Hedge Accounting: a Shortcut to a Shortcut?

FASB takes a shot at clarifying which companies can use fast-track accounting for interest-rate swaps—and how they should be using it.

Seeking to simplify an earlier stab at simplifying the accounting for interest-rate swaps, the Financial Accounting Standards Board earlier this week issued proposed guidelines about how users of the swaps can apply the “shortcut” method of booking them.

Adopted in 1998 as part of FAS 133,
“Accounting for Derivative Instruments and Hedging Activities,” the shortcut method exempts companies from having to prove the future and continuing effectiveness of a hedge if they meet a set of criteria.

Using the method “vastly simplifies the necessary calculations involved in hedge accounting,” according to FASB. That’s because it assumes that the change in value of the swap is a “perfect proxy” for the change in value of the hedged item, thereby resulting in no income statement volatility, the board contends.

Attempts by companies to use the method without meeting all the criteria have led to many restatements over the last few years, however. In February, for instance, Dollar Thrifty ran afoul of the shortcut proviso that the interest-bearing asset or liability in a swap can’t be prepaid. Because of certain prepayment clauses in its contracts, the car-rental company had to restate nearly five years of financials.

FASB’s new proposal
is mum on the prepayment criterion. But the plan does provide guidance on how to determine what a few of the other, perhaps more ambiguous, criteria mean. One criterion for using the shortcut method under FAS 133, for instance, is: “The notional amount of the swap matches the principal amount of the interest-bearing asset or liability.”

Under the proposal, that criterion is met for fair-value hedging if two conditions apply. One is that an interest-rate swap’s notional amount and the principal amount of the hedged item must match over the entire term of the hedged item. The second is that the notional amount of the fixed-rate side of the swap must match the notional amount of the floating-rate side of the swap throughout the life of the hedging relationship.

Besides uncertainties about the criteria for using the shortcut in the first place, another problem is that the fogginess of FAS 133 has led to many different interpretations of how corporations should be using it. “Currently, there is diversity in the way the shortcut method is applied by preparers of financial statements. That diversity has resulted in differences in financial statement information for similar transactions” said Louis Fanzini, a FASB financial services industry fellow.

With its new proposal, the standards board is looking to pare down the diversity. FASB says it wants to push corporations to be consistent in how they gauge when they qualify for the shortcut method and supply investors “with better information about how the shortcut method affects a company’s financial statements.” The deadline for written comments on the proposal is September 21.

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