While the Financial Accounting Standards Board's recent proposal on accounting for financial instruments has irked the banking industry by extending fair-value accounting to loans, another part of the draft could ease the chore of accounting for hedges for other companies.
"There are some elements that will make hedging a little bit easier," says Tom Omberg, the Deloitte & Touche partner who leads the firm's financial accounting and reporting services offering.
Under FAS 133, Omberg explains, companies that didn't use the short-cut or match-terms methods to establish the effectiveness of a hedge had to perform a quantitative assessment of a hedge's effectiveness.
"Those calculations could be difficult to do," he says. "They had to be done at inception and every quarter. When you closed the books, companies had to go back and check effectiveness."
Under the proposed changes, "all you have to do is assert at the inception of the hedge that you expect it to be reasonably effective," he says. And that assertion can be based on qualitative analysis, Omberg says, which might include considering the historical relationship between the hedging instrument and the position to be hedged, or the maturity date of the hedging instrument and a security being hedged.
Helen Kane, founder and president of Hedge Trackers, a derivatives accounting consulting company in Cupertino, Calif., says FASB's proposed changes will eliminate "a lot of busywork around effectiveness testing."
"What they're saying is when there's an obvious economic link between the derivative and the underlying, don't spend a lot of time on proving how that relationship works," Kane says. "Focus instead on where the difference will be going forward in these cash flows, so you can capture the ineffectiveness."
That poses a new challenge for corporate hedgers, she says. "I don't believe a lot of companies have focused really a solid effort on capturing the ineffectiveness in the current relationship."
FASB's proposal would require that hedges be "reasonably effective" to qualify for hedge accounting treatment, rather than the "highly effective" standard it previously cited. And it has proposed eliminating the short-cut and match-terms methods of establishing hedge effectiveness.
"For anyone who uses short-cut or match-terms, this is definitely not going to be easier," Kane says. But Omberg notes that companies have used the short-cut method less frequently in recent years "given the rigid criteria."
One hitch for companies that use hedge accounting is that FASB's proposed changes would no longer allow them to de-designate hedges, that is, stop use hedging accounting for a position. "Under current accounting rules you can designate and de-designate a hedge whenever you want," Omberg says. "The proposal that's out there would not allow you to de-designate a hedge until it was no longer effective." That change "will limit your ability to do dynamic hedging," he says.
Kane says companies that hedge their inventories or contracts might have a problem if they're not able to de-designate, since inventories fluctuate and contracts are altered, situations that companies dealt with in the past by de-designating hedges. "It would become very difficult for inventory hedges," she says. "I'm not sure how those folks would address the changing values."
So which companies would benefit? Those that "have a number of hedges that were more static hedges--put on with the intention of hedging to the maturity of the asset or the liability--and weren't using the short-cut method will probably find the proposal to be helpful," Omberg says. "Companies that do dynamic hedging are going to find the provisions that preclude de-designation to be a problem, and they're going to have to explore how to hedge a pool of assets."
To read about the congressional battle over regulating derivatives, see Rock Solid on OTC Derivatives Regs.