The FAS 133 Deadline. Why Most Can’t Make It (the way they want).

By Don Mumma and Philip Merrill.

FAS 133 is another attempt by the Securities and Exchange Commission (SEC), working through the Financial Accounting Standards Board (FASB) to reduce surprise financial disasters and the resultant impact on a company’s stock price.

Revolutionary Change in Accounting Treatment

FAS 133 uses earnings volatility as an inducement to implement a stringent disclosure and documentation regime for all companies that use derivatives to hedge business risks. As company’s work through the implementation process they are forced to review using derivatives to mitigate business risks. To get the desired earnings result the board of directors must consider the FAS 133 implementation in relation to the impact on risk management, tax, legal, and technology issues

FAS 133 requires a detailed link between a company’s policy on using derivatives down to the individual derivative transactions which are paired off with an asset, liability, or firm commitment. Once adopted FAS 133 can only be changed by an earnings adjustment. Transition to FAS 133 could involve a significant earnings impact for deferred items under the old accounting rules

What is at stake?

The big risk for most companies is they will have to restate earnings as a result of faulty FAS 133 implementations on audit by the SEC or auditing firm over a year after adoption. Even if they pass the audit, any changes after adoption must go through earnings Adopting FAS 133 will increase a company’s earnings volatility.

Not qualifying for “hedge accounting” means all derivatives go on the balance sheet with changes in value going through earnings. Even with hedge accounting treatment, large portfolios, are subject to an earnings impact caused by changing price relationship between derivative and hedge required to be booked quarterly in earnings. Also, extreme price movements, could break hedge accounting treatment creating the potential for loss on the hedged item and derivative booked in current earnings.

Why are Organizations taking so long?

Many managements have underestimated the impact of FAS 133, so it is stalled in the accounting policy group. Implementations are hard to get organized when the FASB is still making changes to the FAS 133 standard.

Once started, the implementation team may not be working on FAS 133 full time or have full authority to act. There is significant career exposure for team members with little upside benefit. Finally, this is a complex problem involving risk management, operations, tax, legal, and regulatory issues that likely will require review by the board of directors that will further delay the process.

Systems Solutions

The major challenge with the system implication to FAS 133 compliance is the wide range of small options and interpretations available to a company. Even this has been a moving target over the past year. As a result, it is likely that no one system will be able to fully automate all of the processes that are required to handle all of the underlying exposures and all of the hedges and all of the measures that all the users require to comply with the way they all plan to adopt compliance, by the deadline.

Another important issue to the system solution is the implementation resources and effort required by the company and the system vendor ( or IT Department ) to meet the deadline. Think about how long it takes to implement any new functionality in a system and multiply by the number of installations. Divide that by the vender’s simultaneous site implementation resources and you get close to the time when the last user is finished. In the case of IT Departments, the time line goes from spec to development to testing and debugging to implementation.

The big system requirements for any solution are the following:

A. to identify a hedged item as falling under fair value or cash flow treatment;

B. to take sufficient detail of hedged items or hedges for the system to calculate their respective Fair or Net Present Values;

C. to calculate the stand alone Risk Measures and identify the Risk factors of the hedged items and hedges;

D. to calculate the Risk Measures of the hedged item and the hedge on a combined basis; and

E. The ability to track and compare, through time, the changes in Fair or Net Present Value of the hedged item and hedge.

Accounting Systems should be able to perform the tracking function, given the valuation inputs, but the ability to perform prospective risk and mark to market functions is more problematic. Risk Systems, on the other hand, have a better chance of satisfying the risk and mark to market functional requirements.

Making it

When you add everything up, many organizations will not be able to comply with FAS 133 completely the way they want. What are the potential weak spots?

Knowledge

Those who will impact FAS 133 compliance and those who will be impacted need to know what is required. Compliance will impact many parts of an organization, and the key decision makers of the organization need to invest in the time and resources to gain sufficient knowledge of not only the big picture, but also the details. From this knowledge base, a project structure for implementation should be organized and staffed.

Reprinted with the permission of Middle Office Journal