Speech by SEC Staff:
2003 Thirty-First AICPA National Conference on Current SEC Developments
John M. James
Professional Accounting Fellow, Office of the Chief Accountant
U.S. Securities and Exchange Commission
December 11, 2003
As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
The staff has dealt with a variety of registrant and standard-setting issues over the past year. I would like to share with you our views on a number of these issues including those on: (1) the continued emphasis on the appropriate hedge documentation and designation under FASB Statement No. 1331, (2) the interaction between DIG Issue No. B62 and EITF Issue No. 02-33, and (3) the scope of EITF Issue No. 99-20.4
Hedge Documentation and Designation under Statement 133
I would like to take the next few minutes to talk about an issue that has been addressed in previous conferences, but deserves a few words here this year as a reminder. Yes, - I am going to talk about hedge documentation and designation under Statement 133.
But before I do that, let me make an observation about Statement 133. Many have complained that Statement 133 is not a principles-based standard and that its rules are too complex to follow. However, the principle in Statement 133 is fairly straightforward in that derivatives should be recorded on the balance sheet at fair value with changes in fair value reported in earnings. The complexity is mostly associated with achieving hedge accounting, which is optional under Statement 133. Thus, in order to achieve hedge accounting, the Board concluded that entities would be required to meet certain requirements at the inception of the hedging relationship and on an ongoing basis. These requirements include: contemporaneous designation and documentation of the hedging relationship, the entity's risk management objective and strategy for undertaking the hedge - including, identification of the hedging instrument, the hedged item, the nature of the risk being hedged and how effectiveness will be assessed and measured. Additionally, Statement 133 requires an entity to perform a hedge effectiveness assessment at both the inception of the hedge and on an ongoing basis as support for the assertion that the hedging relationship is expected to be (or was) highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the designated hedging period.
Those are the requirements. They were pretty well understood in and around the adoption date of Statement 133; however, as commonly happens as a standard matures, the staff has recently observed situations of "sloppy" documentation and aggressive interpretations of Statement 133's hedge accounting guidance.
One area of concern relates to compliance with Statement 133's requirement that, at the time an entity designates a hedging relationship, it must define and document the method it will use to assess the hedge's effectiveness. Let me focus specifically on the method part of this requirement. The staff has noted that some registrants have interpreted "method" more broadly than we believe was intended.
For example, the staff has noted situations where registrants have specified and documented at the inception of the hedge a series of tests (e.g., a series of three different assessments) that would be considered when determining whether the hedging relationship was highly effective on a retrospective basis. These tests may have included a series of dollar-offset assessments and/or other statistical analyses, using different hedge periods, which were devised to better ensure that the hedge would be deemed to be highly effective in situations where unexpected movements in the fair value of the hedged item or hedging instrument may have caused a disruption of hedge accounting. Accordingly, if any one of these tests indicated that the hedge was highly effective for the past period, registrants employing this method concluded that hedge accounting could continue for that period.
The staff does not believe that this approach is consistent with the criteria in Statement 133, as outlined in paragraph 62 of that standard and DIG Issue No. E75, since more than one method was being used to assess hedge effectiveness. Additionally, the staff has noted situations where the designated hedge period did not coincide with the rebalancing of the hedge portfolio. For example, the staff would object to a documented hedge period of either monthly or quarterly when the hedge is being rebalanced either on a daily or weekly basis. In this situation, the staff believes that the designated hedge period should coincide with the rebalancing of the hedge.
Still on the topic of the method used to assess hedge effectiveness, I would like to highlight another area of recent concern. Specifically, the staff has noted instances where registrants have utilized statistical techniques to assess hedge effectiveness, such as regression analysis, but did not have sufficient experience with or understanding of such techniques to apply them in an appropriate manner. The use of regression analysis is not problematic. What is problematic is when regression analysis is used and the statistical validity of such analysis is not adequately considered. Specifically, the staff is aware of situations where certain registrants have not fully considered the relevant outputs from the regression analysis when assessing whether the hedge is expected to be highly effective. The staff acknowledges that the assessment of whether a hedging relationship is expected to be highly effective will be determined based on the facts and circumstances of that specific relationship. However, the staff believes that, at a minimum, certain regression outputs such as the coefficient of determination (R-squared), the slope coefficient and the t or F-statistic should be considered when using regression analysis to assess whether a hedge is expected to be highly effective. Additionally, depending on the specifics of the hedging strategy, other regression outputs may also need to be considered. The staff expects that if registrants are utilizing statistical techniques to assess hedge effectiveness that they understand how to use and appropriately evaluate such techniques, which may necessitate the use of specialists.
While I have shared some fairly specific observations regarding the staff's recent concerns in the area of hedge documentation, let me conclude my remarks on this subject simply by saying --- don't get sloppy or inappropriately aggressive with your application of Statement 133's requirements. They are there for a purpose and the staff remains interested in how they are being met.
Interaction between DIG B6 and EITF Issue No. 02-3
I would like to spend a few minutes discussing the interaction between DIG Issue No. B6 ("DIG B6") and EITF Issue No. 02-3 ("Issue 02-3").
DIG B6 discusses how an embedded derivative should be bifurcated from a hybrid instrument when separate accounting for the embedded derivative is required. Statement 133 requires that an embedded derivative that is separated from its host contract be reported at fair value. The DIG concluded that the allocation method should result in the bifurcated derivative being reported at its fair value with the difference between the basis of the hybrid instrument and the fair value of the embedded derivative being recorded as the host contract. That is, an entity should use a "with and without" method based on the fair value of the embedded derivative. The clear intent of applying a "with and without" method in this manner is to avoid the recognition of an immediate gain or loss that would occur if the relative fair value method were used.
