Will the FASB clip the hedges?

Do you use hedging strategies to manage risk? Are you confused about the rules on accounting for derivatives? If you answered yes to either question, tread carefully -- the FASB may be bringing big changes your way.

If you've got hedging headaches, you're not alone. CFOs and corporate treasurers are continually barraged with a myriad of financial instruments and techniques for managing the risk in their businesses. But accounting rule makers also have been hard-pressed to keep up with new hedging products and techniques. As a result, accounting rules in this area are piecemeal, often internally inconsistent and sometimes counterproductive to sound economic management. This has made the going tough for financial executives trying to adopt sound economic hedging strategies without undesirable financial-statement results.

Controversial accounting procedures for hedging anticipated future exposures vividly demonstrate the rampant confusion. While one accounting regulation permits companies to defer gains and losses on futures contracts hedging anticipated interest-rate and commodity price risks, another prohibits deferrals on foreign-currency forwards and swaps for hedging anticipated foreign-currency transactions. This is just one example of the regulatory hodgepodge.

After years of prodding by a somewhat frustrated business community, the Financial Accounting Standards Board in 1992 launched a project on hedge accounting and accounting for derivatives and synthetic instruments. Most recently, the FASB staff prepared a "Preliminary Views" document containing tentative conclusions that could significantly change the current rules and practices. Because individual FASB members are divided on certain key issues, and because two of the seven ended their term in June and were replaced with two new members, this document was not released publicly. Rather, the FASB recently released "A Report on Deliberations" on its discussions and tentative conclusions to date and plans to hold meetings in the fall with interested parties.

The existing authoritative accounting rules are spelled out in Statements of Financial Accounting Standards 52 and 80. SFAS 52 deals with foreign currency transactions, including accounting for foreign-currency forwards and currency swaps, and SFAS 80 addresses the accounting for regulated interest-rate and commodity futures contracts. A 1986 issues paper from the American Institute of Certified Public Accountants contains nonauthoritative accounting guidance for options. While no promulgated guidance for interest-rate swaps and other derivatives exists, generally accepted practices have emerged. Finally, the FASB's Emerging Issues Task Force and the Securities and Exchange Commission's Office of the Chief Accountant have occasionally addressed specific issues prompted by regulatory gaps or the internal inconsistencies of existing hedge rules and practices. The table on page 42 lists some key accounting pronouncements on hedging and derivative financial instruments.

The EITF discussions in 1991 and 1992, which centered around options and options techniques to hedge anticipated foreign-currency transactions (EITF issues 90-17 and 91-4), highlighted the inconsistencies between SFAS 52 and SFAS 80. The EITF okayed hedge accounting for simple purchased options used to hedge anticipated foreign currency transactions, but with regard to the more cost-effective forwards and combinations options, the SEC staff objected to permitting this treatment, a conclusion that is baffling for both laypersons and accountants. Companies are forced to either go "naked" on anticipated foreign currency transactions, purchase high-cost options to avoid adverse accounting or risk the income-statement volatility of mark-to-market accounting by using more cost-effective forwards and combination options.

Another conceptual inconsistency involves how companies assess risk, a prerequisite to hedge accounting. If SFAS 52 applies, a company must demonstrate only that a contemplated transaction creates risk, while hedging transactions accounted for under SFAS 80 must meet a much more restrictive "enterprise" risk test. For example, a U.S. company with a firmly committed future sterling revenue stream may choose to hedge using forward contracts. SFAS 52 criteria require that the forward contract reduce the foreign-currency risk created by the revenue stream without considering other "natural" offsetting positions in the company, such as existing sterling liabilities or purchase commitments that already (and maybe unintentionally) offset the foreign exchange risk in the revenue stream. Under the same circumstances, SFAS 80 would preclude hedge accounting if such natural offsets exist.

Cross-hedging foreign currency exposures is another area of inconsistency. SFAS 52 clearly prohibits cross-hedging except under very limited conditions, while SFAS 80 generally allows it. SFAS 80 prescribes a correlation test between the hedged item and the hedging instrument that requires a company to examine historical relationships and to monitor the correlation after it executes the hedging transaction. This permits cross-hedging, provided a strong correlation exists between changes in the hedged item's value and the hedging instrument.

A troubling area that particularly impacts financial risk managers is the prohibition of macro-hedging in the existing accounting rules. All promulgated guidance requires that a hedging instrument be linked to a specific current or future identified transaction, asset or liability. Many companies believe the accounting rules do not reflect today's economic realities, in which hedging strategies encompass a portfolio of anticipated transactions, assets or liabilities rather than a specific transaction.

WHEN SILENCE ISN'T GOLDEN

And the authoritative accounting rules are virtually silent on the multitudes of financial instruments, such as interest-rate swaps, that companies use to create "synthetic instruments." For example, a company needing fixed-rate financing may choose to issue variable-rate debt converted to a fixed-rate exposure by executing an interest-rate swap, which requires the company to make periodic fixed payments and receive periodic floating rate-based payments. In accounting lingo, this translates to synthetically creating fixed-rate debt.

