GAAP and IFRS

Hedge Accounting: Caging the 800-page Gorilla

FASB announces plans to overhaul one of its most confounding creations.
David KatzJune 11, 2008

Trying to simplify perhaps the most notorious example of the complexity of U.S. financial reporting, the Financial Accounting Standards Board is proposing sweeping changes in hedge accounting.

In an exposure draft issued last week, FASB proposed amending Accounting for Derivative Instruments and Hedging Activities, the oft-criticized FAS 133 accounting standard. The proposed amendments would allow more companies to use hedge accounting and would create a single method for doing so, eliminating several alternative methods that currently bedevil both issuers and users of financial statements.

“I think it’s doing a very good job at addressing issues that have been a major source of restatements in recent years,” Charles Mulford, a professor of accounting and head of the Financial Analysis Lab at Georgia Tech, said of the exposure draft. “It’s a breath of fresh air for 133 that was needed.”

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If FASB is successful, hedging would be the latest area of accounting to be transformed by the wholesale application of fair-value measurement, the mark-to-market accounting that the board has also recently applied, or plans to apply, to contingent liabilities, environmental risks, pensions, leases, securities, business combinations, and much else.

To be sure, current hedge accounting rules involve substantial application of fair value measurement. But with more than 800 pages of rulemaking and guidance needed to make sense of FAS 133, the accounting standard has tended to be a black eye for the concept of fair value, and has been in the gunsights of Robert Herz ever since he became FASB chairman in 2002. “Any standard that raises 200 implementation issues is not a good standard,” he told CFO magazine in 2003.

One current critique of FAS 133 is that it allows different companies to account for similar transactions in different ways. It also allows individual companies to mark a hedging instrument at fair value while accounting differently for the hedged risk. Under the new proposal, all companies would use the same method of hedge accounting, and individual companies would be required to use consistent accounting on both sides of a hedge.

The new rule would also require companies to report all changes affecting the value of a hedged risk, not simply the changes against which they had hedged. That might seem to introduce more volatility into financial statements, a common gripe about fair-value accounting. But the new rules also make it easier for more companies to actually use hedge accounting, says Kevin Stoklosa, a FASB technical director. That allows companies to truly reduce quarter-to-quarter volatility — if they hedge well.

Stoklosa offers the example of a company that uses an interest-rate swap to hedge against the risk of decreased earnings stemming from changes in the value of a loan. If the company qualifies for hedge accounting under FAS 133 — which the exposure draft would make it easier to do — it can report changes in the fair value of both the swap and the loan on its income statement.

If it doesn’t qualify for hedge accounting, however, the company would have to treat changes associated with the swap and loan separately. In that case, the swap’s changes would be recorded at fair value on the income statement, while the loan would be recorded using loan accounting and would not be marked to market.

By using hedge accounting, the company could thereby curb the more drastic ups and downs in earnings that could result if the company only accounted for the swap on its income statement.

Currently, companies can only enjoy the benefits of hedge accounting if the company proves that the hedge is “highly effective” or passes tests affirming a hedge’s flawlessness. While FASB won’t define “highly effective,” practitioners have been using an 80 percent effectiveness threshold — that is, the timing of the hedging instrument’s gains and losses can offset at least 80 percent of the timing of the hedged item’s gains and losses — in their compliance efforts.

Under its new plan, however, FASB would lower the standard to “reasonably effective.” Stoklosa refused to define that term, though he told CFO.com that the bottom measure of hedge effectiveness would, of course, be lower than 80 percent. The board, he said, is purposefully refusing to define such terms in the proposal. “It’s absolutely principles-based,” he says. “That’s the whole idea.”

FASB also wants to drop the current requirement that companies must periodically prove hedge effectiveness, requiring such proof only at the beginning of the transaction unless something “extraneous” happens, according to Stoklosa.

In order to avoid the onerous task of having to prove hedge effectiveness, companies can currently take the route of trying to pass the “shortcut” and “critical terms match” tests. Those tests, which FASB hopes to eliminate under its new proposal, complicate matters by resulting in different methods of hedge accounting for similar transactions.

Under the shortcut method, companies must meet a set of FAS 133 criteria, while under the critical-terms method, they must achieve a perfect match between the hedging instrument and the hedged item in such criteria as dates, amounts, and the nature of the risk. The “difficulties in complying with the strict criteria in the shortcut method and critical-terms matching have led to numerous practice problems and restatements,” the board asserts in the draft.

One problem with the short-cut method has been that many companies that used it to avoid having to measure hedge-effectiveness “were simply assuming that the hedge was fully effective when it wasn’t,” said Mulford. Instead of simplifying hedge accounting, the short-cut method, he added, “only made matters more complicated.”

FASB also wants to jettison the current practice of “bifurcation-by-risk,” which requires companies to mark only the changes in a hedged item that are tied to the hedged risk — for example, companies now must only report the fair value of a credit risk if that’s the risk being hedged against, even if interest-rate risk also changes.

Under FASB’s plan, the board would require companies to label all risks (with certain exceptions) as the hedged risk in the deal, “thus better reflecting the economics of such items and transactions in the financial statements.” The deadline for responses to the exposure draft is August 15. If approved, the proposal, Accounting for Hedging Activities, would become effective after June 15, 2009.