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.
The study found that the “most explicit” and most frequent reason for not designating a derivative a hedge is the burden of documentation and ongoing monitoring of the hedge effectiveness, which was cited by a diverse set of companies, including ConocoPhillips, General Mills, Federal Home Loan Bank of New York, and Sara Lee. For companies like Aspen Technology, Netezza, and Residential Capital, natural hedges provided enough protection and there was little incentive to rack up the extra costs associated with designating the derivatives as hedges. Natural hedges result from situations in which companies have symmetrically opposite positions, such as accounts payable and receivables in euros.
The application of FAS 159, The Fair Value Option for Financial Assets and Liabilities, also contributes to the lack of hedge accounting. ConocoPhillips clearly stated that FAS 159 allows the company to use fair-value accounting without complying with “complex” accounting rules — a reference to hedge accounting, say the authors. Further, Wells Fargo pointed to two cases — mortgage-servicing rights and mortgages held for sale — in which economic hedges replaced fair value and cash-flow hedges, respectively. The term economic hedge is often used to describe a situation in which a derivative shields the company from the volatility in the price of the targeted commodities.
In addition, the study points out that companies including Federal Home Bank of New York, General Finance, and GeoEye said that qualifying hedges were not available, were too costly, or documentation was untimely, inadequate, or unavailable. For example, in its financial results dated December 31, 2007, GeoEye noted that adequate documentation did not exist at the inception of interest-rate swap agreements the company held.
The unspoken reason for shying away from FAS 133, according to the study, is the risk of restatements linked to hedge accounting, particularly related to the documentation and monitoring of the hedge effectiveness. The restatements, both intentional and unintentional, relate to the so-called short-cut method, which requires little or no documentation or ongoing monitoring of accounting hedges. This method allows companies to presume “perfect hedge effectiveness” if several FAS 133 criteria are met. Failure to meet the criteria results in restatements, as was the case with several financial-services companies, including AIG, Bank of America, Fannie Mae, Freddie Mac, Ford Motor Credit, and GE Capital, reports the study.