Hedge accounting: is deferral the only option?

A lack of guidance has resulted in disputes among companies, auditors and regulators.

Although hedging activities have increased virtually exponentially over the past decade, many of the basic accounting problems associated with them remain unresolved. This article focuses on one of those issues: Which method of hedge accounting should be used?

Hedging activities create problems if normal accounting procedures cause gains and losses on hedge components to be reported in earnings in different periods. Hedge accounting responds to such anomalies by altering normal reporting procedures so counterbalancing gains and losses on hedges are reported in the same period. Although using the deferral method of hedge accounting has been the traditional response to such anomalies, other methods have sufficient advantages--both conceptual and practical--so that deferral may not be the best answer in the future. In considering the other methods, it is important to understand why and how entities hedge, the existing accounting standards for hedges and the accounting problems that arise. The exhibit on page 56 summarizes how hedge transactions would be treated under three different hedge accounting methods.

WHY AND NOW ENTITIES HEDGE

Entities hedge to protect themselves against exposure to risks such as changes in interest rates, foreign exchange rates or commodity prices. Some of these risks relate to entities' existing assets, liabilities and firm commitments while others relate to forecasted transactions.

Entities can protect against risk by acquiring or creating financial instruments that counterbalance their exposures. The result is a hedge between two or more otherwise separate positions: Losses or gains on an item being hedged (known as the "hedged item") are expected to be counter-balanced in whole or in part by gains or losses on an instrument acquired or created to hedge it (the "hedging instrument"). The hedged item and the hedging instrument collectively are known as "hedge components."

Commonly hedged items include financial instruments, commodities such as grains and metals and forecasted purchases, sales or borrowings. Common hedging instruments include financial instruments such as options, futures contracts and interest rate swaps and nonfinancial contracts such as commodity swaps and options.

CURRENT ACCOUNTING STANDARDS FOR HEDGES

Hedge accounting is considered in two statements issued by the Financial Accounting Standards Board but is not addressed comprehensively by either. FASB Statement no. 52, Foreign Currency Translation, primarily concerns one type of hedged item--foreign currency transactions--while Statement no. 80, Accounting for Futures Contracts, primarily concerns one type of hedging instrument--futures contracts. The statements are inconsistent with each other in some respects and cover only part of the universe of hedging activities. As a result, CPAs must rely on analogies to one or the other of the statements for guidance in accounting for hedges not falling clearly within the scope of either statement--for example, interest rate swaps.

The lack of guidance has resulted in disputes among companies, auditors and regulators about how certain hedging activities should be reported in the financial statements and is reflected in the growing number of hedge accounting issues brought to the FASB emerging issues task force (EITF). Clearly, more comprehensive guidance is needed.

WHAT ACCOUNTING ANOMALIES ARISE FROM HEDGING?

Hedge accounting was developed to overcome the potential anomalies of hedging activities. One anomaly involves hedges of existing positions, and the other involves hedges of forecasted transactions. An anomaly arises with hedges of existing positions because the hedged items and the hedging instruments are measured differently. Without hedge accounting, hedged items typically are measured on a historical cost basis, while hedging instruments are measured at current market prices. Thus, even though economic gains and losses on hedge components may occur in the same period and counterbalance each other, generally accepted accounting principles may preclude recognizing those gains and loss in the same period. As a result, gains may be reported in income in one period and related losses in another.

Moreover, even if both hedge components are measured on a historical cost basis, a problem may arise if one hedge component terminates before the other. When that happens, the gains or losses on the terminated component normally are reported before the counterbalancing losses or gains on the remaining components.

A different sort of anomaly arises with hedges of forecasted transactions because hedged items do not yet exist--the transactions have not yet occurred. As a result, gains and losses on the hedging instruments are not counterbalanced by losses and gains on the hedged items. The resulting anomaly is fundamentally different because the gains and losses that are supposed to counterbalance each other actually occur in different periods.

HOW ALTERNATIVE HEDGE ACCOUNTING METHODS DIFFER

The two FASB statements mentioned above use deferral hedge accounting to correct perceived anomalies. Deferral hedge accounting defers recognition of gains and losses on hedging instruments from the period in which they occur (and normally are recognized) to a later period when the related gains and losses on hedged items are recognized.

