The challenges of hedge accounting: the explosion of new hedging instruments has outpaced accounting guidance.

THE CHALLENGES OF HEDGE ACCOUNTING

The explosion of new hedging instruments has outpaced accounting guidance.

Increased volatility of interest rates, foreign exchange rates and other prices has elevated hedging to an important business necessity. A tremendous variety of hedging products has sprung up in recent years to meet this need.

How should these products be reported in financial statements? Because traditional guidance fails to answer this question satisfactorily, the challenge of hedge accounting is here. This article describes hedging and why it's important, some of the financial reporting issues involved, the accounting profession's response and the significant problems that exist.

WHAT'S HEDGING AND WHY IS IT IMPORTANT?

Hedging is a tool for transferring price, foreign exchange or interest rate risk from those wishing to avoid it to those willing to assume it. Specifically, hedging is the act of taking a position in a hedging instrument--such as in the futures, forward, options or swap market--opposite to an actual position that's exposed to risk. (See exhibit 1 Definitions of the basic hedging instruments.) Hedging reduces the risk of loss from adverse price or rate fluctuations that may occur in owning or owing items over a period of time. Conversely, hedging may limit the gain from favorable changes. Among the items hedged are

* Owned assets including financial instruments or commodities such as grains, metals and livestock.

* Existing liabilities such as foreign currency-denominated borrowings.

* Contractual (firm) commitments to buy or sell items such as commodities or financial instruments.

* Anticipated, but not contractually committed, transactions such as purchases or sales or the issuance or refinancing of debt.

Volatility in interest rates, foreign exchange rates and other prices has created a demand for instruments that could help borrowers, lenders, financial institutions, manufacturers and other industrial companies reduce their risks--risks that if not properly managed could threaten the very survival of their companies. This volatility--combined with increased internationalization, competition, global deregulation, technology, sophisticated analysis techniques and tax and regulatory changes--has promoted an almost unbelievable explosion of innovative financial instruments that may be used as hedging vehicles.

WHY THE NEED FOR HEDGE ACCOUNTING?

The need for some special accounting for hedges arises in part because of our historical cost, transaction-based accounting system. Under that system, the effects of price or interest rate changes on many existing assets and liabilities aren't recognized in income until realized in a later transaction. If the gains or losses on the underlying assets or liabilities are reported in a time period different from that of the losses and gains reported on the instruments used to hedge these assets and liabilities, the accounting result could be reporting related, offsetting accounts in income during different reporting periods. This reporting would tend to cause fluctuations in income, implying increased exposure to price or interest rate changes when, in fact, the exposure has been reduced.

A somewhat similar result would occur if gains or losses were recognized currently for instruments entered into to hedge firmly committed or probable transactions not involving existing assets or liabilities. Under traditional accounting, the unrealized gains or losses associated with these future transactions may not be reflected in the financial statements until realized.

The accounting challenges are to develop special or different accounting (hedge accounting) that addresses these issues and then to specify the conditions under which this hedge accounting is appropriate.

THE FASB's RESPONSE

How have accounting standard setters, primarily the Financial Accounting Standards Board, responded to the challenge? In general, the standard setters' response has been slow, ad hoc and inconsistent; but there's some hope in the long run with the FASB's financial instruments project.

In 1981, the FASB issued Statement no. 52, Foreign Currency Translation, which deals with hedge accounting for foreign exchange forwards, futures and currency swaps. In 1984, it issued Statement no. 80, Accounting for Futures Contracts, which addresses all types of exchange-traded futures, except foreign currency.

However, problems persist. For many of the new instruments and transactions, the problem is a total absence of accounting guidance. Not covered are

* Interest rate forwards.

* Almost all types of options.

* Interest rate swaps.

Interest rate swaps were born in the early 1980s and the market has grown to over $1 trillion. The accounting standards say virtually nothing about how either users or market makers should account for these swaps. Similarly, the market for options of all types--exchange-traded and over-the-counter--on commodities, foreign currencies, financial instruments and futures contracts has soared in recent years, but existing accounting standards address only accounting for options on common stocks (FASB Statement no. 12, Accounting for Certain Marketable Securities).

