COPING WITH FAS 133.

For many months, public companies have been grappling with ways to implement the Financial Accounting Standards Board's Statement No. 133, which took effect in January. Still, controversy and confusion remain over Statement 133's central issue -- how to account for derivatives on the balance sheet at fair market value.

Much of the debate centers on theoretical constructs, conceptual premises, timing issues and the like. However, what seems to have been lost in the frenzy is how FAS 133 will impact the way corporations will be managed in the future -- especially areas like financial strategy and internal operations.

In an interview with Christopher Pieszko, senior vice president and corporate controller of McDonald's Corp., FEI explores the practical impact of the new rule.

Pieszko is responsible for all corporate financial and accounting functions. He began his career with McDonald's in 1978 as an accounting supervisor. Since then, he's worked his way up the corporate ladder, becoming vice president/U.S. controller and assistant corporate controller before assuming his current role in 1997.

Q: FAS 133 has been criticized on many fronts. What, in your mind, have been the major difficulties in implementing it?

A: We are all aware that FAS 133 is very complex. Much of the complexity of implementation arises from the level of depth that FASB has dug into -- details of financial option theory, theses written to explain the financial accounting form of derivatives and other financial instruments. It's resulted in tremendous complexity, controversy and a huge amount of time and paper that they just can't get out of and, therefore, neither can we.

It's also a moving target. Many questions are still not answered, and yet we were expected to comply by the beginning of the 2001 fiscal year. One of the major challenges and points of risk was making assumptions about where the rules were going and changing the way we do transactions without knowing if our assumptions are right.

Q: How has McDonald's changed its strategy in order to accommodate to FAS 133?

A. Because of some of the provisions in this statement, we've had to change the way we actually run the business in terms of financing. The instruments that we had in place that were effective for us under the old rules in terms of hedging and currency management had to change. We've modified our portfolio significantly to reduce any P&L volatility that could result from FAS 133.

Q: What instruments have been most affected at McDonald's?

A. The biggest area has been cross-currency swaps. We would borrow money in the U.S. debt markets and then swap those funds into foreign currency liabilities. We would lend them on to our foreign [subsidiaries].

This did two things. First, it would serve as a hedge of our net investment in the foreign subsidiary and second, because the interest expense was swapped into a foreign denomination, it also served as a natural hedge against fluctuations in revenues or earnings from those foreign assets. That's the way we would like to run the business, and that's our biggest issue with 133 right now. We won't be able to swap out of functional currency debt into foreign currency debt as we have in the past, which was cheaper for us. Now, we have to go out and actually borrow that currency in the local market and typically those markets aren't as efficient as the swaps market is.

Q: How has FAS 133 affected your international subsidiaries?

As everyone knows, McDonald's has operations around the globe. We receive royalties from our foreign operations. For example, the McDonald's restaurants in Germany pay a royalty to the parent company in Germany. That company then pays McDonald's Corp. intercompany royalties that are denominated in foreign currency.

Typically, we've hedged those, and we've used options for a portion of that hedge. The matching worked very well in terms of any currency swings on those foreign revenues, and it would pretty much be offset by the option. Because of FAS 133, we have to split each option into its components, a time-value component and then a component that actually deals with the swing in the currency value.

Because you value them differently, the result is that the part that goes into your P&L won't necessarily match the swing in the value of the foreign currency revenue. By the time you get to the end of the option, you really are in the same boat, but in the interim you've got volatility in your P&L. The new rules won't let us finance our foreign subsidiaries in a way that we feel makes sense or reflects the economics of the transaction.

Q: Would you say that other companies are doing the same thing in terms of rearranging their portfolios?

A. Certainly other companies are in similar situations. They've had to change the way they finance their business. Since most companies typically go to the cheapest source of financing, it goes without saying that these changes will be more expensive in some way.

McDonald's has gone to using different forms of hedging techniques and instruments, which, as I previously said, are more expensive. Companies that aren't as concerned about earnings volatility may continue to use the derivative instruments that they've always used. It depends on the size of their business in foreign markets and what their functional currency is.

