For the uninitiated, it's a typically arcane accounting dispute. But the restatement forced on Fannie Mae could amount to billions of dollars. At the end of last year, two other firms were forced to restate–no small matter in the eyes of Sarbanes-Oxley. Colonial BancGroup amended its accounts for the four annual periods since the introduction of FAS 133, resulting in decreases in earnings per share in three of those periods. Consumer finance company CIT Group also restated its 2005 earnings at the end of last year, and experts are predicting that the hardened stance of the auditors on the shortcut issue will begin to spill over into the corporate world during 2006. "We think the issue is going to spread," says Bridget Gandy, global head of international accounting research with Fitch Ratings in London. "Many of the problems arising with FAS 133 have been because the shortcut has been applied when it shouldn't be. Auditors are starting off with banks and will then look at corporates. If they've previously signed off on the shortcuts being used by banks, the chances are that they've been signing off on corporate use of the shortcut as well."

FASB continues to be criticized for its inflexibility, and a board meeting held on Feb. 14 saw the powers-that-be at the standard setter decide to take a fresh look at the shortcut method, says Lott, who was present for the meeting. "There will not be fundamental reconsideration at this point," he says. "It will be more a case of repairs and maintenance. I don't think anybody knows exactly what will happen, though. They could change the requirement, so it says that close to zero is good enough."

AVERTING CHAOS

For many, this would certainly be a welcome eleventh hour reprieve, but it may not represent the only outstanding salvation. The European Union (EU) introduced harmonized accounting rules for the 7,000 listed companies on European exchanges as of last January, and those companies are now releasing their first full annual statements under the new regime. FAS 133′s European counterpart, IAS 39, falls within the new International Financial Reporting Standards (IFRS). While the EU's derivatives rules are similar in intent to FAS 133, the independent standard setters also felt the need to produce something more definitively European. And, in this case, it may ultimately be good news for U.S. companies. "Some of those changes resulted in a lot of detail being omitted," explains Pauline Wallace, senior partner with PricewaterhouseCoopers' global accounting consulting services group in London. "IFRS is meant to be principles-based, not rules-based, and FAS 133 had too much detail for them to swallow."

Standard setters in the two jurisdictions meet regularly and agreed last year to work to eliminate the differences between their respective sets of rules. Given the glacial pace of change in accounting, that may seem an impossibly distant dream–and no timetable has been set–but against the odds, convergence is already happening and looks set to benefit U.S. companies.

Arguably, the biggest difference between FAS 133 and IAS 39 is the latter's inclusion of something called the "fair value option," which allows companies to mark certain assets or liabilities to market. The idea is that, where hedge accounting is impossible to achieve (because the effectiveness of the hedge can't be proven), companies can elect to mark both sides of the hedge to market anyway. After all, if the hedge is effective, little or no earnings volatility will result. This makes the EU rules a little more flexible than FAS 133, says Sue Harding, European chief accountant with ratings agency Standard & Poor's (S&P) in London: "In essence, it's a lighter route that avoids some of the stresses of hedge accounting."

Now, in keeping with the long-term aim of accounting convergence, FASB is laying the foundations for the introduction of a fair value option–an exposure draft was published on Jan. 26. "The idea had been kicking around for a few years here," says FASB's Lott, "but once the EU adopted the fair value option, it became a convergence issue and that added a little impetus. But the main reason for doing this is to offer something that works like hedge accounting to people who wouldn't otherwise have qualified."

Of course, there are other differences between FAS 133 and IAS 39 (see table) but, if the convergence project continues, the end result will be parallel rules which mirror each other almost exactly. This could produce a simpler, more flexible standard for U.S. derivatives users: In addition to the fair value option, IAS 39 offers other advantages. For example, it makes it easier for companies to qualify for hedge accounting by giving them greater latitude when designating a hedging relationship. In both standards, companies that want to use hedge accounting have to document exactly which risks are being hedged by which derivatives–for example, they have to designate a matching swap and bond. But the market value of a bond isn't driven solely by interest rates, while a swap is a purely interest rate hedging product. The resulting mismatch can make it look as though the swap is an ineffective hedge and disqualify it from hedge accounting treatment–in fact, the swap is doing the job it is intended to do. To counter this problem, both standards allow companies to designate a portion of the underlying risk to be hedged.

Where IAS 39 scores more highly than FAS 133 is in the flexibility allowed in these designations, says PwC's Wallace: "IFRS is very flexible on what you regard as a portion of risk. FAS 133 allows you to do it to a limited extent, but it requires you to use a benchmark rate and actually specifies the benchmark rates you can use."

The EU's standard also allows a certain amount of so-called "macro" hedging. In a macro hedge, rather than pairing off individual derivatives and exposures, a company can designate a pool of assets as the underlying exposure which is being hedged. This is a particular boon for businesses that need to hedge big exposures of uncertain duration–for example, mortgage loan portfolios. Because borrowers can pay off loans early, there's no way for the lender to achieve hedge accounting since the maturity of a derivative can't be guaranteed to match the duration of a loan. Again, the effect of this provision in IAS 39 is to make it easier to hedge risk and also obtain hedge accounting.

ONE FROM COLUMN A

But FAS 133 doesn't always come off second-best. PwC's Wallace gives the example of a situation in which a company has issued a variable-rate bond and wants to swap the floating-rate cash flows for fixed-rate ones. In certain circumstances, she says, the U.S. standard allows companies to demonstrate the hedge's effectiveness simply by matching up the variable leg of the swap with the variable flows on the bond: "If they match, that's accepted as proof of effectiveness," says Wallace. By contrast, IAS 39 takes the view that the full fair value movement of the swap has to be included in the effectiveness test–and because those movements are driven by fixed rather than variable rates, effectiveness is far harder to prove. European companies may also be vexed by the fact that, despite its flaws, they have no equivalent of FAS 133′s shortcut method.

As things stand, there are plenty of reasons for companies in Europe and the U.S. to gaze longingly across the Atlantic at the fabulous advantages conferred upon their competitors overseas. They will be hoping that, as the two regimes converge, standard setters manage to keep the wheat and ditch the chaff–rather than the other way around.