Lost in the Maze

Problems with hedge accounting caused a wave of restatements in 2005. Are FASB's rules too hard to follow, or are companies simply too lax?

It has been almost six years since companies began complying with FAS 133, the standard that governs the accounting treatment of derivatives. Yet judging from the growing number of restatements due to FAS 133 errors, many are still wrestling with these rules. Last year, 57 companies restated their earnings because of faulty hedge accounting, up from 27 in 2004 and 13 in 2003, according to Glass Lewis — Co. of San Francisco, which specializes in assessing corporate risk. The biggest such restatement, Fannie Mae’s, was still pending at press time. First announced in December 2004, it is expected to lower the earnings from previous years by a whopping $10.8 billion.

The spike in restatements can be partly attributed to Sarbanes-Oxley. (Indeed, restatements overall have risen sharply since 2003, from 514 to about 1,200 in 2005.) But the companies producing the restatements frequently cite two other reasons for the problems: overly rigid requirements, and the complexity of the rules.

“While we took great care in implementing FAS 133 in 2001, including a review by our independent auditors, it is a very complex accounting standard,” said Lee Puschaver, executive vice president and CFO of the Federal Home Loan Bank of Atlanta, in a statement last August. (Puschaver resigned this past February.) The bank is one of several in the federal home-loan bank system that have been obliged to restate prior years’ financials, and abandon hedge accounting for the positions in question, as a result of inadequate compliance with the rule.

Onerous and Unforgiving

In a 2004 study, Fitch Ratings found enormous inconsistencies in corporate implementations of FAS 133, which created considerable confusion for investors and rating agencies. Last November, Fitch announced that the situation had not improved, judging from the jump in restatements alone (see “Disclosing Derivatives” at the end of this article).

Indeed, the situation is likely to get worse as the use of derivatives increases. In the last 12-month period for which data is available — the end of the first half of 2004 to the end of the first half of 2005 — total notional amounts of interest-rate and currency derivatives outstanding rose 22 percent, from $164 trillion to $201 trillion, according to the International Swaps and Derivatives Association. More than 90 percent of the world’s largest companies use derivatives to hedge risk, reports the ISDA.

Under FAS 133, these companies are required to mark derivatives to market and record them as assets or liabilities in their financial statements. To mitigate the increased volatility the mark-to-market requirement can produce, companies may qualify for hedge accounting if used to offset the risk associated with a particular asset or liability. With hedge accounting, losses or gains in a derivative’s value do not have to be recorded in earnings until it is offset by gains or losses in the hedged items.

To qualify for hedge accounting, a company must document all derivative hedges at their inception and explain how it will determine the effectiveness of the hedges. It must also demonstrate that the derivatives are “highly effective” in hedging the underlying item on a continuing basis. If the company fails to do this, it will be disqualified from using hedge accounting and will be required to record losses or gains on its derivatives in current earnings.

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