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New accounting rules could mean greater earnings volatility, whether or not you use derivatives to hedge
Simon Boughey, CFO Magazine
January 1, 1999
Worried about earnings volatility? Get set for more, thanks to a new rule from the Financial Accounting Standards Board concerning accounting for derivatives.
The new standard, known as FAS 133, becomes mandatory for fiscal years beginning next June 15, although companies are free to adopt it before then. Few companies want to. Not only are the rules complex, but they're also likely to affect earnings even when a company hedges financial risk. How so? The rules will require companies that use derivatives to hedge to prove that they are effective at that task. But few, if any, hedges are perfect. And to the degree that they are not, companies will have to include the gains and losses on their derivatives contracts in earnings.
On the other hand, the rules could also increase the cost of obtaining more-effective hedges. Custom-made products, along with more expertise in applying them, are likely to be required. If hedging becomes expensive enough, companies may choose instead to take on more financial risk, and that, too, could lead to greater fluctuations in profits.
So why is FASB requiring this change? The accounting rulemaker began considering it after Procter & Gamble and Orange County were damaged severely by these instruments in the early 1990s, the use of which did not show up on the balance sheet, leaving shareholders and taxpayers in the dark. And FASB concluded that was intolerable. But now CFOs have to hope their constituents don't flee because of the rule's impact. As Bob Strickler, a partner in PricewaterhouseCoopers LLC, says, "Everyone is very concerned about volatility. You want to avoid significant swings."
Currently, FASB merely requires companies to disclose their derivatives exposure, based on their mar-ket value, in a footnote to their financial statements, and defer changes in their value, along with that of any asset or liability they hedge, on the balance sheet.
Under FAS 133, however, companies will be required to recognize derivatives as either assets or liabilities on their balance sheets. And changes in the value of both the derivative and any hedged asset or liability may have to be recorded in income, not deferred. Robert Wilkins, a senior project manager with FASB, explains that the rules are designed to improve transparency and standardize the ways in which hedge accounting applies.
Much has been made of the fact that FAS 133 acknowledges that derivatives can be used as hedges. In theory, that makes it possible for any losses or gains on the value of many derivatives to continue to be deferred.
And it helps explain why many companies don't see much significance in the new rule. "I don't think it will change much," observes a senior treasury official at a leading lending institution that uses swaps and options but who asked not to be identified. "Not too many people are talking about it." Asserts another finance executive who insisted on anonymity: "It won't change our behavior one way or another. There will be no volatility in our P&L."
But that assumes derivatives can be perfect hedges, and the fact is, even the best hedges are sometimes ineffective, simply because no two financial instruments move in perfect opposition to each other.
To be sure, few small companies use derivatives, nor do large companies that lack sufficiently high credit ratings to justify the cost. But financial institutions will be hard hit by the new regulations. In fact, most large firms will be affected to one degree or another, especially those in commodity businesses.
Not all users are sanguine about the change. Holly Pearson, treasury manager of Toyota Motor Credit Corp., the Torrance, California, finance subsidiary of the Japanese automaker, concedes that TMCC will have to modify its behavior. "We will continue to use derivatives," says Pearson, "but we will have to be more creative. It will require more work, and it won't be as easy from an operational standpoint."
The reason is that it won't be easy for a derivative to qualify as a hedge. Under a less widely discussed provision of the new rule, hedges will have to meet rigorously defined and applied criteria. In essence, companies will have to vouch for the expectation, based on a coherent and plausible rationale, that the derivative will be "highly effective" in offsetting a potential loss. Otherwise, the change in the derivative's value will go straight into earnings, even if a company considers it a hedge.
And even when a hedge relationship between a derivative and an asset or liability is proved to exist, any "ineffective" portion of the hedge, that is, any change in the fair value of the hedge that is greater than the change in the fair value of the hedged item, will have to be recorded in earnings. To the extent that hedges are completely effective, with their fair value equal to the hedged item, companies could still defer changes in value. Earnings would then be unchanged, assuming auditors vouched for the hedges' effectiveness.
But again, the great majority of hedges do not change in price to exactly the same degree as the hedged item. And the analysis of a hedge's effectiveness that will be required by FAS 133 can be complicated by its purpose. Specifically, the rule allows three basic types of hedges: fair-value hedges, cash-flow hedges, and foreign-currency hedges. (Fair-value hedges are designed to offset exposure associated with changes in the price of a recognized asset, liability, or firm commitment. Cash-flow hedges offset the variability in expected cash flow transactions. Foreign-currency hedges, as the name suggests, hedge exposure to foreign-exchange risk.)
A More-Exclusive Club
Since companies will be allowed to indicate which purpose a hedge is serving, they will have some flexibility in determining when it is ineffective. In cash flow hedges, for example, any derivative's gain or loss is not recorded immediately, but is placed in a "holding tank" until the cash flow it is designed to hedge is realized. Only then will the result be recorded in earnings. But this may be small consolation.
"It's inconceivable that a commercial enterprise using hedge accounting wouldn't have some degree of concern about income volatility," says Ira Kawaller, of Kawaller & Co., a New York financial consultancy. And he worries that by adding such complexities, FASB has restricted favorable accounting treatment for hedging to only the most adept and dexterous companies. "Only mathematically sophisticated users will be able to articulate 'effectiveness' and 'objective' appropriately for all their needs," says Kawaller. "We may be requiring a degree of sophistication that is exclusionary, and forming a small club," he says.
