Hedge Accounting: A Matchless Future?

FASB soldiers on with a plan to drop the requirement that companies must prove they aren't speculating in derivatives.
Marie LeoneMay 24, 2007

The Financial Accounting Standards Board voted to start work on a proposal to eliminate one of the more onerous hedge accounting requirements: assessing and testing the effectiveness of a hedge instrument.

At its weekly meeting on Wednesday, the standard-setting board agreed to move ahead with a project to simplify FAS 133, Accounting for Derivative Instruments and Hedging Activities. Under the plan, FASB would replace current assessment and testing mandates with a fair-value approach. No timeline has been announced for completion of the project.

Currently, to qualify for hedge accounting — in which gains and losses on derivatives can be deferred until they mature — a company must prove that the derivatives are being used to manage risk, rather than just for market speculation. Under FAS 133, corporations that take positions in derivatives purely to generate gains aren’t entitled to use the more favorable hedge- accounting treatment.

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To prove that the hedge is a risk management tool, companies are required to show evidence that the derivative amount and timing match the attributes of the commodity being hedged. This proof via pairing means managers have to thoroughly document each hedge from the outset and explain why the company is undertaking the transaction. They must mark their derivatives to market every quarter, then prove that the company is effectively hedging the underlying exposure.

Although FAS 133 offers explicit direction on how companies can qualify for hedge-accounting treatment, critics say the rules remain vague and overly complex. Indeed, shareholder consultancy Glass Lewis has reported that over 100 corporate restatements over the last two years have been tied to the misapplication of FAS 133.

Just before she cast her vote to add the project to the FASB agenda, board member Leslie Seidman declared that FAS 133 “is held up as the poster child of complexity and rules-based standards. [Therefore] we have to respond.”

Under the fair-value approach being developed, FASB would shed the requirement that derivatives buyers assess the hedge and test its effectiveness, while continuing to require companies to mark their hedges to market. The rest of the formula would work the same as it does now: for fair-value hedges, the derivative and hedged item would be measured at fair value and the changes in value recognized in earnings. For cash-flow hedges, the derivative would be measured at fair-value, with the effective portion of the gain or loss reported in other comprehensive income and the ineffective portion reported in earnings.

In effect, companies would “no longer have to qualify to play the game,” Kevin Stoklosa, the board’s FAS 133 project manager, told The new fair-value approach would also purge the rule of FASB’s short-cut method of hedge accounting—an earlier, not very successful attempt to unravel the testing process.