On the adoption of full fair value treatment for derivatives through the balance sheet and income statement, concerns were raised32 that recognition and measurement inconsistencies (i.e. accounting mismatches), between the hedging instrument and hedged items, could trigger artificial earnings volatility. A mixed measurement approach33 and accounting mismatches can for example arise when a derivatives instrument (e.g. a cross currency swap) is accounted for on a fair value basis but the hedge (e.g. a held-to-maturity bond) is accounted for on a historical cost basis.
To address the concerns of artificial’ earning volatility, the accounting standard setters allow hedge accounting. Hedge accounting requires a similar accounting approach of both the hedging derivatives instruments and the hedge (i.e. source of risk exposure). The ‘hedge to hedge instrument’ matching principle under hedge accounting is effectively an exceptional accounting treatment to the general requirement to apply full fair value, and recognise gains and losses through the income statement, regardless of how the hedge is being accounted for (Hague, 2004). The main hedge accounting approaches are:
Fair value hedge accounting;
Cash Flow hedge accounting; and
31
Currently there is a disaggregation in the recording of gains and losses between OCI and net income. Therefore to recreate a full fair value picture, adjustments have to be made to reported income. A full fair value income statement would only be achieved if a) all items were accounted for on a fair value basis and b) their gains and losses were only recognised, through the current income statement.
32
These concerns were especially pronounced from the financial services industry with claims that a mixed attribute accounting will distort the reflection of their asset and liability management practices.
33
Mixed measurement accounting refers to the use of multiple measurement bases (historical cost and fair value) across different asset and liability categories. This is problematic for assets and liabilities with similar economic characteristics or items that need to be matched (e.g. a hedge and hedging instrument).
Net investment hedge accounting.
The main difference in the hedge accounting options is in the timing and location of recognised derivatives value gains and losses. Recognition of gains and losses could occur in the current period income statement or it could be deferred through the comprehensive equity statement (OCI). However, there areno differences in the balance sheet recognitionof fair value amounts under the hedge accounting options (i.e. all derivatives fair values are recorded on balance sheet). I describe the hedge accounting options in more detail below:
2.6.3.1 Fair value hedge accounting
Hedge accounting aims to resolve accounting mismatches and fair value hedge accounting adjusts the accounting treatment of the hedged item to that of the derivatives instrument. Given that the derivatives is accounted for on a fair value basis with gains and losses recognised through the income statement, the hedged item is adjusted to conform to the derivatives accounting approach. Hence, the gains and losses of the hedging instrument and hedged exposure are recognised in the income statement during the current period.
Fair value hedge accounting is applied to hedge fixed rate assets, fixed rate liabilities and unrecognized firm commitments. A firm commitment is a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates. An example of a fair value hedge is the use of an interest swap to hedge the value of a fixed rate bond (i.e. the principal risk or variation is in the value of the bond, which rises/falls with fall/rise of interest rate).
2.6.3.2 Cash flow hedge accounting
An additional reason for allowing hedge accounting was to enable managers to better reflect the management of risks associated with future transactions, given that future transactions are not reflected in current period income statement or balance sheet. Hence when management enters into derivatives transactions with the objective of managing future transactions, it is desirable to match the derivatives to the future transactions by deferring the recognition of gains/losses of the derivatives instrument (Hague, 2004). Cash flow hedge accounting is applied to forecast transactions (e.g. sales, purchases) and future interest rate payments.
The accounting treatment works in the opposite direction of fair value hedge accounting only as far as income statement treatment is concerned. Cash flow hedge accounting effectively adjusts the accounting treatment of the derivatives to that of the hedged item, while fair value hedge accounting works the other way round. It requires the deferral of derivatives gains and losses through the accumulated other comprehensive income (AOCI) statement or statement
of equity and only transferred to the income statement at a future date. The idea of cash flow hedge accounting is to match the gains and losses of the derivatives to the gains or losses of the hedged item. The subsequent transfer from AOCI to income statement occurs either when the hedge is ineffective or when the derivatives instrument is realised (Ramirez, 2007). The movement from AOCI to the income statement in accounting parlance is referred to as ‘recycling’ of gains and losses.
Under cash flow hedge accounting the hedging instrument and underlying exposure valuation adjustments are not recognised periodically through the income statement but rather recognised through comprehensive equity income statement in the balance sheet until the point of realisation of the anticipated cash outflow or inflow. Hence the fluctuations in derivatives value do not get reflected in reported earnings but instead the adjustments in hedging derivatives value and the underlying exposure are only recognised in the income statement and thus reflected in earnings only at the point of realisation.
An example of a cash flow hedge is if an airline manufacturer such as EADS has orders for the Airbus carriers from different airlines, located in different countries, due in 3 years time. It is appropriate to hedge the anticipated foreign currency revenue receipts, given that the carrier construction costs are incurred using local currency (i.e. the Euro), lest the profitability may be adversely affected should the Euro appreciate significantly relative to the revenue currency. Another example would be the use of an interest swap to primarily hedge interest rate payments of a floating rate bond (i.e. the principal risk is in the variation of interest payments).
