From the moment FAS 133 was proposed in June 1998, it has been widely criticized. After substantial modification, the rule was finally adopted in 2001, but the complaints have not abated. Added to the concerns about onerous if not impossible requirements, companies today are upset by the enormous amount of resources devoted to trying to satisfy them. On top of that, they say, auditors are conducting unforgiving reviews.
Moreover, the fix for a lapse in documentation is draconian. A company may not simply correct the effort; instead, it must forgo hedge accounting for the position and restate to mark the derivative to market in current and prior earnings.
The devil lies in the details.
Take the so-called shortcut method, which exempts companies from the requirement that they prove the effectiveness of a hedge prospectively and on a continuing basis — as long as they meet a set of nine criteria specified in FAS 133. Mark Scoles, a partner in Grant Thornton’s accounting principles group, says that using the shortcut method without meeting all the criteria is a common problem among restating companies.
In particular, companies frequently stumble over the requirement that the fair value of a swap at its inception be zero. They can belatedly realize that because a broker fee was embedded within the swap, its fair value was therefore not zero.
That was the case with General Electric Co., which announced a hedge accounting restatement in May 2005. Before the rule was enacted, GE had entered into swaps with up-front fees, says Philip D. Ameen, the company’s comptroller. When FAS 133 was adopted, GE reasoned that the fees on those swaps were trivial, and applied the shortcut method to those hedges. But in a subsequent audit review, GE concluded that because the swaps’ fair values at inception were not zero, using the shortcut method was improper.
Another shortcut-method criterion many companies have overlooked or misinterpreted is the prohibition against hedging debt with an interest-rate swap if the debt could have been prepaid.
Vienna, Virginia-based Allied Defense Group Inc. has had to restate its earnings at least twice in the past year because it failed to provide “contemporaneous” documentation of its hedges, says CFO Robert Dowski. This common pitfall can arise from a misunderstanding about the definition of “contemporaneous,” according to a partner at one of the Big Four. According to FAS 133, the documentation must occur “at the inception of the hedge,” says the partner, who spoke on condition of anonymity. But accountants can disagree as to whether that means the same day, the same week, or the same month, he adds.
Complexity, ambiguity, and overly strict requirements may not be the only reasons for the hedge accounting restatements. Some attribute the problem in part to widely shared but incorrect accounting practice. Observes Glass Lewis analyst Jason Williams in a January report on hedge-accounting restatements: “It appears companies actually failed on some of the simpler aspects of [FAS 133].”