FAS 133: increasing transparency

Standard & Poor’s Jack Kennedy and Neri Bukspan believe new Financial Accounting Standards Board rules for US energy traders will make it easier to measure a firm’s risk management ability, liquidity position and equity capital

Having analysed the October 25, 2002 Emerging Issues Task Force (EITF) ruling on derivative accounting, Standard & Poor’s analysis has initially determined that the decision would have minimal effect on the credit profiles of US energy trading and marketing firms.

The EITF is a group within the US’s Financial Accounting Standards Board (FASB) and sets standards on emerging topics. As part of the task force’s deliberation of EITF Issue 02-3: Accounting for Contracts Involved in Energy Trading and Risk Management Activities, it withdrew the previous consensus reached in EITF Issue 98-10: Accounting for Contracts Involved in Energy Trading and Risk Management Activities.

Released in 1998, Issue 98-10 required energy traders to use mark-to-market (MtM) accounting to account for physically settled contracts. As a result of the consensus on Issue 02-3 and the withdrawal of Issue 98-10, only transactions complying with the definition of a derivative under FASB Statement 133: Accounting for Derivative Instruments and Hedging Activities (FAS 133) will be carried on the books at fair value.

Essentially, the new ruling will curtail the types of trade, such as tolling arrangements, that can be valued using non-standard methodologies or, to put it another way, non-market quotes. As of October 25 – for new transactions and in fiscal periods starting after December 15, 2002 for pre-existing transactions – these physically settled transactions must be accounted for using accrual accounting – even by broker-dealers that account for financial information at fair value. Firms can adopt the new rules earlier, provided that financial statements are not yet issued for the period.

Importantly, the effect of fair-value hedges on earnings – those transactions qualifying under FAS 133 – are non-cash in nature, and therefore will not affect cashflow. As a result, the new ruling will mostly affect the evaluation of a firm’s book equity layer and leverage ratios because the value of transactions related to those elements is recognised as a component of accumulated comprehensive income. Comprehensive income is the outgrowth of fair-value accounting. It is the account within the equity section where unrealised gains and losses appear on a balance sheet.

In another significant decision, Issue 02-3 requires all gains or losses (realised and unrealised) on energy trading derivatives (physically and non-physically settled) to be reported on a net basis in the income statement. Prior to that decision, certain trades were reported gross and, at times, the gross reporting basis created an incentive for multiple ‘round-trip’ trades. Although this change will not affect net income or earnings-per-share amounts, it will reduce, by the same amount, the gross reported earnings and the related costs.

The FASB established accounting and reporting standards for derivative instruments and hedging activities under FAS 133. Generally, FAS 133 added all derivative contracts onto the balance sheet as an asset or liability, established definitions for certain types of hedges and determined whether such hedges are to be reported under earnings or comprehensive income.

The effect of hedges that fit the ‘fair-value’ definition showed up in earnings. The impact of derivatives defined as ‘cashflow’ hedges showed up in comprehensive income, under equity on the balance sheet. As cashflow hedges mature, the current portion becomes a fair-value hedge and flows through earnings.

Derivatives used for hedging strategies are generally defined as cashflow hedges. Hence, any gain or loss associated with a contract’s value would increase or decrease comprehensive income, thereby affecting equity. S&P’s analysis of these firms has taken into account any increase or decrease in comprehensive income due to FAS 133.

This approach reinforces the importance of cashflow when assessing a firm’s ability to meet its fixed payment obligations. Standard & Poor’s overall view of FAS 133 is that it may erode access to capital markets due to lower book equity levels. However, cashflow coverage is unlikely to be affected.

From an energy trading and marketing point of view, the effect of FAS 133 reflects the level of success or failure of a risk management strategy. FAS 133 gives insight into the effectiveness of a firm’s use of derivatives that would increase comprehensive income. This insight is due to the gain – or positive MtM value (where the assets from risk management activities are worth more than the respective liabilities account) – increasing comprehensive income and, therefore, equity. The net effect is that capital structure appears stronger, which artificially strengthens a firm’s financial profile. Obviously, a loss – where liabilities are greater than assets – will reduce a firm’s equity layer.

From a risk management perspective, the control process should effectively measure current exposure, forecast potential future exposure and account for financial repercussions due to counterparty defaults. FAS 133 accounting compels energy trading and marketing firms to disclose the derivative instruments and their fair value that are used to mitigate risks. Hence, FAS 133 provides increased transparency in respect of a firm’s prowess in risk management, its liquidity position and its equity capital.

John Kennedy is an analyst at rating agency Standard & Poor’s in New York
e-mail: john_kennedy@sandp.com

Neri Bukspan is chief accountant at S&P
e-mail: neri_bukspan@sandp.com

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