STATEMENTS OF LESLIE F. SEIDMAN, MEMBER, FINANCIAL ACCOUNTING STANDARDS BOARD; MARTIN F. BAUMANN, EXECUTIVE VICE PRESIDENT, CHIEF FINANCIAL OFFICER, FREDDIE MAC; PETER J. WALLISON, RESIDENT FELLOW, AMERICAN ENTERPRISE INSTITUTE; AND THOMAS J. LINSMEIER, RUSSELL E. PALMER ENDOWED PROFESSOR AND CHAIRPERSON, DEPARTMENT OF ACCOUNTING AND INFORMATION SYSTEMS, ELI BROAD COLLEGE OF BUSINESS, MICHIGAN STATE UNIVERSITY

Ms. SEIDMAN. Thank you. I am Leslie F. Seidman, a Member of the Financial Accounting Standards Board. I am pleased to appear before you today on behalf of the FASB. I have brief prepared remarks, and I would respectfully request that the full text of my testimony and all supporting materials be entered into the public record.

Mr. STEARNS. By unanimous consent, so ordered.

Ms. SEIDMAN. The FASB is an independent private-sector organization subject to oversight by the United States Securities and Exchange Commission. Our independence from enterprises, auditors, and other constituents is fundamental to achieving our missionto establish and improve standards of financial accounting and reporting for both public and private enterprises. Those standards are essential to the efficient functioning of the capital markets and the U.S. economy because investors and other users of financial reports rely heavily on credible, transparent, comparable, and unbiased financial information to make rational resource allocation decisions.

Beginning in the 1980's and continuing in the 1990's, as the use and the complexity of derivatives and hedging activities grew rapidly, many investors, creditors, and other users of financial statements were surprised and concerned by large unexpected losses on derivatives that were reported by several enterprises that had previously provided little if any information about those contracts in their financial reports.

Members of Congress, the SEC, the GAO, and the AICPA, as well as many investors, creditors, and other users of financial reports urged the FASB to develop and issue a standard that would provide comprehensive accounting requirements for derivatives and related hedging activities.

At the time, the existing standards applicable to the accounting for derivatives and hedging were incomplete. There were no specific standards for many types of derivatives and hedging activities. Where standards did exist, they were inconsistent. Where they did not exist, the practices that had developed varied widely. As a result, the financial statements of enterprises that used derivatives did not report their derivative and hedging activities in a way that users of those financial statements could compare or understand. Following an extensive and open due process, described more fully in the full text of my testimony, in 1998, the FASB issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities.

Statement 133 requires that an enterprise report all of its derivatives as either assets or liabilities on the face of its financial statements and measure those instruments at their fair value.

Statement 133 also generally requires that any changes in the fair value of derivatives, or derivative gains or losses, be reported in the enterprise's earnings in the period of the change.

If, however, certain conditions are met, an enterprise may specifically designate a derivative as a hedge of a related item and receive special accounting for the combination of the derivative and the related item.

Hedge accounting reflects an entity's intended strategy between two separate items. Rather than applying the applicable standards to each component of the strategy, hedge accounting allows the entity to recognize the gains or losses on the derivative in the same period as the income statement effect of the hedged item. Entities engaged in risk management activities desire hedge accounting so that the income statement reflects the effect of their hedging strategies in the same period as the item being hedged. Because hedge accounting defers recognition of gains and losses on derivatives, numerous restrictive conditions must be met at the outset of the transaction and over the life of the transaction; these are called hedge criteria. The criteria differ, depending on the nature of the risk being hedged.

In general, a derivative may be specifically designated as a hedge of the exposure to changes in the fair value of an asset or liability, a fair value hedge, or as a hedge of the exposure to variable cashflows of a forecasted transaction, a cash-flow hedge. The accounting for changes in the fair value, or the gains or losses, of the derivative differs depending on that designation.

For a derivative designated as hedging the exposure to changes in the fair value or price of an asset or liability, the gain or loss on the derivative is recognized in earnings in the period of change together with the offsetting loss or gain on the hedge item attributable to the risk being hedged. An example of a fair value hedge is the use of an interest rate swap to change the interest rate risk on a fixed-rate bond from fixed to floating. In a perfect hedge, hedge accounting will show net interest expense at the new floating rate. However, if the hedge is not perfect, the differences are required to be reported in earnings and, thus, are transparent to investors.

For a derivative designated as hedging the exposure to variable cash-flows of a forecasted transaction, the gain or loss on the derivative is initially deferred in a balance sheet account to the extent that the hedge is effective; the gain or loss is subsequently reclassified into earnings in the period that the related forecasted transaction affects earnings. An example of a cash-flow hedge is the use of an interest rate swap to change the risk profile on a floating-rate loan-the swap serves to lock in the interest cash-flows associated with the transaction. In a perfect hedge, hedge accounting will show net interest income at the new fixed rate. To the extent that the swap is not effective in offsetting the floating cash-flows on the loan, any ineffectiveness is reported in earnings immediately and separately disclosed.