Granted, some transactions will qualify for much-coveted short-cut accounting, which bypasses some of the more complex stages of hedge accounting and allows the balance sheet to be grossed up without constant adjustments to the value of the hedge and the hedged item. But any "ineffectiveness" still has to be recorded at fair value.
And the terms for short-cut accounting are no less exacting than for hedge accounting. The basic obstacle in either case has to do with derivative instruments that are designed to be hedges but that FASB considers mismatched to the underlying assets and liabilities. With an interest rate swap from fixed to floating rates, for example, short- cut treatment is allowed only if the notional principal and dates of what are swapped match very closely. Auditors may allow a degree of flexibility on the dates, but it will be a matter of days rather than weeks. This presents no problem for users that match terms very closely. Not so for those that pool risk on a portfolio basis, and alter the proportion of floating-rate debt they hold according to a view on interest rates or the yield curve. And again, any discrepancies in changes in value between hedge and hedged item--the aspect FASB deems "ineffective"--must still be marked to market and recorded in earnings.
The potential problems with what FASB considers mismatched hedges don't end there. Kawaller cites mortgage portfolios as one "potential time-bomb." These are often hedged by index amortizing swaps. However, some mortgage-backed securities in baskets of investments will prepay earlier than others, while still others will not prepay at all. The terms of an index amortizing swap cannot be said to be a perfect match. That means these instruments will not qualify for hedge accounting, let alone short-cut treatment, exposing the holder to earnings volatility. (For examples of other potential headaches, see sidebar, page 82.) As a result of such problems, listed products such as generic options may not merit hedge accounting, which could lead to a defection from the exchanges to OTC products. Robert Sullivan, another partner in PricewaterhouseCoopers, notes the "potential for the disruption of the entire options market."
In any case, the need for instruments that match very closely could well initiate a movement away from plain-vanilla products and toward more sophisticated, customized ones. "Much more tailored products will be needed," says David Morris, financial director of Chase Manhattan Bank, and chairman of the accounting committee at the International Swaps and Derivatives Association.
No one doubts that Wall Street is up to the task of providing products that can accommodate FAS 133's demands. Says Strickler of PricewaterhouseCoopers: "The financial services industry is looking at it hungrily and developing new, more customized products."
However, that could send more business into the hands of bigger, more sophisticated banks, cutting out niche players and driving up the cost of hedging.
"People should have short-cut treatment for options," says Kawaller. "But unless users have the confidence that options can be used without earnings volatility, there will be a wholesale move to shun them in favor of tailor-made swaps. That would be a shame."
Finally, users must also complete the documentation that identifies the objective for the hedge and the expectation of "effectiveness" before a transaction is completed. A mere detail? Traders often complain that corporations are too slow to react to opportunities in a fast-moving market, but this could only further reduce the speed of their response.
FASB's Wilkins contends that the need for disclosure and transparency outweighs such concerns. "A lot of entities use swaps," he says. "If one of them swaps a floating-rate liability to fixed rate and then rates fall, the firm is worse off and the shareholders are worse off than if it hadn't done the swap. Hitherto, that would not have shown up on the balance sheet."
In any case, some consultants contend that the changes needed in software systems to deal with FAS 133 are no less horrifying than the impact on earnings. "Mechanically, it will be a nightmare," predicts Sullivan of PricewaterhouseCoopers.
All in all, FAS 133 is very likely to cause more than a few hiccups when it is finally implemented.
"There will be a number of embarrassments," predicts Strickler. "You think you've got ABC result and you've actually got XYZ. Either the buyer or the seller will have it wrong."
Simon Boughey is a freelance writer based in New York.
------------------------------------------------------------------------ CLIPPED HEDGES
Derivatives used to hedge won't be able to do more--or less--without affecting earnings.
The new accounting rules for use of derivatives will complicate popular hedging techniques, including some designed to reduce exposure to foreign-currency and interest-rate risk.
Say a U.S. manufacturer buys a call on British pounds sterling to hedge the prospective purchase of machine parts from the U.K. at a strike price of £1.70 to the dollar and an expiration timed to coincide with the trade date. If the spot price is above 1.70 at the trade date, the effective price will still be 1.70 plus the option premium. If the price is below 1.70, then the cost will be the new spot price plus the option premium. While the hedge will have been highly effective and the option premium can currently be deferred, it may have to be recorded in earnings under FAS 133. Why? Because it's not clear that the hedge and the hedged item are closely enough related for FASB's purposes.
Similarly, consider the case of a firm that is exposed to floating-rate debt and creates a collar to protect itself against fluctuations beyond a certain magnitude. It does so by purchasing a cap--an option that protects the buyer from rises in interest rates above a "strike" yield--and selling a floor--an option that protects the buyer from the opposite. That collar can qualify for hedge accounting only if the cap and floor are priced over the same index. But a buyer may wish to price his cap over forward Libor rates and his floor over short-term Treasurys, as the current shape of the yield curve makes this a more efficient buy. However, it is not at all clear that this will merit hedge accounting.
In any case, the company will be required to mark to market the time value of the positions, and if rates move up toward the strike price of the cap, the company will have to record a loss, even though its out-of-pocket costs have not changed and will not change. And if the strike price moves toward the floor, the changes have to be recorded as income, though none has actually been received. - S.B.