In Issue 02-3, the FASB staff expressed the view that an entity should not recognize an unrealized gain or loss at inception of a derivative instrument unless the fair value of that instrument is obtained from a quoted market price in an active market or is otherwise evidenced by comparison to other observable current market transactions or based on a valuation technique incorporating observable market data. Thus, under Issue 02-3, an entity may recognize dealer profit at the inception of the contract if the fair value is supported by a quoted market price, other current observable market transactions or other observable market data. For example, assume that a bank writes an option contract (on a standalone basis) and receives a premium of $5 from the customer. Simultaneously, the bank then hedges out the entire risk from the contract in the marketplace at a cost of $4. Under Issue 02-3, the fair value of the contract would be determined to be $4 and the bank would recognize $1 as dealer profit.
Now let's change the fact pattern slightly and incorporate the embedded derivative discussion. Assume that a bank issued a structured note to a customer that included an embedded derivative that would be required to be bifurcated pursuant to Statement 133 and that the embedded derivative in the structured note is the same as the written option previously discussed in the standalone derivative example. Under GAAP, non-derivative financial instrument liabilities are carried at historical/amortized cost except where specifically allowed under the literature. In this instance, the structured note is not carried at fair value. The proceeds received by the bank from the customer for issuing the structured note were $100. When bifurcating out the embedded derivative, the bank recorded the embedded derivative at $4, the structured note (i.e., the host contract) at $95 and a day one gain of $1 since the entire risk of the embedded derivative contract could be (or was) hedged in the market place at a cost of $4. In reaching this conclusion, the bank believed that the answer should be the same regardless of whether the derivative was issued on a standalone basis and accounted for under Issue 02-3 or embedded in a hybrid contract and accounted for under DIG B6.
The staff objected to the proposed accounting as we do not believe that DIG B6 supports the notion of recording a day one gain when bifurcating an embedded derivative from a host contract. As previously stated, DIG B6 uses a "with and without" approach in allocating value between the embedded derivative and the host contract, with the embedded derivative being recorded at its fair value. It does not include any notion that provides for recognition of a dealer profit or day one gain. In the example previously discussed, the fair value of the standalone derivative was determined to be $4 based on the fact that it could be hedged in the marketplace at that price. Accordingly, given this example, the staff believes that the derivative should be recorded at its fair value of $4 and the structured note (i.e., the host contract) recorded at $96. This conclusion effectively results in the day one gain, if it exists, being embedded in the host contract and amortized as a yield adjustment over the life of the host contract.
Scope of EITF Issue No. 99-20
During the course of this year, the EITF and a related working group have devoted a substantial amount of attention developing a model for assessing when an other-than-temporary impairment of debt and equity securities should be recognized. Those discussions continue.
While we wait for that model to be finalized, registrants and auditors are reminded that they should still look to the applicable guidance contained in Statement 115, the Statement 115 Implementation Guide, Staff Accounting Bulletin Topic 5-M, and Statement on Auditing Standards No. 92 in assessing when an other-than-temporary impairment of debt and equity securities should be recognized.
In addition, registrants are reminded that if the debt security falls within the scope of EITF Issue No. 99-20 ("Issue 99-20"), the impairment and income recognition guidance of that consensus should be applied. In this regard, it has recently been brought to the staff's attention that there may be some confusion on how to apply one element of the scope guidance of that issue. Paragraph 5(e) of Issue 99-20 provides a scope exclusion for "beneficial interests in securitized financial assets that
(1) are of high credit quality (for example, guaranteed by the U.S. government, its agencies, or other creditworthy guarantors, and loans or securities sufficiently collateralized to ensure that the possibility of credit loss is remote) and
(2) cannot contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment."
The confusion centers around the determination of whether the beneficial interest is of "high credit quality". The Task Force did not provide any specific guidance on how to assess "high credit quality" beyond that contained in the short parenthetical in the issue summary.
The parenthetical language was intended to exclude beneficial interests from the scope of the consensus that were of such high credit quality that the impairment and income recognition guidance of the consensus would lead to counterintuitive financial reporting results if applied. For instance, the parenthetical language would exclude from the scope of Issue 99-20 most beneficial interests that are issued by or contain the guarantee of a government agency or a government-sponsored entity.
We understand that some registrants have asserted that any investment grade beneficial interest (for example, BBB or better based on an S&P credit rating system) is deemed to be of "high credit quality" for purposes of ascertaining whether the first part of the scope exception in paragraph 5(e) applies. However, given the language in the parenthetical, it appears that the EITF only intended to exclude those beneficial interests where the likelihood of loss was remote. Based on reference to the rating definitions used by the rating agencies, the staff noted that an AA rating is defined as "the obligor's capacity to meet its financial commitment on the obligation is very strong" which appears to be consistent with the intent of the Task Force when using the "high credit quality" terminology. The staff also notes that the rating definition for an investment grade rating of BBB is that of an "obligation that exhibits adequate protection parameters but that which under adverse economic conditions or changing circumstances is likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation." The staff believes that an investment grade rating of BBB is not consistent with the intent of the Task Force when using the "high credit quality" terminology. Accordingly, the staff believes that only beneficial interests rated 'AA' or better should be deemed to be of "high credit quality" for purposes of applying the scope language of Issue 99-20.