An enterprise that elects to apply special hedge accounting is required to identify and document at the inception of the hedge (1) the specific items that are being hedged and the entity's risk management strategy; (2) the method it will use for assessing the effec

tiveness of the hedging derivative, and (3) the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's overall risk management approach.

At the time Statement 133 was issued, the Board established a Derivatives Implementation Group of outside experts to assist the FASB in evaluating questions that companies might face as they began implementing the statement. More than 150 constituent questions have been answered through that effort.

In April 2003, the FASB issued an amendment to Statement 133 to clarify the scope of the statement and codify several issues that had been identified and resolved as part of the DOG process.

Consistent with its mission and Rules of Procedure, the FASB stands ready to consider any additional guidance or potential improvements to the accounting for derivatives and hedging activities. Thank you, Mr. Chairman. I would be happy to respond to any questions.

[The prepared statement of Leslie F. Seidman follows:]

PREPARED STATEMENT OF LESLIE F. SEIDMAN, FINANCIAL ACCOUNTING STANDARDS

BOARD

Chairman Stearns, Ranking Member Schakowsky, and Members of the Subcommittee: I am Leslie F. Seidman, a Member of the Financial Accounting Standards Board ("FASB" or "Board"). I am pleased to appear before you today on behalf of the FASB. My testimony includes a brief overview of (1) the FASB, (2) derivatives and hedging activities, (3) the basis for the Board's decision to develop and issue Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (“Statement 133"), (4) the process the Board followed in developing Statement 133, (5) some of the key requirements of Statement 133, and (6) how the FASB has responded to requests for additional guidance and other improvements to Statement 133.

THE FASB

The FASB is an independent private-sector organization.1 Our independence from enterprises, auditors, and other constituents is fundamental to achieving our mission-to establish and improve standards of financial accounting and reporting for both public and private enterprises.2 Those standards are essential to the efficient functioning of the capital markets and the United States ("US") economy because investors and other users of financial reports rely heavily on credible, transparent, comparable, and unbiased financial information to make rational resource allocation decisions.

The FASB's independence, the importance of which was recently reaffirmed by the Sarbanes-Oxley Act of 2002 ("Act"),3 is fundamental to our mission because our work is technical in nature, designed to provide investors and the capital markets with the most accurate possible yardstick to measure and report on the underlying economic transactions of business enterprises. Like investors, Congress and other policy makers need an independent FASB to maintain the integrity of a properly designed yardstick in order to obtain the financial information necessary to appropriately assess and implement the public policies they favor. While bending the yardstick to favor a particular outcome may seem attractive to some in the short run, in the long run an inaccurate yardstick (or a biased accounting standard) is harmful to investors, the capital markets, and the US economy.

The FASB's authority with respect to public enterprises comes from the US Securities and Exchange Commission ("SEC"). The SEC has the statutory authority to establish financial accounting and reporting standards for publicly held enterprises. For 30 years, the SEC has looked to the FASB for leadership in establishing and

See Attachment 1 for information about the Financial Accounting Standards Board.

2 See Attachment 2 for a discussion of the importance of the FASB's independence and neutral accounting standards.

3 Sarbanes-Oxley Act of 2002, Public Law Number 107-204, Sections 108-109 (July 30, 2002).

improving those standards. The SEC recently issued a Policy Statement reaffirming this longstanding relationship.4

The Policy Statement, consistent with the language and intent of the Act,5 also reemphasizes the importance of the FASB's independence described earlier. It

states:

By virtue of today's Commission determination, the FASB will continue its role as the preeminent_accounting standard setter in the private sector. In performing this role, the FASB must use independent judgment in setting standards and should not be constrained in its exploration and discussion of issues. This is necessary to ensure that the standards developed are free from bias and have the maximum credibility in the business and investing communities." The SEC, together with the private-sector Financial Accounting Foundation,7 maintains active oversight of the FASB's activities.

The FASB has no power to enforce its standards. Responsibility for ensuring that financial reports comply with accounting standards rests with the officers and directors of the reporting enterprise, with the auditors of the financial statements, and for public enterprises, ultimately with the SEC.

WHAT ARE DERIVATIVES AND HEDGING ACTIVITIES?

In general, a derivative is a contract between two or more parties that involves little or no up-front exchange of assets. The contract obligates one party to give up cash (or other assets) at some later date and entitles the other party to receive the cash. The amount of cash to be exchanged is often derived from two factors specified in the contract. Those factors are commonly referred to as the "underlying" and the "notional amount."

The underlying is a variable-usually a price index, an interest rate or interest rate index, a foreign exchange rate, or the price of a financial instrument or commodity. The notional amount is an amount of currency or a physical quantity (for example, a number of bushels or pounds). The product of the two (the underlying times the notional amount) determines the amount of cash to be exchanged. Some common examples of derivatives are options, swaps, forward contracts, and futures contracts.

Enterprises may use derivatives to hedge against or offset adverse changes in price or changes in cash flows. Derivatives also are used to seek extra returns, which is a form of speculation. Of course, a derivative usually is a two-edged sword. Many derivatives offer as much potential for loss as for gain.