A second problem is that the standards promulgated are inconsistent. To the extent instruments covered by existing standards seem analogous to the new financial instruments, the inconsistencies create uncertainty about which rules to follow.

WHAT'S HEDGE ACCOUNTING?

Both Statements nos. 52 and 80 provide for hedge accounting. The underlying broad concept of both statements is to achieve some sort of symmetry between accounting for the hedging instrument and the assets, liabilities or transactions being hedged. If specified criteria are met (reduction of risk, designation, effectiveness and so forth), gains or losses on the hedging instrument are recorded at the same time and in the same manner as the losses or gains on the hedged item. If the losses or gains on the item being hedged are deferred--for example, assets carried at cost or a future transaction--then the gains or losses on the hedging instrument are deferred as part of the carrying amount of the hedged item rather than recognized currently in income.

Similarly, if unrealized changes in the market price of the hedged item are included in income or in a separate component of stockholders' equity (for example, net investment in a foreign entity), gains or losses on the hedging instrument also are recognized as they occur in income or in the separate component of stockholders' equity--thus providing a match.

If the hedging instrument doesn't meet the specified criteria for hedge accounting, it's accounted for separately at value with gains and losses recorded currently in income.

Despite the similarities in concept between Statements nos. 52 and 80, important inconsistencies exist. These inconsistencies relate both to the conditions necessary to qualify for hedge accounting and the application of hedge accounting when the criteria actually are met.

CONFLICTS BETWEEN STATEMENTS nos. 52 AND 80

Exhibit 2 Hedge accounting comparison compares the provisions of Statements nos. 52 and 80 in several key areas. Also included are comparisons with the advisory conclusions in the American Institute of CPAs issues paper, Accounting for Options, and interest rate swap accounting as applied in practice. It's apparent many conflicts exist, some of which are discussed below.

Risk reduction. One criterion for hedge accounting is the hedging instruments must reduce exposure to risk. The statements, however, take different approaches to the determination of risk reduction. Statement no. 80 requires an enterprise approach: A futures contract should reduce the enterprise's overall exposure to risk. If the enterprise's other positions already offset the exposure the futures contract is supposed to hedge, the contract won't qualify for hedge accounting. Statement no. 52 provides for a transaction approach: Foreign exchange forward contracts or futures need only hedge particular transactions, even if other positions already offset the exposure.

Hedges of anticipated transactions. Statement no. 80 allows the designation of futures contracts as an accounting hedge of an anticipated probable transaction (a transaction that an enterprise expects but isn't obligated to carry out in the normal course of business). Statement no. 52 forbids designating foreign currency forward and futures contracts as an accounting hedge of an anticipated foreign currency transaction.

Cross hedging. Cross hedging involves hedging an exposure, such as commercial paper, with an instrument whose underlying basis differs from the item being hedged, such as U.S. Treasury bill futures. Statement no. 80 permits cross hedging if a clear economic relationship exists and high correlation is probable. Statement no. 52, however, usually does not permit using one currency to hedge another.

Split accounting for inherent elements (premium or discount). Futures and forward contracts incorporate a premium or discount representing the difference between the current spot price of the underlying commodity or instrument and the future or forward price. This difference reflects, among other things, the time value of money. For futures and forward contracts accounted for as hedges, Statement no. 52 requires the premium or discount be accounted for separately from the changes in value of the futures or forward contract (split accounting). Statement no. 80 forbids separate accounting for the premium or discount except in rare circumstances.

Valuation of speculative (nonhedge) positions. Statement no. 80 requires futures positions that don't qualify for hedge accounting to be valued at market value. However, Statement no. 52 provides for a formula value that ignores the time value of money. (Note that the FASB's emerging issues task force [EITF] reached a consensus in Issue no. 87-2, Net Present Value Method of Valuing Speculative Foreign Exchange Contracts, which says that discounting is allowed but not required in applying Statement no. 52.)

FILLING THE VOID

As discussed above, many hedging instruments aren't covered by authoritative generally accepted accounting principles--that is, standards issued by the FASB or its predecessors. To fill the void until the FASB addresses hedge accounting as part of its financial instruments project, accountants have to improvise. They can do this by looking to nonauthoritative guidance and by drawing analogies to existing GAAP. Some of the sources of help and problems in analogizing are described below.

