It seems logical to assume that finance chiefs would want to take advantage of a new accounting rule that suppresses earnings volatility. But results from a forthcoming study find that when it comes to accounting for hedging activity, some CFOs would rather risk volatility than designate derivative instruments as hedges for accounting purposes.
The Financial Accounting Standards Board has proposed an amendment to FAS 133 aimed at making hedge accounting less complicated and generally more appealing. But the proposed changes may not provide enough incentive for CFOs to embrace hedge accounting, says research that soon will be released by the Financial Analysis Lab at the Georgia Institute of Technology. Indeed, the research indicates that there may be other reasons “apart from the complexities” of FAS 133 that companies avoid hedge accounting.
Generally speaking, the purpose of hedge accounting is to reduce earnings volatility, says Charles Mulford, director of the Georgia Tech Financial Analysis Lab and co-author of the research. That’s important because research has shown that earnings volatility has a negative effect on a company’s value.
Volatility is reduced because hedge accounting allows companies to record in earnings a gain or loss on the hedged item, and the loss or gain on the related hedge, in the same time period. That matching applies whether a gain or loss on the hedged item is recognized right away or deferred in accumulated other comprehensive income, say Mulford and co-author Eugene Comiskey.
For example, under hedge accounting, a loss arising from a forward contract to sell yen would be recognized in earnings along with a gain on an underlying yen-denominated receivable, notes the study. The matching of gains and losses “is a desirable outcome,” says the research, but not possible unless FAS 133 criteria is met. Under FAS 133, a hedge must be “highly effective” in offsetting specified risks — such as changes in fair value or variability in cash flows — and the effectiveness of the hedge must be monitored regularly after it is put in place.
The authors point out, however, that those hurdles are often difficult and sometimes costly to meet, which forces many companies to sidestep FAS 133. Even the proposed changes to the standard are unlikely to increase the use of hedge accounting, concludes the study. The FAS 133 amendments, issued for public comment by FASB in June, lessens the threshold for applying hedge accounting from highly effective to reasonably effective. Further, although the proposal requires an effectiveness evaluation when the hedge is applied, subsequent assessments are required only if circumstances suggest that the hedging relationship may no longer be reasonably effective.
But the new research, which examines the financial results of 50 companies, underscores four “explicit” reasons why CFOs shun hedge accounting. To start, companies said that the substantial cost of documentation and ongoing monitoring of designated hedges is not worth applying the rule. They also cited the availability of highly-effective natural hedges, as well as the new fair-value accounting rule (FAS 159), which broadens the applicability of natural or economic hedges. Finally, companies said that qualifying hedges are frequently not available, too costly, or too poorly documented. In addition, the authors blame the increased risk of restatement that accompanies hedge accounting as another reason for avoiding FAS 133, although none of the surveyed companies cited that motive.