From the July-August 2008 issue of Treasury & Risk magazine

Hedging on FAS 133 Takes a Fair-Value Turn

FASB Accounting Standard (FAS) 133 on derivatives and hedging might be the regulation that everyone loves to hate but after 10 years and multiple revisions, many companies have gotten used to it as the devil they know. So, not surprisingly, FASB's latest fair value accounting proposal for hedges is garnering mixed reviews. The revision would simplify accounting for some - but by no means all - hedges and expand disclosures in financial statements. "People have been suggesting revisions almost since FAS 133 was issued in 1998," says Darren Greway, vice president of product development at treasury services provider FXpress. Greway sees the proposal as a step toward a better model for hedge accounting. "This is probably the most anticipated revision of any FASB statement for a long time," he adds.

Others question the need for more tinkering with FAS 133. "The trend in our market is that companies are becoming more comfortable with FAS 133," says Wolfgang Koester, CEO of FiREApps, a provider of foreign exchange exposure technologies.

Jiro Okochi, CEO and co-founder of Reval, which specializes in managing derivative hedges and implementing FAS 133, agrees: "The feedback we're getting from a lot of companies is, 'You've got to be kidding. Enough is enough.'" By suggesting that there's still room for improvement, FASB "has already made it worse for those companies that invested the time and money to get [hedge accounting] right," he says. (See Jiro Okochi's Final Word on page 46.)

FAS 133 established several special accounting methods to address the differences in the way hedge items and hedging instruments are recognized and measured, and to let companies manage both cash flow risk and the timing of the recognition in income of the gains and losses on hedging instruments. Two methods, critical terms matching and the shortcut method, permit companies, upon meeting strict criteria, to assume that a hedge is highly effective (offsets 80% to 125% of the gain or loss on the hedged item) and recognize the hedge as completely effective.

Citing such stringent criteria and their costs, some companies have complained that consistent application of FAS 133 is too hard. FASB also worries that bifurcation-by-risk, a method requiring companies to hedge risks individually, keeps investors in the dark about risks that aren't hedged in a transaction.

FASB is proposing that bifurcation-by-risk, critical terms matching and the shortcut method be replaced with fair value accounting. Generally, companies would hedge only the overall risk of the changes in fair value of the hedged item or the overall risk of the changes in the hedged cash flows, so that their income statements would reflect the effects of both risks that are hedged and that aren't hedged.

The revision would also make hedge accounting available to more hedges by lowering the effectiveness threshold for application from highly effective to reasonably effective, and by requiring qualitative tests of hedge effectiveness in many cases instead of quantitative tests. To cut costs, testing would occur only at the start of a hedge, unless the hedge appeared no longer reasonably effective.

Some special hedge accounting would remain, however. Bifurcation-by-risk would be optional for benchmark interest rate risk hedged for a company's own debt, since issuing that debt and entering into an interest rate swap may be less expensive than simply issuing that debt. Another exception would be made for foreign exchange risk, an area of hedge accounting carried over from foreign currency accounting in FAS 52, and which could not be reconsidered without reconsideration of that standard.

Also, FAS 133 would still require quantitative testing when no obvious reasonably effective hedge exists. "They're leaving the wording so vague that most companies will probably come up with a quantitative assessment anyway," says Okochi.

Jason Halpern, product manager at FXpress, agrees. "With the death of critical terms matching and the shortcut method, companies will be forced to measure ineffectiveness and will increasingly rely upon hedges using hypothetical derivatives," observes Halpern, adding, "This will result in a challenge of defining and valuing these contracts."

FiREapps' Koester believes the real problem with FAS 133 isn't its cost or complexity, but that it needs to provide more guidance on valuing derivatives. "Say you've got $500 million worth of derivatives on the books," says Koester, "and they're being moved by a hedge into the real world. Do you really have a $500 million underlying exposure, going into that hedge? And what is the derivative instrument intended to do?" Derivatives should be valued in relation to their underlying risk exposures, he says.

Adoption appears likely, say experts, if not simply because the comment period is so short and conveniently during the summer vacation season. In addition, the Securities and Exchange Commission has been pushing FASB to end critical terms matching and the shortcut method for some time and, as Greway of FXpress points out, "many corporates, taking the hint, have been moving to long-haul hedge accounting - step-by-step, quantitative assessment of changes in fair value of hedged risk."

If adopted, the changes would apply to fiscal years beginning after June 15, 2009, and interim periods within those fiscal years. The proposed revision of FAS 133, out for comment until Aug. 15, will probably draw the usual barrage of criticism, says Russ Mallett, a partner at PricewaterhouseCoopers. "There was a lot of dialog and letter writing when FAS 133 was first exposed," he says. "Companies cried foul because their existing hedge strategies weren't going to fit into the new standard. I think that many of the same companies will express similar concerns."

Clearer descriptions of a reasonably effective hedge and qualitative assessment would ease many of those concerns. FASB might include such guidance if it decides to adopt the proposed revision of FAS 133. Otherwise history could repeat itself, and this revision wouldn't be the last, again.

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