Notwithstanding the lack of formal guidance, accounting practices have evolved allowing companies to account for the cash flows on the swap as if they were interest payments on debt. Most accountants would agree with this treatment, particularly if the debt and swap were issued simultaneously. But complexities with synthetic-instrument accounting crop up quite easily. For example, what happens if an interest-rate swap was executed some time after the debt to which it was linked? Market conditions could be quite different, making the relationship between the "old" debt and new interest-rate swap somewhat tenuous. Also, investment bankers continually dream up multitudes of transactions to meet a company's financing needs more effectively while also taking advantage of market conditions. These instruments can be very complex, even if designed to act as traditional financing instruments.

DRAMATIC CHANGES

Although the FASB has decided not to release its tentative conclusions for general public comment, the changes implied could have far-reaching consequences for companies engaged in hedging and financial risk-management programs. For example, it's generally agreed that hedge accounting should be permitted for hedges of existing assets, liabilities, or firm commitments, given the existence of a clear economic relationship between the hedging instrument and the item being hedged, and a reasonable expectation at the hedge's inception of high inverse correlation. But several board members believe that hedge accounting should not be permitted for anticipated transactions that are not firm commitments (referred to as "forecasted transactions"). TABULAR DATA OMITTED This would be a significant roll-back of the current rules, which permit deferrals of gains and losses on qualifying hedges involving interest rate and commodity futures (SFAS 80) and on purchased foreign currency options (EITF Issue No. 90-17) used to hedge anticipated transactions considered likely to occur.

This view reflects certain FASB members' and SEC's Office of the Chief Accountant's concerns over both the conceptual propriety of the current hedge accounting model and the more practical concern over the ability to develop workable rules that prevent companies from deferring losses in situations where the expected transactions may never materialize. Changing these rules could profoundly affect companies that extensively hedge interest-rate risk, commodity price risk or foreign-currency risk associated with anticipated but not firmly committed future transactions. Continuing such hedging programs would mean mark-to-market accounting on the hedge instruments, while discontinuing them would expose companies to unwanted price risks. At this point, FASB members are far from unanimous on this issue and could be swayed by the likely torrent of criticism the board will receive on any formal proposed revision of the current rules along these lines.

The board's tentative conclusions also reflect other potential changes in the current model. As discussed above, the current rules provide tests relating to risk reduction and continuing high correlation between the hedge and hedged item. As currently contemplated, a "partial effectiveness method" would be employed under which a hedge would be considered effective if the cumulative change in the fair value of the hedging instrument does not exceed the cumulative inverse change in the fair value of the item being hedged. If this does happen, the excess would be recognized currently in earnings.

To illustrate, consider two situations involving a grain company's hedge of its wheat inventory through the sale of wheat futures contracts. If wheat prices increase such that the wheat inventory's value rises by $1,100, while the futures contract has a $1,000 unrealized loss, the entire loss would be deferred. On the other hand, if the inventory value rose by only $900, only that amount of the futures contract losses could be deferred, with the remaining $100 charged to current-period earnings. Under the current rules, the entire loss would be deferred in both scenarios. Still, using the partial-effectiveness method would simplify and broaden the current rules by eliminating the often-troublesome continuing high-correlation requirement of SFAS 80 and would permit hedge accounting for cross-currency hedges. Under the current SFAS 52 rules, these do not generally qualify for hedge accounting treatment.

For financial institutions and other entities that manage net interest rate or currency risk of their overall asset/liability position, the board is tentatively leaning toward permitting macro- and dynamic hedging under an alternative mark-to-market pool approach. Therefore, all components of the dynamically managed portfolio (i.e., the assets, liabilities and related derivatives) would be measured at current-market or fair value, with the resulting gains and losses reported in current-period earnings.

SYNTHETIC ACCOUNTING

Finally, the FASB has also discussed synthetic instrument accounting, where derivatives are used in connection with borrowing or lending transactions to modify the structure of a transaction or to synthetically create a single "prototype" financial instrument. Under the proposed approach, the company would combine and measure the separate instruments used in the synthesis at net proceeds received or paid, reporting the combined instruments as the single prototype being synthesized. For subsequent financial-reporting periods, the company would recognize in current-period earnings the difference between the changes in fair value of the synthesized instrument and the prototype instrument.

This approach seems to restrict synthetic instrument accounting to situations where the swap or other derivative is entered into at the inception of a borrowing or lending transaction. Thus, for example, the company that borrowed on a floating-rate basis several years ago and that now, due to lower interest rates, locks in a fixed rate on the remaining borrowing term by entering into an interest-rate swap, would be precluded from using synthetic instrument accounting and would presumably have to carry the swap on a mark-to-market basis. This would depart significantly and, we think, inappropriately, from current practice, under which companies usually can avoid mark-to-market accounting for swaps that change the interest characteristics of existing debt or assets, even if the swap is begun some time after the original borrowing or lending transaction.

In short, if you engage in or are contemplating entering into hedging and financial risk management programs, get to know both the current rules and the FASB's possible changes. Also, keep an eye on the FASB's continuing deliberations and, as appropriate, express your views directly to the board or through industry associations and business groups. Most of all, tread carefully with new derivatives and synthetics transactions.

Mr. Herz is a partner in the financial advisory services group at Coopers & Lybrand in New York City and is a member of the Financial Instruments Task Force of the Financial Accounting Standards Board. Mr. Beier is a director in the financial advisory services group of Coopers & Lybrand in New York City.