Capital Markets

Private Firms Loving FASB Breaks on Interest-rate Swaps

But the hedge accounting alternative may give the biggest private companies an unfair edge on public company competitors.
David KatzJune 14, 2016

Despite worries that privately held giants like Koch Industries and Cargill will gain an unfair advantage over public companies via a Financial Accounting Standards Board simplified hedge accounting alternative for reporting interest-rate swaps, the board enacted the measure in 2014.

Michael Cheng, FASB project manager

Michael Cheng, FASB project manager

With Accounting Standards Update 2014-03 going into effect for quarterly reporting this year, however, smaller private companies have been welcoming the provision with open arms, according to one account. (The standard  went into effect for annual periods beginning after December 15, 2014 and for interim periods within annual periods that started after December 15, 2015.)

The companies welcoming the update contend that the standard makes it easier for them to deal with complexities they can’t avoid if they’re trying to line up fixed-rate debt. “I think this ASU is extremely welcomed by our clients. Most of them were applying this alternative way before it became available,” said an unidentified audience member, apparently a private company, at a private-company town hall meeting hosted by FASB and the Private Company Council (PCC) at Baruch College in New York on Monday. (Early adoption of the ASU was permitted under the FASB update.) “It’s a wonderful alternative.”

The reason they were seeking an alternative was that FASB Topic 815, the standard the ASU updated,  “is so complicated for most of our client base,” she said. Further, her private company clients that had sought fixed-rate financing had entered into interest rate swaps “based on instruction from the banks. So it wasn’t an option for them: they had to enter into [such swaps] in order to get into the financing arrangement.”

Steven Brown, credit risk manager and senior vice president of US Bank in Portland, Oregon, said that he didn’t particularly agree with the audience member’s characterization of the banks’ role. “It depends on what type of bank you’re dealing with and what their funding sources are. Some banks will not want to go into a 30-year mortgage, so they’ll try to figure out how” to satisfy their private-company clients seeking such arrangements, he said at the town hall.

In certain situations, “a banker will say, ‘Here’s a way to accomplish that: if you’re looking for fixed-rate debt for a long period, then [an interest-rate swap] is the best way to execute that,’” said Brown, a member of the PCC, the group that advises FASB on private company alternatives to generally accepted accounting principles.

In the run-up to the FASB update, the PCC had received input that private companies often find it hard to borrow at fixed interest rates. To do so, some private companies enter into an interest rate swap to “economically convert their variable rate borrowing to a fixed-rate borrowing,” according to a board publication.

Topic 815, however, requires that a company must record all of its derivative instruments in its balance sheet as either assets or liabilities and measure them at fair value. To curb the income statement volatility of recording a swap at fair value, companies can choose hedge accounting if they meet certain requirements.

“Some private company stakeholders contend that because of limited resources and/or the difficulty of understanding and applying hedge accounting, many private companies lack the expertise to comply with the requirements to qualify for hedge accounting,” according to the FASB publication.

Thus, they choose not to apply hedge accounting. That choice results in income statement volatility “because changes in the fair value of their derivative instrument are recognized in earnings,” it says.  

Reducing the Volatility

The FASB update, however, makes hedge accounting more appealing by reducing that volatility. “Under the accounting alternative provided for interest rate swaps, when a private company applies the simplified hedge accounting approach, the income statement charge for interest expense will be similar to the amount that would result if the company had directly entered into a fixed-rate borrowing instead of a variable rate borrowing and an interest rate swap,” according to the FASB publication.

The alternative provides another perk for private companies looking to hedge. Under the existing rules, companies had to provide documentation of the hedge’s effectiveness at the hedge inception date. But under the simplified hedge accounting approach, to qualify for hedge accounting the private company must complete the same documentation “by the date on which the first annual financial statements are available to be issued after hedge inception,” according to the ASU.

FASB project manager Michael Cheng called this “contemporaneous documentation” provision “the most contentious” part of the update. “In hedge accounting, whenever you’ve entered into a hedge, the first thing you have to do [is]…document why your hedge is effective” within the first day or first few days of the inception date, he said.

Under the alternative, however, issuers can present the documentation chronologically “up to the date your statements are made available for issuance. That’s a huge change from what existing GAAP is,” Cheng said.

FASB member Larry Smith, however, said that he dissented from voting for the ASU precisely because it differed so much from the current version of GAAP that public companies must follow. “I really thought that this was a good standard that I would have adopted for public companies as well,” he said at the gathering.

Concerning contemporaneous documentation, Smith said that he argued that FASB could relax the rules somewhat. But if the reporting requirement was flexible enough that a company could take a full year between the hedge’s launch and the date it files it financials, “it enables a company to play around quite a bit,” he said.

Another panelist, PCC member Lawrence Weinstock, contended that it’s “relevant” for FASB to ease up on the reporting rules for private companies on interest rate swaps because fewer of them are doing it to structure their debt than for the reason “that this is the only way private companies can get fixed rate debt.”

In response, Smith said, “let’s not lose sight of the fact that Koch Industries and Cargill are both private companies, and they can avail themselves of this.”

4 Powerful Communication Strategies for Your Next Board Meeting