OTHER SOURCES OF INFORMATION

In 1986, the AICPA accounting standards executive committee (AcSEC) finalized an issues paper, Accounting for Options, whose conclusions incorporate many of the concepts of FASB Statements nos. 52 and 80. However, because the FASB statements' conclusions are inconsistent, AcSEC had to make choices and developed some new ideas along the way, in some cases adding to the inconsistencies. (See JofA, Jan.87, page 87, for how options work and AcSEC's conclusions.)

The options issues paper has been submitted to the FASB. Although not authoritative, it represents a source of information for practitioners. However, because some of the issues paper's conclusions are inconsistent with existing authoritative literature (for example, Statement no. 12), care must be taken in using it.

Other sources of hedge accounting information CPAs may find useful include

* Another AICPA issues paper published in 1980, Accounting for Forward Placement and Standby Commitments and Interest Rate Futures Contracts.

* Articles describing how hedging products work, the accounting issues and current practice. An example is the article on interest rate swaps in the September 1985 Journal of Accountancy (page 63).

Further, the EITF has dealt with several hedging issues (see exhibit 3 Hedging issues dealt with by the emerging issues task force), but the solutions sometimes have been ad hoc, and in some cases no consensus was reached.

THE PROBLEMS OF INCONSISTENCIES

Despite the fact that some information exists, the inconsistencies among existing FASB standards, AICPA recommendations and EITF consensus make it difficult to address accounting for new products by analogy. The result is uncertainty about which accounting should be followed. It's particularly difficult and confusing to resolve practice problems because the instruments--futures, forwards, options, swaps and so forth--have similarities. Here are some accounting dilemmas:

What does a CPA do with foreign currency options? Does the CPA

* Follow Statement no. 52 and not permit hedge accounting for anticipated probable (but not firmly committed) transactions?

* Follow the more recent Statement no. 80 and the AICPA option issues paper and permit it?

Statement no. 52 does not mention options partially because it was written before options became a factor in the market. And even if anticipatory hedge accounting is acceptable for foreign currency options, what does the CPA do with instruments such as foreign exchange participating forwards and range forward contracts that have elements of both options and forwards? Statement no. 52 clearly prohibits anticipatory hedge accounting for foreign currency forwards, futures and swaps.

What does the CPA do with interest rate forwards or interest rate swaps? Does he or she follow

* The designation and enterprise-risk-reduction criteria of Statement no. 80?

* The designation and transaction-risk-reduction criteria of Statement no. 52 and the AICPA recommendations?

* None of these?

As indicated in exhibit 2, practice is not uniform. What about an option on an interest rate swap? What about hedging anticipated, but not firmly committed, transactions with interest rate swaps?

What does a CPA do with synthetic instruments? Does the CPA

* Analogize to existing hedge accounting criteria and rules?

* If so, which ones?

* Simply account for the instrument?

Synthetic instruments are created in several ways. For example, an entity issues fixed-rate debt to creditors and at the same time enters into an interest rate swap with a third party. It receives fixed-rate interest and pays floating-rate interest on a notional principal amount that equals the principal on the debt. The combination of the debt and the swap converts fixed-rate debt to "synthetic" floating-rate debt.

Synthetic instrument accounting is accounting for that which the synthetic instrument is meant to replicate--in this case, floating-rate debt. Other examples of synthetic instruments include

* Callable debt synthetically changed to noncallable debt through writing (selling) an option on an interest rate swap.

* Synthetic puttable debt created from callable debt.

* Synthetically shortening the mandatory maturity of callable debt.

* Synthetic yen debt created from dollar-denominated debt and a currency swap.

All of these synthetic instruments behave like basic identifiable financial instruments in the marketplace, but they're created synthetically because the total cost is perceived to be lower. Synthetic instrument accounting is frequently used in practice. Sometimes the same results could be achieved by applying hedge accounting, but in other cases the criteria for hedge accounting aren't satisfied. For example, the synthetic instrument may well increase transaction and enterprise risk.