WHAT WAS THE BASIS FOR THE BOARD'S DECISION TO DEVELOP AND ISSUE STATEMENT 133?

Beginning in the 1980s and continuing in the 1990s, as the use and the complexity of derivatives and hedging activities grew rapidly, many investors, creditors, and other users of financial statements were surprised and concerned by large unexpected losses on derivatives that were reported by several enterprises that had previously provided little if any information about those contracts in their financial reports.

Members of Congress, the SEC, the General Accounting Office, the American Institute of Certified Public Accountants, and many investors, creditors, and other users of financial reports urged the FASB to develop and issue a standard that would provide comprehensive accounting requirements for derivatives and related hedging activities.

At the time, the existing standards applicable to the accounting and reporting for derivatives and hedging activities were incomplete. There were no specific standards for many types of derivatives and hedging activities. Where standards did exist, they were inconsistent. Where they did not exist, the practices that had developed varied widely. As a result, the financial statements of enterprises that used deriva

4 Policy Statement: Reaffirming the Status of the FASB as a Designated Private-Sector Standard Setter, Exchange Act Release Nos. 33-8221; 34-47743; IC-26028; FR-70 (April 28, 2003).

5 Sections 108-109; The legislative history of the Sarbanes-Oxley Act of 2002 is clear that the provisions of the Act relating to the FASB were intended to "strengthen the independence of the FASB... from... companies whose financial statements must conform to FASB's rules." Senate Report 107-205, 107th Congress, 2d Session (July 3, 2002), page 13.

6 Page 5 of 8.

7 See Attachment 1 for information about the Financial Accounting Foundation.

8 United States General Accounting Office, Report to Congressional Requesters, Financial Derivatives: Actions Needed to Protect the Financial System (May 1994).

"AICPA Special Committee on Financial Reporting, Improving Business Reporting-A Cus tomer Focus (December 1994).

tives did not report their derivative and hedging activities in a way that users of those financial statements could compare or understand.

Many enterprises reported only the current cash payments or receipts on their derivatives. For example, enterprises that were users of interest rate swaps usually reported only the amount of the next payment or receipt on the contract. Reporting only the next payment or receipt did not accurately represent the financial position of the users of the swap. If interest rates changed significantly following the initiation of the swap, one party could be expected to make relatively large future payments and the other could be expected to receive those payments. One party had an unrecorded asset and the other had an unrecorded liability.

Some of the other results of the incomplete and inconsistent accounting for derivatives were:

• Different enterprises reported very similar derivative activities differently, and even an individual enterprise could report similar activities differently.

• Gains and losses on derivatives used to hedge risks often were reported as liabilities and assets, rather than as income or expenses in the enterprise's income statement. Reporting an actual loss as an asset or a gain as a liability was misleading to the users of the financial statements.

WHAT PROCESS DID THE FASB FOLLOW IN DEVELOPING STATEMENT 133? Because the actions of the FASB affect so many organizations, its decision-making process must be fair. The FASB carefully considers the views of all interested parties-users, issuers, and auditors of financial information. Our Rules of Procedure require an extensive due process. It involves public meetings, public hearings or roundtables, and exposure of our proposed standards to external scrutiny and public comment. The Board makes final decisions after carefully considering and analyzing the input of all parties. While this process is similar to the Administrative Procedure Act process used for federal agency rulemaking, it provides far greater opportunities for interaction with the Board by interested parties. It is also focused on making technical, rather than political or legal judgments.

Some of the highlights of the FASB's due process in developing Statement 133 are as follows:

• The Board began deliberating issues related to derivatives and hedging activities at public meetings in January 1992.

• The Board appointed outside experts who represented various points of views on the issues to a Financial Instruments Task Force ("FITF"). The FITF provided expertise, a diversity of viewpoints, and a mechanism for communicating with those who would be affected by any change to the accounting for derivatives and hedging.

• Between January 1992 and June 1996, the Board discussed issues related to the accounting for derivatives and hedging at 100 public meetings.

• In June 1996, the Board issued an Exposure Draft of a proposed standard. 10 Approximately 300 organizations and individuals responded to the Exposure Draft, some with multiple letters.

• The Board held four days of public hearings in November 1996. Thirty-six individuals and organizations testified. In addition, six enterprises participated in limited field tests of the provisions of the Exposure Draft.

• In December 1996, the Board met with the FITF to discuss the issues raised during the comment letter process and during the public hearings and field tests. • The Board considered the comments and field test results during its redeliberations of the issues addressed by the Exposure Draft in 21 public meetings in the first 7 months of 1997.

• The FITF met again with the Board in April 1997 and discussed, among other things, proposed changes to the Exposure Draft reflected in a draft of the final Statement.

• In August 1997, a revised draft of the standards section of the final Statement and related examples was made available to the FITF and other interested parties for comment on the draft's clarity and operationality.

• The Board received approximately 150 comment letters on the revised draft and discussed those comments in 10 public meetings. Those comments led to additional changes to the requirements, intended to make the Statement clearer and more operational.

10 FASB Exposure Draft, Accounting for Derivative and Similar Financial Instruments and for Hedging Activities (June 1996).