19.2 HISTORICAL BACKGROUND. Prior to FAS 133, U.S. generally accepted ac-
counting principles (GAAP) on derivatives consisted of over 20 years of inconsistent,
incremental, and inadequate attempts at measurement and disclosure. Derivatives
could be accounted for on the basis of historic cost, which was often zero, or fair
value. Foreign exchange (FX) options were allowable hedge instruments, but for-
ward contracts were not. Synthetic instrument accounting reigned unchecked. Seven-
year floating LIBOR-to-fixed interest rate swaps magically transformed a commer-
cial paper portfolio into long-term fixed-rate debt. Derivative gains and losses could
be classified as liabilities and assets, respectively, but were most often entirely ig-
nored. No GAAP existed for commodity hedging.
In June 1998, the FASB issued FAS 133. This controversial pronouncement
adopted the simple premise that foreign exchange, interest rate, and commodity de-
rivatives represent assets and liabilities, and should be recorded as such at their fair
value on the balance sheet. Synthetic instrument accounting—viewing a derivative
hedge and the underlying instrument as one whole instrument—was completely abol-
ished. Instead, all derivative hedges must be documented and proven to be a highly
effective hedge of the underlying hedged position. If not, then any changes in the fair
value of the derivative are to be recorded in current earnings. In addition, while a
hedge may be highly effective, the change in value on the hedge may not fully offset
the change in the hedged underlying, and that difference—hedge ineffectiveness—
must be reported currently into earnings.
For the first time, U.S. GAAP is requiring hedging performance, rather than hedg-
ingintent, as the criterion for evaluating whether deferral accounting of the deriva-
tive gain or loss is appropriate. With FAS 133, deferral hedge accounting is a privi-
lege, not a right, and that privilege must be earned in a rigorous fashion.
As a result, two surveys by the Association for Finance Professionals have shown
that U.S. corporate derivative hedging is now lower than the activity prior to FAS
- “Macro” or portfolio hedges are no longer done. Arguably, the FASB has
achieved its goal of eliminating the speculative, “closet” hedging that existed in the
1990s. No longer can companies speculate and hide derivative losses in the financial
statements to the detriment of the investors who relied upon them.
The original FAS 133 statement was vague in explaining how to determine
whether hedges were highly effective and how any ineffectiveness might be calcu-
lated. To deal with these and other implementation issues, the Derivative Implemen-
tation Group (DIG) was formed, consisting largely of the then Big 5 national office
derivative experts plus some industry representatives. By the spring of 1999, it was
clear that too many issues still needed resolution, FAS 133–compliant systems were
nonexistent, and Y2K was consuming scarce corporate resources. Thus, FAS 137 was
issued in May 1999, postponing the mandatory implementation date for FAS 133 for
one year.
In June 2000, the FASB issued FAS 138, which corrected some obvious deficien-
cies in FAS 133. Consistent with widespread hedging practices, FAS 138 allows the
netting of cash flow FX exposures under certain restricted circumstances as well as
allowing for the first time cross-currency interest rate swap hedging of foreign cur-
rency debt. In addition, FAS 138 modified interest rate hedging, changing it from the
hedging outright interest rate, including the credit spread, to hedging a “benchmark”
interest rate. Eliminating the requirement to account for the credit spread eliminated
a significant source of interest rate hedging ineffectiveness.
19 • 2 FAS 133: ACCOUNTING FOR DERIVATIVE PRODUCTS