Accounting & Tax

Swaps and Ends

Two professors argue that interest rate swap terminations should be classified as operating cash flow. The argument is more than academic.
Edward TeachSeptember 12, 2007

For nearly 25 years, Charles Mulford and Eugene Comiskey have been making investors wiser and CFOs warier. Professors of accounting at the Georgia Institute of Technology in Atlanta, the two have conducted copious research on financial reporting — in particular, on how companies manage the operating, financing, and investing components of cash flow. The fruit of their collaboration has been numerous reports and several books, including Creative Cash Flow Reporting (2005) and The Financial Numbers Game (2002).

Their latest research report, focuses on interest rate swap terminations and how companies account for the resulting payments or receipts — as operating cash flow or financing cash flow. Currently there is little or no GAAP guidance that addresses swap terminations, say the professors. Yet, how a company accounts for a swap termination could have a material effect on its reported operating cash flow, a metric that investors closely monitor.

In “The Cash Flow Classification of Payments and Receipts Associated with the Termination of Interest Rate Swaps”, Comiskey and Mulford reviewed about 200 10-K filings for 2006 to learn why companies used interest rate swaps, why they discontinued them (the answer in most cases was because the underlying debt had been retired), and how they accounted for the associated settlements. What they found above all was a lack of consistency. “Companies were all over the place in their reporting,” says Mulford.

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In a representative sample of 44 companies that terminated interest rate swaps, 25 classified the payments or receipts as financing cash flow, while 19 classified them as operating cash flow. What’s more, of the 22 companies in the sample that used swaps as fair-value hedges — exchanging fixed interest rates for floating, to eliminate fluctuations in the value of the underlying debt — 10 classified swap terminations as operating cash flow, even though debt issues and repayments are classified as financing cash flow.

Meanwhile, of the 22 firms that used swaps as cash-flow hedges — swapping floating rates for fixed, to hedge against interest rate fluctuations — 13 classified swap terminations as financing cash flow, even though interest payments are classified as operating cash flow. “Nobody really knows what to do,” comments Mulford. “It’s a good example of principles-based accounting where there is no clear guidance, so companies make their own interpretations.”

The professors recommend that cash received or paid from swap terminations be classified as operating cash flow. Since SFAS No. 95 classifies interest payments under operating cash flow, and since interest expense is either increased or decreased as the result of a swap termination, “an operating cash flow classification would appear to be in order,” write Comiskey and Mulford.

In some of the companies surveyed, reclassifying a swap termination would have put a dent in their reported operating cash flow. For example, if Wolverine Tube Inc. and Brookdale Senior Living Inc. had classified swap termination payments as operating instead of financing cash flow, their reported operating cash flows for 2006 would have decreased by 89 percent and 83 percent, respectively.

On the flip side, had Texas Industries Inc. and Dominion Homes Inc. classified their swap termination receipts as operating cash flow, they would have seen their 2006 operating cash flow increase by 72 percent and 66 percent, respectively.

“Analysts and investors,” conclude Comiskey and Mulford, “should be aware of what appears to be the somewhat arbitrary classification of the cash flows associated with swap terminations.” Financial managers, too, might reconsider their accounting practices in view of the report. At least one already has. Responding to a query sent by the professors, a financial manager at Nordstrom Inc. replied: “In the light of your question, we have reviewed our past accounting policy. If we entered into a swap today, we may not designate our swap as a hedge of the fair value of our debt, but rather of our interest payments. In this situation, we would classify the cash flows in operating activities.”