In fact, the deferral method even defers recognition of some realized gains and losses. For example, futures contracts used as hedging instruments are settled daily, resulting in realized gains and losses that are deferred under deferral hedge accounting. Deferring realized gains and losses clearly is a departure from GAAP, which recognizes accounting gains and losses no later than when they are realized.

An alternative to deferral hedge accounting that is arousing interest is mark-to-market hedge accounting, which measures both hedged items and hedging instruments at current market prices and recognizes gains and losses on both hedge components in an entity's financial statements in the period their prices change. Some consider this a more faithful depiction of a hedge's underlying economics because it reports the events that were the reasons for entering into the hedge as they occur.

Although proponents of deferral and mark-to-market hedge accounting share the goal of remedying the anomalies, they disagree about the cause. Deferral hedge accounting supporters argue the anomalies are caused by accounting for hedging instruments at current market prices; in their view, hedge instrument accounting should be made consistent with the accounting for hedged items. In contrast, mark-to-market hedge accounting supporters argue the anomalies result from accounting for hedged items at historical cost; in their view, hedged item accounting should be made consistent with hedged instrument accounting.

The effectiveness method is a hybrid that combines certain features of the deferral and mark-to-market methods. It allows special treatment of hedging gains and losses only to the extent the hedge is "effective"--hedging gains and losses are matched by changes in the fair value of hedged items. Like mark-to-market hedge accounting, the effectiveness method reflects in current income the extent to which hedges turn out to be less than perfect. Further, as is the case with deferral hedge accounting, hedging gains and losses are deferred to the extent the hedge is effective.

ADVANTAGES AND DISADVANTAGES

Deferral and mark-to-market hedge accounting have certain advantages and disadvantages that can be characterized in terms of familiarity, understandability, complexity, forecasted transactions and deferred assets and liabilities.

Familiarity. The deferral method is more in line with historical cost measurement practices--hedging instruments are accounted for using the measurement attribute of the hedged items: generally, historical cost. Since historical cost is the most prevalent measurement attribute in financial statements, deferral hedge accounting proponents consider the method to be more familiar: Financial statement preparers, auditors and users have become familiar with the method in the years since Statements nos. 52 and 80 were issued and know how to apply it. They would not need to learn how to apply a new method.

However, mark-to-market accounting is by no means a stranger. All instruments held in financial institutions' trading accounts, including derivatives used as hedging instruments, are marked to market. Futures contracts that are not used as hedges and thus do not qualify for hedge accounting must be marked to market under Statement no. 80, and many other derivatives not used as hedges are marked to market in practice because they are analogous to the instruments addressed in that statement. Furthermore, FASB Statement no. 107, Disclosures about Fair Value of Financial Instruments, requires all financial instruments' fair values to be disclosed when it is practicable to do so. Determining market values for hedge components, therefore, should not be considered unfamiliar.

Understandability. Some argue users would understand mark-to-market hedge accounting better than deferral hedge accounting because marking to market accounts for hedging activities on a commonsense basis--by tracking and recognizing changes in value as they occur rather than by deferring their recognition to future periods. That tracking better reflects the economic reason many hedges are entered into--to protect against a decline in a hedged item's value. Thus, the mark-to-market method's common-sense approach would be more understandable to average investors. Moreover, analysts and large investors are gaining familiarity with fair value information from disclosures, especially those made under Statement no. 107.

Others, however, argue applying mark-to-market hedge accounting across the board might impair rather than enhance understandability. In particular, they point to relationships that are established to lock in future prices or future cash flow streams, for example, by effectively converting a floating-rate financial instrument to a fixed-rate instrument by using an interest rate swap. They see deferral as providing a more understandable reflection of such relationships than the mark-to-market method.

Complexity. Some argue applying deferral hedge accounting is more complex than applying mark-to-market hedge accounting because, to be workable, it requires designating a hedging instrument to a specific asset or liability position. For entities that manage their assets and liabilities together, designating particular hedging instruments as linked to either a specific asset or a specific liability is arbitrary, runs contrary to the economic purpose of many hedges and involves considerable record-keeping. However, designation is necessary both to test a hedge's effectiveness and to determine when deferred gains and losses should be recognized.