Companies that have large volumes and notional amounts of hedging transactions will have the most difficulty implementing FAS 133 and are likely to have the greatest cost in doing this. They're likely to be in supply chain-type industries, commodity industries or any company that has a large finance subsidiary. There's definitely a cost to implementing this statement -- the administrative costs of trying to track all of the hedges according to 133, as well as the system costs.

Q: McDonald's is unusual in that it has chosen not to purchase a new FAS 133 software package. What has been the bottom-line impact of this decision, and how would you compare this to using an external software provider?

A. In my mind, the implementation date was far ahead of the finalization of the rules. Companies that bought software systems have had to incur a lot of expense to work around that fact. I've talked to controllers at other companies that have bought software packages from vendors, and they've had trouble using them because they're constantly changing; they can't keep up with the changes. It's too complex.

Because McDonald's has significantly reduced the size of its hedging portfolio, we felt it made more sense to develop a tracking and accounting system internally, instead of incurring the significant cost of a system that may not he functional because of the changing rules. This has allowed us to stay on top of the changes, hut it's taken a significant effort. It is also very expensive, even though we've chosen not to go to an external software provider. We've had to make significant changes to our base accounting system, not to mention the considerable amount of resources that have been needed on a day-to-day basis to keep up with the changes and get them implemented.

Q. What can FAS 133 be expected to do to the movement of money in general between the U.S. and foreign markets?

A. In the long run, it obviously impacts how companies invest in foreign-denominated assets. For McDonald's, we're talking about very long-term investments in restaurant facilities, which consist of land and buildings. Since this is a longer-term view, we simply may decide not to hedge those long-term investments as we have in the past. We're also borrowing less in U.S. markets and more in foreign markets. On a larger scale, [if] you add up all the companies who make this choice, if you may actually change the flow of capital. In principle, any change in the demand for U.S. funds creates a whole series of economic impacts, and their magnitude will depend on how many companies respond to 133 in the same way McDonald's has.

Q: How do you see fair market valuation evolving, and what is the likely impact of extending it to other financial instruments beyond derivatives?

A. We're concerned about that from a number of different perspectives. First of all, it will open the same kind of Pandora's box with 500 pages of rules extending to other types of financial obligations. Marking those all to market will create more volatility in the financial statements,

You have to understand, since we finance long-term assets (land and buildings are not monetary under the FASB's definition of a financial instrument) with debt, there's a mismatch if you follow what they want to do and go to the fullest extent. Let me give you an example. If we build a restaurant, a building on a piece of land in the U.S., for example, it's recorded at historical cost. We finance it with a debt instrument at eight percent, but [let's say] interest rates go down to six percent. We have an above-market debt instrument. We have to mark that to market on the balance sheet, even though it might be a 20-year debt issuance, yet we don't mark the asset up to fair value.

This results in an economic mismatch. It doesn't make any sense, but that's where it's headed, based on my understanding of the whole fair value project. Also, [the FASB is] doing it [on] a piecemeal basis. They really should lay out the whole vision of where they want to go and make sure they don't implement one piece of the puzzle while the other pieces aren't ready.

Q: What advice could you provide to other companies that are worried about earnings volatility?

A. All companies are different, of course, but for those with similar portfolios to McDonald's and [that] are facing similar earnings volatility issues, I would say: keep it simple. Clean out the more complex derivatives until the major issues get resolved and we see what the fair market value end product will look like.

Once the target stops moving, step back and reassess your portfolio. We've also started to see an influx from the investment banking community of new products that work under FAS 133, which will help re-establish the most cost-effective forms of treasury management. As that market matures, we'll have more hedging alternatives to consider.

Ramona Dzinkowski, a Toronto-based freelance writer, also interviewed Harris Bank CEO Pierre Greffe in the Jan/Feb issue of Financial Executive.