February 21, 2003

 

Ms. Vickie Lusniak
Assistant Project Manager
Financial Accounting Standards Board
401 Merritt 7
P. O. Box 5116
Norwalk, CT 06856-5116

 

Re: Fatal Flaw Review-Statement of Financial Accounting Standards No. 150, Amendment of Statement 133 on Derivative Instruments and Hedging Activities.

 

Dear Ms. Lusniak:

 

The Financial Accounting Policy Committee (FAPC) of the Association for Investment Management and Research (AIMR)¹ is pleased to comment on the Financial Accounting Standards Board's (FASB) Fatal Flaw Review of Statement of Financial Accounting Standards No. 150, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The FAPC is a standing committee of AIMR charged both with maintaining liaison with standard setters who develop financial accounting standards and regulate financial statement disclosures and with responding to new regulatory initiatives. The FAPC also maintains contact with professional, academic, and other organizations interested in financial reporting.

 

Specific Comments

 

1. Paragraph 8, Initial Net Investment-We believe that the shift in emphasis of the definition to the term "nominal amount," where nominal amount is defined in the footnote as "insignificantly small or trifling," is a useful clarification and improvement.
   
   
2. Paragraph 10a, "Regular-way" security trades-We are concerned with the emphasis on the "trade-date basis" for settlement. Instruments settled on this basis are presumably cash instruments that would not need the exception. Consequently, we are uncertain of the Board's objective or intent for adding the language regarding trade date transactions. We believe that the emphasis should be on the normal settlement period in that market. That is, any contracts with terms other than the usual and normal settlement terms for that market and that, for example, extend the settlement period would not constitute regular-way security trades.
   
   
3. Paragraph 10b(4), Power purchase or sales agreement-We disagree strongly with the insertion of a provision that serves the interests of a single industry to the exclusion of similar practices in other industries. Excess capacity contracts are not unique to the electricity, oil, and gas industries associated with power generation. Indeed, such practices are found in a wide spectrum of businesses from consumer products manufacturing to non-utility service industries. If a sound theoretical basis exists for providing special treatment for capacity contracts, then presumably this provision should apply to all industries that write similar contracts for industrial production and delivery. If such a theoretical basis cannot be demonstrated, then the provision should not be made for any single industry.
   
   
4. Paragraph 10d, Certain financial guarantee contracts-We are concerned that this section excludes certain financial guarantee contracts from the provisions of this standard but does not provide reference to other current standards that require disclosure of these commitments, or to future standards in progress that would fulfill statement users' needs for this information. We note that other sections of the amendments clarify where one should look for the guidance on contracts that are excluded from the provisions of Statement 133.
   
   
5. Paragraph 11d, "Forward contracts that require settlement by the reporting entity's delivery of cash in exchange for the acquisition of a fixed number of its equity shares (forward contracts for the reporting entity's shares that require physical settlement)…"-We do not understand clearly why this exclusion is provided. If these contracts are not marked-to-market then we would understand this to be a clarifying scope exception. However, if these contracts are marked-to-market, then we fail to understand the reason for excluding them. We have not yet seen the final full text of Statement 149. The FASB Website states "…the liability should initially be measured by the issuer of the shares at the present value of the amount to be paid at settlement." [Emphasis added] However, this does not address our concern nor clarify for us the subsequent measurement requirements for that liability.
   
   
6. Paragraph 30d, "…If an option contract is used as the hedging instrument in a cash flow hedge…"-We are disturbed to find that the amendments provide for historical cost amortization of the option premium in a statement based firmly in fair value measurement concepts. We realize that this may have been proposed as a practical expedient to cope with difficulties arising from the infirmities of the cash flow hedge model in general, a model that is a hybrid between fair value and historical cost. However, we have not supported the G20 distortions to the Statement 133 model as we indicated in our comment letter. We are concerned that this additional alternative treatment that would extend amortization only for options used as cash flow hedges. We note that paragraph 236 criticized the pre-Statement 133 accounting because the guidance for derivative instruments was inconsistent and differed depending on what instrument was used. Paragraph 238 said that those problems were mitigated by Statement 133. In addition, this provision grants the preparer the sole discretion to elect whether an FX hedge will be accounted for as a fair value hedge or a cash flow hedge and receive substantially different treatment of the premium. We believe that this adds needless complexity and confusion to an already difficult problem. For example, this provision also leaves full discretion to the preparer to decide how to amortize the premium. We are not clear about what would constitute a "rational basis" for amortization.
   
   We would propose that the premium be treated according to the fair value concepts upon which Statement 133 is based. If that is not achievable politically, we would propose that the premium be expensed at inception without regard to whether the instrument was a cash flow hedge or a fair value hedge. However, our preference is that, consistent with Statement 133's basis for conclusion, the instrument should be measured and recognized at fair value instead of electively carrying over past historical cost practices for such instruments.
   
   
7. Paragraph 45A, Reporting Cash Flows of Derivative Instruments That Contain Financing Elements-We believe that a clarification needs to be made for the lender's accounting for such transactions in the cash flow statement. Specifically, should the lender report these transactions as part of operating cash flows or investing?
   
   
8. The amendments to Statement 133 do not provide for the disclosures essential to an understanding of the reporting for derivatives. Many needed disclosures were proposed in the Exposure Draft for Statement 133, but disappeared in the final Statement. Now, we find that additional options are being provided to preparers, with no required discussion of which method has been selected or applied. The net result is that investors and other users of the statements will not be able to understand the economic effects of the company's hedging activities.

   For example, assume a company has two derivatives only. One is a fair value hedge of a fixed interest rate exposure. We are

   (a) unable to determine the change in the fair value of the hedging instrument that is being captured on the balance sheet;
   (b) unable to distinguish the value changes in hedging derivatives from those for non-hedging derivatives; and
   (c) unable to determine whether a company is applying an effective interest rate to the revised carrying value of the fixed rate exposure at the inception of the hedge or only when the hedge has terminated.

   This can create a disconnect between the discussion of the hedge objectives and the effects that are actually reported in the income statement.

   The absence of roll-forwards of AOCI on a quarterly basis precludes us from ever determining the amount of cash flow hedging gains or losses that arose in the period or that were reclassified into earnings in the period.

   We urge the FASB to address these extensive disclosure deficiencies.

 

Concluding Remarks

 

The Financial Accounting Policy Committee appreciates the opportunity to respond to the Fatal Flaw Review-Statement of Financial Accounting Standards No. 150, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. If the Board or staff have questions or seek amplification of our views, please contact Rebecca McEnally at 1-434-951-5319 or at rebecca.mcenally@cfainstitute.org. We would be pleased to answer any questions or provide additional information you might request.

 

Respectfully yours,

 

Jane Adams Chair, Financial Accounting Policy Committee

Rebecca McEnally, Ph.D., CFA Vice-President, Advocacy, AIMR

 

¹ With headquarters in Charlottesville, VA, and regional offices in Hong Kong and London, the Association for Investment Management and Research is a non-profit professional organization of 61,000 financial analysts, portfolio managers, and other investment professionals in 113 countries of which 48,800 are holders of the Chartered Financial Analyst (CFA ) designation. AIMR's membership also includes 118 affiliated societies and chapters in 29 countries. AIMR is internationally renowned for its rigorous CFA curriculum and examination program, which had more than 100,000 candidates from 143 nations enrolled for the June 2002 exam.