The deferral method requires a test of hedge effectiveness or correlation not only at a hedge's outset but also throughout its life to prevent deferring gains or losses on ineffective hedges (those with losses or gains that do not counterbalance sufficiently). In addition, deferral hedge accounting requires keeping track of amounts deferred in previous periods. Testing for hedge effectiveness on an ongoing basis and keeping track of amounts deferred in previous periods are not necessary under the mark-to-market method because all losses and gains on the hedge components are recognized as they occur.

Others argue mark-to-market hedge accounting could be just as complex as deferral hedge accounting. For example, hedges of preexisting assets or liabilities whose fair values at the inception of the hedge differ from their carrying amounts would require keeping track of that difference for each hedged item.

However, mark-to-market hedge accounting could be less complex than deferral hedge accounting if designation could be general rather than specific. Under specific designation, a financial instrument is selected to match a specific existing position and left in place until both mature or expire. Such hedges (sometimes described as "micro hedges") involve assessing risk at the transaction level. While some entities manage hedges that way, others increasingly manage hedges collectively rather than individually. Under general designation, designation is made to groups of assets and liabilities rather than to a specific existing position. Such hedge types (sometimes called "macro hedges") involve assessing risk at a level broader than the transaction level, though not necessarily one as broad as the business unit or enterprise level called for in Statement no. 80.

With general rather than specific designation, the mark-to-market method could involve a two-pool approach: Financial assets and liabilities could be separated into a market value pool and a historical cost pool. The market value pool would constitute a general hedge designation, and all components would be marked to market. In that pool there would be no need to determine hedge effectiveness or to determine when to recognize deferred gains or losses in income, and entities that manage their exposure on a macro basis would not find it necessary to designate one component of the pool as a hedge of another on an individual basis just for accounting purposes.

Financial assets and liabilities in the historical cost pool also could receive hedge accounting treatment. Designation, however, would be specific rather than general for these hedges because hedge effectiveness would have to be determined. In addition, specific designation would be the basis for determining when to recognize deferred gains and losses if deferral hedge accounting was applied to hedges in that pool.

Forecasted transactions. The deferral method can be applied to hedges of existing assets and liabilities as well as hedges of forecasted transactions, assuming the likelihood of the forecasted transaction can be assessed. That's because it focuses on changing the accounting for hedging instruments. Thus, the fact the hedged item is a transaction that has not yet even occurred is not an impediment to the deferral method.

The mark-to-market method, on the other hand, can be applied only to hedges of existing assets, liabilities and perhaps firm commitments. Since forecasted transactions have not yet occurred, there is nothing to mark to market.

Hedges related to forecasted transactions raise questions about whether hedge accounting should be applied to transactions that do not necessarily mitigate risk. Because of the uncertainties involved in forecasting future transactions, this type of hedging is a risk-management activity rather than a risk-mitigating activity. Supporters of the mark-to-market method argue deferral hedge accounting masks that distinction and that the inability to apply the mark-to-market method exposes the dubiousness of accounting for hedges of forecasted transactions.

Deferred assets and liabilities. The deferral method is criticized by some as distorting financial statements by recognizing deferred losses as assets and deferred gains as liabilities even though they do not meet the definitions of assets or liabilities. The Securities and Exchange Commission raised this issue at the March 1992 EITF meeting. The SEC staff observer formally objected to allowing deferral of realized or unrealized gains and losses arising from complex options and similar transactions with respect to anticipated transactions because the deferred gains and losses do not quality as assets and liabilities. The mark-to-market method does not have that disadvantage because deferrals are not inherent in it.

COMPREHENSIVE GUIDANCE NEEDED

The increasing volatility of foreign exchange rates, interest rates and commodity prices, along with increasing competition, internationalization, global deregulation and other market forces, has led to enormous growth in hedging activities. Many believe existing accounting guidance does not address the reporting of such activities adequately and more comprehensive guidance is needed. While the deferral, mark-to-market and effectiveness methods achieve accounting symmetry with concurrent recognition of gains and losses, the deferral method has certain disadvantages the other methods overcome.

The FASB currently has on its agenda a project to develop comprehensive hedge accounting standards. It is considering the extent to which the disadvantages inherent in the deferral method are overcome by other methods, and the circumstances in which alternative methods might be applied. The FASB expects to issue an exposure draft in 1994.

