Hedging’s End?

New accounting rules could mean greater earnings volatility, whether or not you use derivatives to hedge

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.

Nobody’s Perfect

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.”

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