A closer look at amended hedge accounting rules

September 6, 2010
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Companies in Grand Rapids and surrounding areas can take a lesson from Irish author George Moore, who was once quoted as saying, "Everybody sets out to do something, and everybody does something, but no one does what he sets out to do."

Moore may just as well have been speaking about the confusing messages in the accounting rules update recently proposed by the Financial Accounting Standards Board on hedge accounting — that is, accounting for the derivatives companies use to hedge against fluctuations in interest rates, foreign currencies and commodity prices. Because these amended rules will govern just how easily companies can apply hedge accounting treatment to minimize profit and loss impacts to earnings, having a say about them now will be key.

Let’s take a look at a couple of important changes the FASB is making and how they relate to Moore’s quip.

The FASB is proposing to make changes to the area of “hedge effectiveness,” the test applied to a hedging instrument to determine whether it will be eligible for hedge accounting. These changes seek to make the accounting rules for hedging transactions more transparent, but in effect, will make them more difficult to follow. Here’s why:

A hedge is considered “highly effective” if the gains and losses of the exposure — the interest rate on a loan, for example — closely matches the gains and losses of the derivative instrument used to offset the exposure. The FASB amended the rules used to assess hedge effectiveness by proposing to eliminate the qualitative methods of assessment (short-cut and critical terms match) and instituting an amended version of the quantitative method of assessment (long-haul). The problem is the amended version of the quantitative method of assessment is now nearly as simple as the short-cut method, but instead of asking for a “highly effective” hedge, it asks companies to determine what a “reasonably effective” hedge is, which is anybody’s guess. This is like removing the speed limit on the highway, mandating speed limiters in vehicles but allowing them to be set between 20 and 200 miles per hour.

Many may commend the FASB for mandating measurement in all circumstances, but it seems odd to go as far as eliminating the “highly effective” criteria under the current quantitative assessment requirement. The FASB states that “eliminating the short-cut method and the critical terms match method would result in a more consistent model for assessing hedge effectiveness.”

But while that may be true, the new “consistent model” is one that a company can determine — with a wide degree of freedom — what can and cannot qualify for hedge accounting. This will be difficult for companies and their auditors to determine, especially in this country where hedge accounting guidelines have been rules-based, versus principles-based.

It seems that the reasoning for the FASB’s relaxation of the rules for determining hedge effectiveness is really as follows: “The board believes that the costs of compliance would be reduced because an entity would not have to develop sophisticated quantitative statistical models to prove a hedging relationship is effective in situations in which it is obvious that a hedging relationship is effective.”

But what about situations where it is not obvious? Who determines what makes an “obviously good” hedge? I don’t really expect those questions to be answered, but it seems we are back to Moore’s quote: “Everybody sets out to do something …”: The Board set out to clarify hedge accounting in order to make its application more consistent across companies, leading to more comparable financial statements for investors.

“And everybody does something …”: The board removed short-cut and critical terms match methods and basically removed the quantitative assessment requirements.

“But no one does what he sets out to do.”: It seems that a similar but more cautious proposal would have been to allow a qualitative assessment on a perfectly matched hedge and stay status quo where a perfect qualitative relationship cannot be established.

Companies that want to avoid the potential confusion and ultimate divergence from international regulations in the “reasonably effective” classification may want to weigh in with comments to the FASB by Sept. 30, when the comment period closes. As they do, they may want to keep Mr. Moore’s quote in mind.

Andrew Volz is a solutions consultant and Hedge Accounting Technical Taskforce member of Reval, a derivative risk management and hedge accounting solutions provider. Volz will speak at the West Michigan Association of Financial Professionals Forum on “The Future of Derivatives: A Regulatory Update on Hedge Accounting and OTC Derivative Reform” on Sept. 15. See www.wmafp.org for details.

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