Impact of New Derivative Disclosures on Multinational Firms' Financing Strategies

Financial Accounting Standards Board (FASB) Statement No. 133, issued in 1999, represents the latest attempt to mandate disclosure of derivative transactions in financial statements. FASB 133 requires that all derivatives be recognized as assets or liabilities measured at fair value, and that changes in such values be recognized in current earnings. The unique contribution of this ruling is its recognition of the cash flow impact of hedging activities. This will have far-reaching impact on financing strategies and risk taking behavior multinational firms. The paper examines this impact, as well as a number of serious concerns and problems surrounding its enforceability. INTRODUCTION The purpose of financial accounting is to provide reliable and relevant financial information that is useful to external users such as investors, shareholders, lenders and analysts. Academics, accountants, financial managers and financial analysts have long argued over how to reflect complex financial instruments and transactions, such as derivatives and hedging activities, in financial statements. With the wellpublicized losses from derivatives sustained by financial and non-financial corporations over the past few years, the Financial Accounting Standards Board (FASB) has come under pressure from the Securities & Exchange Commission (SEC) to create new rules that would require reliable and relevant disclosures. As a result, FASB issued FASB 133 "Accounting for Derivative Instruments and Hedging Activities. " It was to become effective in June 1999, however, FASB 137 revised the implementation date to June 2000. FASB 133 establishes accounting and reporting standards for derivative instruments and for hedging activities. It requires that entities recognize all derivatives as assets or liabilities on the balance sheet and measure those instruments at fair value. Changes in the derivative's fair value are to be recognized in the current earnings unless specific hedge accounting criteria are met. The purpose of this paper is to review FASB 133 and assess its impact on multinational corporations' (MNCs') financing strategies. DISCLOSURE FAILURE Disclosure failure can seriously misrepresent the financial condition of MNCs and expose unaware stockholders and investors to huge losses. Recent financial literature is replete with examples of such adverse outcomes, as illustrated by the experience of a major U.S. industrial corporation and a multinational bank based in the United Kingdom. Proctor & Gamble Corporation (P&G) is a large multinational corporation with extensive foreign operations and significant interest rate and foreign currency exposure. In an attempt to manage these risks, P&G negotiated in 1993 with Banker's Trust complex interest and currency swaps that were tied to the German Mark and German interest rate. P&G forecasted that the deutsche mark swap rates would stay between 4.05% and 6.10% and that U.S. and German interest rates would not increase significantly. In April 1994, P&G was forced to disclose that they had experienced a $157 million pretax loss as a result of these transactions. Interest and currency exchange rates had moved opposite to P&G's forecasts, forcing them to borrow at 1,412 basis points above the commercial paper rate (Chance, 1998). Barings PLC, a British investment bank founded in 1763, declared bankruptcy in 1995 after sustaining heavy losses in Nikkei index futures positions. Nick Leeson, a relatively junior official in the bank's Singapore office, speculated regularly by taking long positions in the index futures. As Japanese equities continued to decline in the early 1990's, Mr. Leeson considerably multiplied his long position, and used a special account to conceal his losses. On January 17, 1995, Kobe, Japan experienced a major earthquake and the Japanese stock market fell about 13% over the following five weeks. Leeson generated very large losses, and yet considerably increased his long positions in an attempt to recoup his previous losses. …