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	FASB Exposure Documents

In an effort to simplify one of the most complex and criticized financial reporting regimes, the Financial Accounting Standards Board (FASB) is proposing changes to hedge and derivative accounting rules that, if approved, would (1) (according to FASB) greatly improve comparability of financial results for entities that apply hedge accounting, and (2) require application of the fair-value measurement approach to all transactions, a mark-to-market accounting method long favored by the Board.

In an exposure draft issued on June 6, 2008, FASB proposed amending Accounting for Derivative Instruments and Hedging Activities, better known as FAS 133, a standard the financial accounting community has frequently criticized as being excessively burdensome since it went into effect eight years ago.

"The new proposed guidance is more principles based, simplifies the ability for an entity to qualify for and apply hedge accounting and better reflects the economics of the instruments included in hedging relationships," says Kevin Stoklosa, FASB's assistant director of technical activities.

"I see the proposed amendments to 133 as a plus," says Charles Mulford, director of the Financial Analysis Lab at Georgia Tech. "It makes accounting under the arduous standard easier to apply."

Key Changes

One aspect of FAS 133 that makes it so onerous is that companies can report similar transactions in different ways. Under current rules, entities can account for the hedged instrument and the hedged risk by using three methods of hedge accounting.

Multiple Methods of Hedge Accounting

One valuation approach is "bifurcation by risk," which allows particular risks within a derivative instrument to be broken out for accounting purposes. A second approach is the "critical terms match," where companies must achieve a perfect match between the hedged instrument and hedged risk with respect to a series of criteria including the amount and nature of the risk. And a third approach is the "shortcut method," under which companies must meet a large set of FAS 133 criteria.

This has led to confusion, difficulties in comparing financial reports and restatements of financial reports. "The so-called short-cut method has tripped up so many companies and led to so many restatements," says Prof. Mulford. "Recent examples of 133-related restatements include GE and Fannie Mae."

The proposed amendment would eliminate these multiple methods of hedge accounting available for the same transaction and establish a fair-value approach for all transactions, making sure, for example, that the financial instrument and its associated risk are accounted for in the same way.

"The [fair-value] approach would eliminate many elements that exist under the current hedge accounting model, including bifurcation-by-risk, the shortcut method [and] critical terms match," says the 87-page document issued by FASB. "The idea is to simplify accounting for hedging activities, improve the financial reporting of hedging activities and resolve major practice issues related to hedge accounting that have arisen under Statement 133."

"Reasonably Effective" Test

A second important change proposed by the FASB would require companies to prove that a hedge is "reasonably effective" to allow them to use hedge accounting. Previously, FAS 133 required a hedge to be "highly effective" in order to be eligible. The new proposal "will soften the threshold for applying hedge accounting," says Prof. Mulford. "This simplifies the application of hedge accounting under FAS 133," allowing many more companies to report in their income statements and balance sheets their derivatives and hedging activities.

Reporting All Changes Affecting the Value of the Hedged Risk

A third key difference between the revised financial accounting standard and FAS 133 is that companies now would have to report all changes affecting the value of a hedged risk, and not only the changes against which they hedged.

For example, if a company that uses an interest-rate swap to hedge against the risk of decreased earnings stemming from changes in the value of a loan qualifies for hedge accounting – which the new FAS 133 would make it easier to do – it would be required to report changes in the fair value of both the swap and the loan on the income statement. But if it doesn't qualify, it would have to treat changes related to the swap and loan separately. In that case, the swap's changes would be accounted for at fair value on the income statement, while the loan would be recorded using loan accounting. By using hedge accounting, the company could balance the ups and downs in earnings that might result if the company only accounted for the swap on its income statement.

Convergence

Many people in the financial accounting industry believe that standards should gravitate towards global convergence, but for some, FASB's proposal seems to go in the opposite direction. In fact, two FASB board members, whose opinion are outlined in the draft proposal, say the proposed amendments only "add to the differences between standard 133 and the international standard on derivatives and hedging, at a time when we should move forwards."

The proposed revision of FAS 133 does diverge from the hedge accounting requirements of the International Accounting Standards Board outlined in Financial Instruments: Recognition and Measurement, also known as IAS 39 (International Standards on Derivatives and Hedging). But IASB is currently considering two general approaches to changing hedge accounting requirements. The first approach, according to FASB, would be to eliminate and possibly replace existing hedge accountings requirements. The second approach would be to maintain and simplify the existing requirements, a similar approach to FASB's proposed amendment.

"The International Accounting Standards Board has issued a discussion paper on accounting for Financial Instruments and Hedging Activities that is similar to what is proposed in the FASB Exposure Draft. So if the changes to FAS 133 occur sooner than the changes to IAS 39, then the accounting differences would only be for a short time. However, the two standards would be converged if and when the US moves to international standards," says FASB's Stoklosa.

Prof. Mulford agrees. "The amendments are not necessarily focused on IAS 39, [but] I still see them moving in the right direction."

Impact on Hedge Funds – To be Determined

It is still too early to adequately assess the opinions of the financial community towards the potential revisions to FAS 133. The big auditing firms are still digesting the document. So far, according to Stoklosa, FASB has not received any comments. The deadline for comments is August 15, 2008, and the board's goal is to issue a final statement by December 31, 2008, then to start application of the new rules for fiscal years beginning after June 15, 2009.

The proposed changes provide guidance on how to account for derivative instruments and hedging activities for all entities, says Stoklosa. "In other words, the guidance in FAS 133 is the same for hedge funds as it is for any other entity."

To the extent hedge funds use derivatives for speculative purposes, the changes are not likely to prove especially troublesome. "I don't see the softening of hedge accounting rules as being particularly burdensome to hedge funds," says Prof. Mulford. However, to the extent hedge funds use derivatives to hedge other risks, they – like other derivatives market participants – would have to understand and incorporate the proposed accounting changes.