Tenneco Inc. will restate three years’ worth of financial statements following the Public Company Accounting Oversight Board’s inspection of its external audit firm, Deloitte & Touche. When the PCAOB reviewed Deloitte’s audit of Tenneco’s financials, the oversight board found that the manufacturer’s accounting for interest-rate swaps was incorrect.
As a result, Tenneco will change how it accounts for interest-rate swaps and restate results for the past three years ending in 2006 as well as for the first three quarters of 2006. By now using mark-to-market accounting for the swaps, the company will increase the pre-tax interest expense it reports by $6 million for the affected periods, according to a regulatory filing.
The company’s current treatment of interest-rate swaps started with three fixed-to-floating interest-rate swaps Tenneco entered into with two financial institutions in April 2004. The company swapped a total of $150 million of its 10.25 senior secured notes to floating interest rate debt at LIBOR plus an average spread of 5.68 percentage points.
Since it executed the swaps, the company applied the so-called “short-cut” method of fair-value hedge accounting under SFAS 133, Accounting for Derivative Instruments and Hedging Activities.
As Tenneco explained in the filing, however, interest-rate swaps that qualify for the “short-cut” method of hedge accounting must match the terms of the debt it is hedging. If the swaps and the debt constitute “mirror images” of each other, the company can assume that the changes in the value of the hedges and the underlying debt exactly offset each other—and thus have no effect on earnings.
In its review of Deloitte’s audits, the PCAOB unearthed an issue that the audit firm had apparently missed: there were indeed differences between the swaps and the underlying debt. The swaps, therefore, failed to meet the mirror image requirements of the short-cut method. A Deloitte representative said that “professional standards preclude us from commenting on client matters that are confidential.”
One difference is between the 30-day notice period to terminate the swaps and the 30-day to 60-day notice period to redeem the notes, Tenneco explained. Another is that while the debt and swaps could both be redeemed before their maturity dates, the notes enable the company to make redemptions in increments of $1,000, while the interest-rate swap agreements imply that they can only be redeemed in their full amounts.
Tenneco will discontinue accounting for the swaps as hedges. Instead, the company will record the changes in the fair value of the interest-rate swaps as increases or decreases to interest-expense in each period, without recording an offset for changes in the fair-value of the underlying debt. The fair value of these swaps has been disclosed in the footnotes to the financial statements each quarter since the swaps’ inception, according to Tenneco.
“The accounting standards for interest-rate swaps are complex and we are disappointed in having to restate our financial results,” said Gregg Sherrill, Tenneco’s chairman and CEO.
Tenneco also said that the restatement will also reflect other accounting adjustments, which will not be significant. For example, the company will move the accounting charge taken for employee stock options in the fourth quarter of 2006 to earlier periods to which it relates. The company added it is still completing its analysis of these adjustments and will reflect all of the changes in an August filing.