Identical Companies, Different Financial Statements.

One purpose of financial accounting standards is to create comparability between companies to allow financial statement users to make evaluations and decisions based on the consistent presentation of useful information about a company. However, in some cases, accounting standards can be applied or modified in ways that make it more difficult to compare financial data or understand what it means, which could undermine the quality of the earnings presented. An analysis of the different ways companies might apply Financial Accounting Standards Board Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, provides a useful example.

Three Approaches

Statement No. 133, in codifying much of existing practice and acknowledging that risk reduction is in the eye of the beholder, permits identical companies to look quite different depending on what they say they are doing. For example, assume we have three companies, each with the same fixed-rate asset, variable-rate debt, and a pay-fixed, receive-variable swap. Each company makes a different choice.

* Company A designates the swap as a fair value hedge of its fixed-rate asset. The derivative is marked to market and the carrying amount of the fixed-rate is marked for changes in the benchmark interest rate. Line items on the balance sheet will fluctuate but, assuming no ineffectiveness, fluctuation will be by equal and offsetting amounts, and there might be no income statement effect. There are two reasons for this: No ineffective piece is reported in earnings and the effective yield need not be recalculated until termination of the hedge.

This approach--continuing to adjust the basis of the hedged asset without requiting recalculation of the effective yield and reported interest income/expense--allows companies to change what otherwise would have been recorded as interest income (varying with changes in the benchmark interest rate) into gain or loss on disposition of the asset. The discretion in choosing where the swap is classified on the balance sheet allows companies to put the best spin on solvency, liquidity or other ratios.

* Company B designates the swap as a cash flow hedge of its variable-rate debt. While the swap is marked to fair value, the debt is already at fair value--so there will be more balance sheet volatility. The change in the value of the swap is stored as part of comprehensive income.This company must report the swap's change in value by adjusting the reported interest rate, creating real income statement differences between the first two companies. The same discretion exists about where to place the swap in the balance sheet.

* Company C chooses not to apply hedge accounting. Its balance sheet assets and liabilities look the same as the second company's do, but its income statement is different from either Company A or B since the gain or loss on the swap is recorded directly in earnings.

This example demonstrates that without improved disclosures, analysts will have no basis for comparison. For example, consider again Company A with its fair value hedge. If interest rates fall, it has a loss on the swap. If an effective yield were used, the fixed-rate asset would report lower interest income, while the interest expense on the variable rate debt is reported at its lower amount. Instead the company decides not to adjust the effective yield until hedge accounting stops. The result is higher earnings because interest income is reported at the higher fixed-rate amount, while interest expense is lower.

What would this company's management's discussion and analysis say about the impact of interest rate changes? Would we be able to reconcile its MD&A statements about the effect of interest rates to the fact that its footnote indicates (if we are lucky) that it is hedging its fixed-rate asset using a fair value hedge?

Another Difference

A change recently proposed by the FASB will create another difference--this time in the treatment of an option's time value in the assessment of effectiveness of a cash flow hedge. Let's say two identical companies purchase a call option. The first company designates it as a fair value hedge of a fixed-price firm sales commitment. The second identifies the option as a cash flow hedge of its future inventory purchases. The FASB is proposing that this company can define its effectiveness test based on the future proceeds of the option contract. This means:

* No ineffectiveness in earnings for the time value portion.

* All changes in value will be reported as a separate component of equity.

* Time value adjusts the basis of the acquired commodity, affecting margin.

Depending on the choice made, the substantive performance of the effectiveness test is quite different. When and where the option premium is recognized is quite different and absolutely elective. Such changes do not improve the quality of earnings if they provide substantively different accounting results for the same instrument and exposure.

This article is based on remarks made at the AICPA/FEI Benchmarking the Quality of Earnings Conference, held in New York in April 2001.

Jane Adams is an Accounting and Tax Analyst in the Equity Research Group at Credit Suisse First Boston. Ms. Adams served as Deputy Chief Accountant in the U.S. Securities and Exchange Commission's Office of the Chief Accountant from 1997 to 2000. Ms. Adams also was Director of Accounting Standards at the AICPA from 1996 to 1997 and a Project Manager at the Financial Accounting Standards Board from 1987 to 1996.