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’s a matter of companies following accounting guidance based on the industry norm,” says Mark Grothe, an analyst at Glass Lewis. He compares the spate of FAS 133 restatements to those stemming from lease accounting in 2005.

Williams offers sharper words in his January report. “Some companies and their finance executives appear to be incapable of following published accounting rules,” he writes. Citing as examples the “big bath” restructuring charges and acquisition-related write-offs that were common in the 1990s, Williams then moves on to lease accounting: “In 2004 and 2005, close to 300 companies that failed to follow black-and-white lease accounting rules that were 30 years old had to correct the related errors in their financial statements.”

And today? “In the latest rendition of this hocus-pocus type of accounting,” he says, “we are seeing ‘hedge’ accounting disappear before investors’ very eyes.” While Williams allows that some aspects of FAS 133 are indeed complex, “the proper application of the shortcut criteria should not be that difficult for accountants with appropriate expertise.”

Fixing the Problem

Hocus-pocus or not, companies’ struggles with FAS 133 are not going to vanish overnight. Financial executives have varying opinions about how to stem the rash of restatements. Allied’s Dowski would like to see auditors and regulators be more reasonable in their review of hedge accounting. “I think hedge accounting is the accurate way to portray this use of derivatives,” he says. “But it doesn’t need to be an all-or-nothing test. It should be good enough if documentation and the rest were done on a 90 percent–correct basis.”

Ameen agrees. General Electric already has the equivalent of 40 people working full-time to ensure the accuracy of its hedge accounting and will continue to strive for perfection, he says. But mistakes are inevitable, he adds, particularly at companies like GE, which hedges currency, commodity, and interest-rate risk with derivatives and has thousands of derivatives contracts outstanding at the end of any given year (about 6,000 at the end of 2005). An accounting standard that requires perfect execution will lead to reporting that misses the economics, says Ameen.

And if regulators continue to insist on perfection? In that case, some companies will consider abandoning hedge accounting. Allied, for example, may go this route if it doesn’t achieve perfection by the end of the first quarter, Dowski says. Then, his company will deal with the “phantom gains and losses rolling through the P&L” that can result from derivatives accounting by “footnoting the heck out of it,” he says.

Others contend that the problem is often a lack of understanding of derivatives and hedging. Hedging is complex, and FAS 133 simply reflects that reality, says Ed Ketz, an associate professor of accounting at Smeal College of Business at Pennsylvania State University. Any company that is unable to do the accounting simply does not sufficiently understand hedging and probably should not be using it. “The documentation is not excessive,” says Ketz. “It’s what I’d expect a company to do if I were investing.”

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