SEC Chairman Arthur Levitt and Financial Accounting Standards Board (FASB) Chairman Edmund Jenkins came under political heat recently for pushing for a requirement that corporations mark their derivatives positions to the market and account for gains and losses in their earnings statements.
Both men were yanked into Congress this fall to testify on planned accounting rule changes. Alan Greenspan also got into the act; the Fed chairman wrote the FASB voicing a concern that the rules may be hasty and might have an adverse impact on the capital markets.
The issue is whether corporations should be able to keep derivatives that aren't purely used for hedging purposes off their balance sheets. Companies can use the products to time gains and losses, and thereby smooth their reported earnings per share (EPS).
Wall Street, of course, sells derivatives, but Street firms also are some of the biggest users, along with mortgage lenders and banks. These institutions use derivatives to offset risks on their asset-backed portfolio inventories.
"You saw a simple version of this when IBM bought back its own shares on Tuesday [Oct. 27, just after the Dow fell 554 points]. They now have fewer shares outstanding so their EPS will be greater on whatever they earn-more money will go to fewer shares," says one Wall Street accounting analyst who declined to be identified. "Firms do play with their earnings."
Deborah Harrington, an FASB spokesperson, says the derivative exposure would only show if a hedging strategy the company used didn't exactly match.
"No derivative exposure would be shown on their income statement unless they hedge," says Harrington. "If they are hedging and it perfectly matches [gains to losses], no exposure would be shown. But if there is a gain or loss, it would show up."
Harrington says the rule is intended to alert investors and analysts when a company is trying to manage its earnings. The rules would affect all corporations that use derivatives to hedge.