CPE Conference Brief
The sometimes uncomfortable marriage between FAS 133 and 157
Last month, I attended and chaired CPE’s Derivative Accounting Conference. I want to take this opportunity to share some of the key takeaways. Perhaps the most important (and most troubling) discussion revolved around the interaction between FAS 133 and 157, e.g., how derivative hedge accounting concepts align with 157′s requirement to take the entity’s own and the counterpart credit, when measuring fair value.
With the FASB’s Bob Wilkins and Brian Fields, a fellow at the SEC’s Office of the Chief Accountant in attendance, participants had a unique opportunity to hear firsthand the Board and the SEC’s view on this topic. In several cases, the standard setters’ responses were quite counterintuitive and even disturbing.
Effects on FAS 133 journal entries
The standard setters began by reiterating some of the core principles in FAS 133, particularly the concept that only time value (or forward points) can be excluded from effectiveness testing and recorded directly in earnings. FAS 157 has added a new twist: how to handle the fair value changes attributable to credit risk for cash flow hedges?
Under 133, effectiveness tests address the derivative’s ability to offset the gains or losses attributable to the hedged risk. Although hedgers can bifurcate the risk for assessment purposes, when it’s time to record journal entries, the credit risk must be addressed.
Mr. Wilkins indicated that the guidance in the recently issued FAS 133r (the ED is currently on indefinite hold) highlights the acceptable (and perhaps preferred) method of measuring ineffectiveness by attributing the credit features of the derivative to the hedged item.
Asset/Liabilities flip flopping
Under FAS 157, when discounting the fair value of an interest-rate swap to adjust for credit changes, the result can be counterintuitive. In some cases, the credit-related effects on the fair value of a swap may turn a swap asset (using standard market valuation) into a liability (post-credit effect) and vice versa.
This asset/liability flip flop takes place when changes to fair value attributable to changes in the credit of one of the parties not only reduces an asset to zero, but moves it to the other side of the balance sheet.
Both the FASB’s Mr. Wilkins and Mr. Fields, of the SEC indicated they were comfortable with the principle, an approach that one of the attendees labeled as “Mark to Make Believe.”
Looking for bright lines
Finally another recurring theme was the dissonance between the FASB’s efforts to provide principals-based guidance and the push by regulators and the audit firms’ to identify a single correct answer.
All in all it was a stimulating conference and I look forward to chairing the next conference May 14-15 in Washington D.C.