What does the CPA do with hedging using cash instruments? Statement no. 52 permits hedge accounting when the hedging instrument is a cash instrument, such as foreign currency-denominated debt or time deposits. However, opinions differ about the acceptability of hedge accounting using cash instruments in other areas, such as U.S. government bonds. In Issue no. 87-1, Deferral Accounting for Cash Securities That Are Used to Hedge Rate or Price Risk, the EITF did not reach a consensus, although a majority of the EITF members would prohibit hedge accounting in these other areas.

Compounding problems. Further compounding the problem are some aspects of Statements nos. 52 and 80 that many believe just don't make sense--that is, they don't follow economic substance:

* The prohibition of anticipatory hedge accounting in Statement no. 52.

* The general absence of split accounting for futures in Statement no. 80.

* The effective prohibition of cross hedging (tandem currency) in Statement no. 52.

* The procedures in Statement no. 52 for valuing speculative foreign exchange positions at formula rather than market value.

HOPE FOR RESOLUTION

There's hope for a resolution of these practice problems, but probably not in the near term. That hope is the FASB's project on financial instruments, which includes one segment addressing instruments that transfer risk.

I believe the goals of that project should be to

* Create a level playing field by developing a conceptually based approach that will account for similar instruments similarly and different instruments differently.

* Achieve accounting consistent with economic substance.

* Modernize and generalize accounting standards to deal with new products.

* Address the needs of both product users and market makers.

Any solution should be able to handle existing instruments as well as instruments that will be developed in the future. Many of the new hedging products will be permutations of existing products.

It's worth noting again that the need for hedge accounting is in part--but not completely--driven by our historical cost system. The more market value accounting is used for existing assets and liabilities (and that issue also is part of the FASB's project), the less need for special hedge accounting rules. But until the FASB issues new, comprehensive standards, CPAs will have to solve problems by analogizing to existing literature and current practices and by relying on the EITF.

EXHIBIT 1

Definitions of the basic hedging instruments

Forward:     An agreement between two parties to
             exchange specific items--for example,
             two currencies--at a specified future
             date and at a specified price.
Futures:     An exchange-traded contract for future
             delivery of a standardized quantity of
             an item at a specified future date and at
             a specified price. Changes in the
             market value of the futures contract are
             settled in cash daily.
Option:      A contract allowing, but not requiring,
             its holder to buy (call) or sell (put) a
             specific or standard item at a specified
             price during a specified time period or
             on a specified date. Options may trade
             on exchanges or over-the-counter.
Interest     An agreement between two parties to
rate swap:   exchange one interest stream--for
             example, floating rate--for another--fixed
             rate--based on a contractual or notional
             amount. No principal changes hands.
Currency     An exchange of two currencies
swap:        according to an agreement to re-exchange the
             currencies at the same rate at a
             specified future date. During the term of the
             agreement, exchanges of interest
             payments denominated in the respective
             currencies also may occur.

EXHIBIT 3

Hedging issues dealt with by the emerging issues task force

Issue no.   Topic
84-7        Termination of Interest Rate Swaps
84-14       Deferred Interest Rate Setting
84-36       Interest Rate Swap Transactions
85-6        Futures Implementation Questions
86-25       Offsetting Foreign Currency Swaps
86-26       Using Forward Commitments as a Surrogate
            for Deferred Rate Setting
86-28       Accounting Implications of Indexed Debt
            Instruments
86-34       Futures Contracts Used as Hedges of
            Anticipated Reverse Repurchase Transactions
87-1        Deferral Accounting for Cash Securities That
            Are Used to Hedge Rate or Price Risk
87-2        Net Present Value Method of Valuing
            Speculative Foreign Exchange Contracts
87-26       Hedging of Foreign Currency Exposure with a
            Tandem Currency
88-8        Mortgage Swaps
88-18       Sales of Future Revenues

[Exhibit 2 Omitted]

JOHN E. STEWART, CPA, is a partner of Arthur Andersen & Co., Chicago. He serves on the Financial Accounting Standards Board's task force on financial instruments and off-balance-sheet financing and is the chairman of the American Institute of CPAs financial instruments task force. He is a member of the Illinois CPA Society, the National Association of Accountants and the American Accounting Association.