Hedge Accounting: Caging the 800-page Gorilla

FASB announces plans to overhaul one of its most confounding creations.

Trying to simplify perhaps the most notorious example of the complexity of U.S. financial reporting, the Financial Accounting Standards Board is proposing sweeping changes in hedge accounting.

In an exposure draft issued last week, FASB proposed amending Accounting for Derivative Instruments and Hedging Activities, the oft-criticized FAS 133 accounting standard. The proposed amendments would allow more companies to use hedge accounting and would create a single method for doing so, eliminating several alternative methods that currently bedevil both issuers and users of financial statements.

“I think it’s doing a very good job at addressing issues that have been a major source of restatements in recent years,” Charles Mulford, a professor of accounting and head of the Financial Analysis Lab at Georgia Tech, said of the exposure draft. “It’s a breath of fresh air for 133 that was needed.”

If FASB is successful, hedging would be the latest area of accounting to be transformed by the wholesale application of fair-value measurement, the mark-to-market accounting that the board has also recently applied, or plans to apply, to contingent liabilities, environmental risks, pensions, leases, securities, business combinations, and much else.

To be sure, current hedge accounting rules involve substantial application of fair value measurement. But with more than 800 pages of rulemaking and guidance needed to make sense of FAS 133, the accounting standard has tended to be a black eye for the concept of fair value, and has been in the gunsights of Robert Herz ever since he became FASB chairman in 2002. “Any standard that raises 200 implementation issues is not a good standard,” he told CFO magazine in 2003.

One current critique of FAS 133 is that it allows different companies to account for similar transactions in different ways. It also allows individual companies to mark a hedging instrument at fair value while accounting differently for the hedged risk. Under the new proposal, all companies would use the same method of hedge accounting, and individual companies would be required to use consistent accounting on both sides of a hedge.

The new rule would also require companies to report all changes affecting the value of a hedged risk, not simply the changes against which they had hedged. That might seem to introduce more volatility into financial statements, a common gripe about fair-value accounting. But the new rules also make it easier for more companies to actually use hedge accounting, says Kevin Stoklosa, a FASB technical director. That allows companies to truly reduce quarter-to-quarter volatility — if they hedge well.

Stoklosa offers the example of a company that uses an interest-rate swap to hedge against the risk of decreased earnings stemming from changes in the value of a loan. If the company qualifies for hedge accounting under FAS 133 — which the exposure draft would make it easier to do — it can report changes in the fair value of both the swap and the loan on its income statement.

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