FASB 133
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Statements of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, commonly known as FAS 133, is an accounting standard issued in January 2001 by the Financial Accounting Standards Board (FASB) that provides companies with the ability to measure all assets and liabilities on their balance sheet at “fair value”. This standard was created in response to significant hedging losses involving derivatives years ago and the attempt to control and manage corporate hedging as risk management not earnings management.
All derivatives must be recorded at fair value as an asset or liability. A derivative that qualifies as a hedge, basically matches gains and losses in the value of the derivative with gains and losses in the value of the underlying transaction.
To be designated and qualify for FAS 133 hedge accounting, a commodity must have a hedging relationship with a highly effective correlation ratio between 80% and 125%. If the derivative commodity does not meet these criteria, the hedging derivative would be considered ineffective and designated to be marked-to-market (MTM) in the companies’ earnings. This ineffectiveness and re-designation can lead to significant volatility in corporate earnings. Now, the financial community has had enough experience with FAS 133 that companies and constituents better understand this process and are less critical of the volatile impact on earnings.
Creating forward commodity values to determine correlation, required by FAS 133, is not perfect due to the nature of different OTC derivative commodities and the fact that they are not quoted in exchanges like NYMEX and ICE. Many companies outsource this data collection to insure that industry methods and standards are achieved. As important as FASB 133 is in risk management and hedging, this reporting system has limited some creative hedges solely based on the potential negative impact on the companies’ earnings.