EXECUTIVE SUMMARY

* AN INCREASE IN HEDGING activities has brought with it an increase in unresolved accounting issues. Chief among them is the question of whether hedge accounting should allow deferral of associated gains and losses.

* TWO FINANCIAL ACCOUNTING Standards Board pronouncements, Statement no. 52, Foreign Currency Translation, and Statement no. 80, Accounting for Futures Contracts, cover only part of the universe of hedging activities. CPAs thus must rely on analogies to one or the other of the statements for guidance on accounting for hedges that do not fall clearly within either statement's scope.

* HEDGE ACCOUNTING WAS developed to overcome potential anomalies in reporting gains and losses on the components of hedge transactions. How hedges are measured--at historical cost or current market price--an result in recognizing gains and losses in different periods.

* ALTERNATIVES TO DEFERRAL hedge accounting are mark-to-market hedge accounting, which measures both hedged items and hedging instruments at their current market prices and recognizes gains and losses on both components in an entity's financial statements in the period their prices change, and the effectiveness method, a hybrid that combines certain features of the deferral and mark-to-market methods.

* AS AN UNSTABLE ECONOMY leads to an increase in hedging, it's clear existing accounting guidance is not adequate; more comprehensive guidance is needed.

How the hedge accounting methods work

In anticipation of possible labor strife at its suppliers, Company X purchases $1,000,000 of inventory at the beginning of period 1, enough to carry it into the next period. To protect itself from a possible drop in the value of its inventory (in the event the labor problems are resolved quickly), Company X sells futures contracts to hedge its purchase. By the end of period 1 , the inventory increases in value by $100,000 and the futures contracts decline in value by $120,000. The inventory is sold and the futures contracts are closed out on the first day of period 2.

Assuming all criteria for hedge accounting are satisfied, Company X's income statements for the two periods would include the following relative to the inventory and the hedge on it under the various hedge accounting methods.

Period 1 Period 2

Deferral method:

  Gain on inventory                -0-    $100,000
  Loss on futures contracts        -0-   (120,000)
    Net                            -0-   ($20,000)

Mark-to-market method:

  Gain on inventory           $100,000         -0-
  Loss on futures contracts        -0-         -0-
    Net                      ($20,000)         -0-

Effectiveness method:

  Gain on inventory                -0-    $100,000
  Loss on futures contracts        -0-         -0-
    Net                      ($20,000)         -0-

TAX TREATMENT OF HEDGES

In a change from its previous position, the Internal Revenue Service released proposed and temporary regulations that treat gains and losses from most business hedging transactions as ordinary rather than capital. The new rules provide that hedges of interest rate, currency and price risk give rise to ordinary gains or losses. The temporary regulations are effective as of October 20, 1993, for all open tax years.

The three-part guidance includes

* A temporary regulation (TD 8493) regarding the characterization of business hedges.

* A notice of proposed rulemaking (FI-46-93) with additional identification requirements for hedging transactions.

* A notice of proposed rulemaking (FI-54-93) that addresses the timing of reporting income, deductions, gains and losses from hedging transactions.

The proposed regulations on hedge accounting (FI-54-93) do not make taxpayers' treatment of hedges for financial accounting purposes determinative for tax purposes because financial accounting standards for hedges still are being developed.

L. TODD JOHNSON, CPA, PhD, is a research manager at the Financial Accounting Standards Board, Norwalk, Connecticut. He is a member of the American Institute of CPAs and the American Accounting Association. HALSEY G. BULLEN, CPA, is a project manager at the FASB. He is a member of the AAA. VICTORIA W. KERN is a staff accountant at Price Waterhouse, San Diego.

Mr. Johnson and Mr. Bullen are employees of the Financial Accounting Standards Board, which encourages expressions of individual views by staff members. The views expressed in this article are those of Mr. Johnson, Mr. Bullen and Ms. Kern. Official FASB positions are determined only after extensive due process and deliberation.

The authors wish to express their appreciation to Jane B. Adams, Jules M. Cassel, Carol M. Clarke, Corliss J. Montesi and Raymond E. Perry of the FASB staff for their comments on earlier drafts of this article.