to this conclusion may
believe that the consequent income volatility is acceptable, given the time, effort, and possible
expense of satisfying the prerequisite requirements for getting the hedge accounting treatment.
Another reason why hedge accounting might not be deemed necessary is that normal accounting
frequently yields the intended matching of gains or losses on an exposure with compensating
derivative results. This outcome arises, for example, when entities use derivatives to hedge the
currency risk of assets or liabilities that are denominated in a foreign currency -- the category
with the lowest frequency of all, to apply hedging accounting. Offsetting gains and losses are
recorded in current income making the application of special hedge accounting unnecessary.
2
Uses hedge accounting for at least some of their hedged exposures.
Technical Discussion
The following section looks at the technical aspects of hedge accounting for those companies
that apply such techniques.
Hedge Effectiveness Testing
Methods Used for Hedge Effectiveness Testing
(Percentage Distribution)
Not applicable
Always Sometimes Never to my company
Dollar offset calculations/scenario
32% 16% 10% 42%
analysis
Regression 10 17 27 46
Value at risk calculations 13 13 27 48
In testing for hedge effectiveness, several alternative methodologies are available; including dol-
lar offset calculations, regression, and value at risk calculations. For those companies where
hedge effectiveness tests are relevant, dollar offset calculations are the favorite methodology for
satisfying the testing requirements. Over 80 percent of respondents who conduct hedge effec-
tiveness testing use this method at least some of the time, and most of these companies making
such calculations do so with reference to individual period changes, as opposed to cumulative
changes. About half of respondents who conduct hedge effectiveness testing report using the
regression methodology while half of respondents (not necessarily mutually exclusive) also use
"value at risk" calculations.
The preference for the dollar offset ratio is likely due to its relative simplicity. That is, dollar off-
set ratios can be calculated quickly and easily. In contrast, the use of regression analysis or
value-at-risk techniques requires a much higher level of technical expertise and also a greater
reliance on more extensive data sets. However, these alternatives generally will preserve uninter-
rupted hedge accounting. In contrast, dollar offset ratios often fall out of acceptable bounds
when small price changes are observed, thereby fostering a termination of the use of hedge
accounting because offset ratios.
Interest Rate Swaps
Sixty-five percent of respondents report that they use interest rate swaps for managing
interest rate risks, a figure that represents about 92 percent of all companies that hedge
interest rate exposures. Respondents also reflect a preference for the "shortcut treatment"
for interest rate swaps is used, which it obviates the need to measure hedge effectiveness.
3
See Kawaller, I.G., "The 80/125 Problem," Derivatives Strategy, March 2001 for a more detailed discus-
sion on this point.
This survey addressed two questions in regard to the use of interest rate swaps: first, what is the
importance of the shortcut treatment? Second, which of the three allowable methods for measur-
ing hedge effectiveness is used when shortcut treatment is not used?
Company Use of the "Shortcut Treatment" for Interest Rate Swaps
(Percentage Distribution)
The shortcut treatment is always employed 24%
The shortcut treatment is sometimes employed 27
The shortcut treatment is never employed 9
Company does not use interest rate swaps to convert from 41
fixed to floating interest rate exposures, or vice versa
Application of the short-cut treatment is attractive, in part, because it obviates the need to meas-
ure hedge effectiveness. Even so, shortcut treatment is not permitted unless the prerequisite con-
ditions are satisfied. Nearly 40 percent of companies that use interest rate swaps always qualify
for and apply the short-cut treatment while fewer than ten percent indicated that they never apply
the shortcut.
Methods Used by Companies to Measure Hedge Effectiveness
When Not Applying Shortcut Method
(Percentage Distribution)
Method 1 based on variable cash flows of the swap 7%
Method 2 based on the results of a hypothetical derivative 5
Method 3 based on total cash flows of the swap 22
Not applicable to my company 66
When the shortcut is not employed, hedge effectiveness must be measured. Derivatives
Implementation Issue G7 (DIG Issue G7) sanctions three different measurement methods: the
Change in Variable Cash Flows Method (Method 1), the Hypothetical Derivative Method
(Method 2), and the Change in Fair Value Method (Method 3). The favored approach, by nearly
two-thirds of the responders, is Method 3. About 20 percent of respondents who do not employ
the shortcut favor Method 1, while the balance (15 percent) opts for Method 2.
DIG Issues G20 and H15
Accounting Treatment Companies Apply When Hedging with Options
(Percentage Distribution)
Company applies G20 and bases hedge effectiveness consider-
ations on total cash flows of the options
24%
Company excludes time value or volatility value from hedge 13
effectiveness assessments
Company does not hedge with purchased options 62
When purchased options are used in cash flow hedges, DIG Issue G20 allows the assessment of
hedge effectiveness to be based on the total changes in the option's cash flow.4 The benefit of the
G20 methodology is that can result in less income volatility during the hedging period compared
to any alternative treatment. While only about 38 percent of the respondents report using
options, the G20 method was favored almost 2:1 among those using options.
Company Use of DIG Issue H15
(Percentage Distribution)
My company always applies DIG Issue H15 6%
My company sometimes applies DIG Issue H15 14
My company never applies DIG Issue H15 18
My company does not hedge prospective purchases or sales
from or to foreign suppliers
61
DIG Issue H15 provides for yet another special accounting treatment -- this time in connection
with currency hedges when specific conditions are met. That is, this treatment may be applied
only when the same forward contract is used to hedge the prospective purchase or sale in the
non-functional currency and the subsequent currency settlement. The H15 treatment would like-
ly result in less income volatility during the hedging period than would otherwise be the case.
Among those companies that face this kind of exposure, only 15 percent of companies that
hedge prospective purchases or sales from or to foreign suppliers consistently avail themselves
of this treatment. An additional 37 percent of respondents report that their company uses the
H15 treatment sometimes; but almost half never elect to apply this procedure.
With both of these issues, FASB somewhat belatedly allowed reporting companies to apply spe-
cial accounting practices that would likely result in lower reported income volatility than alterna-
4
Without G20, companies would likely exclude the option's time value or volatility value from the assess-
ment of effectiveness.
tive treatments. Even so, significant portions of respondents who were eligible for these pre-
ferred treatments chose not to use them. In some cases, this election may likely have been due to
having previously implemented other procedures before these newer alternatives were author-
ized. Alternatively, this outcome may also be a reflection of the more onerous valuation and doc-
umentation requirements associated with these treatments, relative to alternative procedures.
Conclusion
In the nearly 18 months since AFP conducted its first survey on FAS 133, companies report that
they have reduced their hedging activity. This reduction appears to be motivated, in part, by
these new rules -- particularly for hedgers of interest rate and commodity risks. However, a
part of the reported decline in hedging activity may have been due to a perceived reduction in
the need for hedging, due to more stable and favorable market conditions.
Readers of this report should appreciate that the response to this year's survey was limited and
that some "self-selection bias" may be inherent in the results. As a result, while the findings
provide good indication of the attitudes and practices of the subset of firms that participated in
the survey, these firms may not necessarily reflect the actions and opinions of the business com-
munity at large.