The costs, compliance burdens, and restatement risks of hedge accounting are spurring many companies to report naturally occurring foreign-currency hedges under a less-onerous standard, a forthcoming research report suggests.
Such “natural hedges” are gaining in significance in the financial management of many companies, according to an author of the report.
To be sure, many companies have gained favorable accounting treatment for their derivatives use under the Financial Accounting Standards Board’s Statement 133, “Accounting for Derivative Instruments and Hedging Activities.” The statement, now codified as FASB Topic 815, enables companies to record an earnings gain or loss on a hedged item and a matching loss or gain on an associated derivative either right away or in a deferred manner.
The use of hedge accounting has helped companies curb earnings volatility by allowing them to wait until the derivative fully offsets the liability before they must report the effects of the transaction on their income statement. But that flexibility has come at a high price. “All you need to do is mention Statement 133 and hedge accounting to a CFO, and he’ll likely roll his eyes and tell a horror story,” says Charles Mulford, director of the Georgia Tech Financial Analysis Lab, who wrote the report, “Natural Hedges and the Management of Foreign Currency Risk,” with Eugene Comiskey.
Under Statement 133, when a company enters into a derivative arrangement that is being used as a hedge, it must at that time designate that derivative as the hedge of a specific item. It must also show quantitatively that the derivative is “highly effective” in offsetting the earnings effects of the underlying asset or liability — and monitor the effectiveness of the hedge in an ongoing way.
Such processes are costly and time consuming. But perhaps the direst downside of using hedge accounting is the risk that a company will have to restate its financials if its compliance goes awry. Says Mulford, “The problem was that if you messed up in any way — if, for example, the [Securities and Exchange Commission] came in and afterwards showed the hedge wasn’t sufficiently effective, or that you didn’t monitor it closely enough — then all of the hedge accounting you had applied would be disallowed.”
That threat apparently caused many companies to shy away from hedge accounting altogether. In a 2008 research report, “The Non-designation of Derivatives as Hedges for Accounting Purposes,” Mulford and Comiskey noted that companies were frequently choosing not to designate derivatives as hedges for accounting purposes.
How then to account for them? As it happened, FASB had issued a standard the year before that has proved a no-fuss, low-cost answer for many companies. Under the standard, “The Fair Value Option for Financial Assets and Financial Liabilities“ (SFAS 159, codified as ASC825-10-25), companies can mark both the hedge and the financial asset or liability to market and include those market-value changes in earnings.
If the hedge actually offsets the earnings effects of changes in the fair value of the company’s assets and liabilities, “no net earnings effect would be experienced,” according to the new report from Georgia Tech.