In sum, cash flow hedge accounting through its deferral requirements, reduces the earnings volatility that would arise from the fair value recognition of derivatives.
2.6.3.3 Net investment hedging
This refers to the hedging of investments in subsidiaries in foreign countries, where the subsidiaries’ functional currency (i.e. the currency which an entity reports its performance in the financial statements) differs the domestic parent company’s functional currency. Net investment hedging is the approach to hedging foreign currency translation risk exposures of foreign subsidiaries.
Net investment hedging requires the reporting of the derivatives instrument in the same manner as the foreign currency translation adjustments. The changes in a derivatives that hedges a net investment in a foreign operation are reported in the Foreign Cumulative Translation Adjustment (FCTA) account, in the comprehensive equity statement, to
correspond with translation adjustment. However, if the derivatives gain or loss is greater than the translation adjustment, then such changes are recorded in current earnings. In addition, if the functional currency is the domestic currency (i.e. USD), then the gain or loss of derivatives in foreign investments are recorded in current earnings, under re-measurement gains or losses (Trombley, 2003). Effectively net investment hedging only allows the matching of the hedging instrument to the hedge, if the functional currency is the foreign currency. It is similar to cash flow hedge accounting in that changes are posted to the comprehensive equity account but it differs as it does not allow recycling. Table 2.2 summarises the impact of the different hedge accounting options on the primary financial statements.
Table 2.2 outlines and clarifies the posting of hedge accounting balances, gains and losses to respective balance sheet and income statement accounts.
Table 2.2 Hedge accounting: Impact on primary financial statements
34
Only amounts that are less than or equal to the translation gain/loss of foreign investment are recorded in comprehensive income statement. Otherwise it is recorded in income statement
Gain/loss recognised in income statement Gains /losses recognised in comprehensive income statement Mark to market in balance sheet No designated hedging relationship
(Speculative derivatives and
unqualified hedges) X X
Fair value hedge accounting
Fair value hedge instrument (e.g.
interest rate swap) X X
Fair value Hedged item (e.g. fixed
rate bond) X X
Cash flow hedge accounting X
Effective portion of derivatives
instrument X
Ineffective portion of derivatives
instrument (i.e. ineffective hedge) X
Forecasted transaction (e.g. sales) Effective portion on realisation (e.g. order delivery for forecasted
export sales) X
Ineffective portion X
Net Investment in a foreign
subsidiary X
Foreign currency portion of
transaction gain/loss X
2.6.3.4 Consequences of SFAS 133 requirements
SFAS 133 has several consequences including: Imposing significant interpretation and implementation costs;
Sub-optimal instrument selection; and
Increasing earnings volatility.
Implementation complexity
Choosing the appropriate derivatives accounting method and complying with the hedge accounting requirement is an onerous requirement for financial statement preparers (Ramirez, 2007).To qualify for hedge accounting, firms need to fulfil stringent criteria to demonstrate anticipated hedge effectiveness (i.e. effectively minimising exposure volatility). A hedge is deemed effective if, at its inception and throughout the life of the hedge, the enterprise can expect the changes in the reported value or cash flows of the hedged item to be almost fully offset by the changes in the fair value or cash flows of the hedging instrument, and the actual results are within 80 to 125% of such value. Otherwise, the hedge is deemed ineffective and firms have to immediately recognise all the derivatives gains and losses incurred too date. There are onerous prospective (prior to qualifying for hedge accounting) and retrospective tests (applied during the period of application of hedge accounting). These tests could include regression analysis of the exposure on derivatives value and a simulation of values. These tests are onerous as they are prospective in nature, and are skill and cost intensive (Ramirez, 2007).
The multi-layered complexity arising from hedge accounting also leaves investors with the burden of deciphering the managerial intent underpinning each derivatives accounting choice as the accounting depends on the nature of the underlying risk exposure, under hedge accounting rules. Furthermore, allowing multiple variations in accounting for derivatives (i.e. cash flow hedge accounting, full fair value) reduces comparability and leaves room for inconsistent35derivatives accounting.
Sub-optimal instrument selection
The onerous requirements on hedge accounting have had the unintended consequence of accounting policy effectively dictating risk management choices in certain instances. The design of the complex hedge accounting eligibility tests is based on the presupposition that
35For example, an interest swap’s accounting will depend on the hedge. If it is a fair value hedge, all gains and losses go through
hedge accounting would likely be the favoured accounting option for derivatives users, as it minimises the accounting mismatches. The stringent hedge accounting requirements inherently make it difficult for certain risk management derivatives instruments to qualify for hedge accounting. Options and non linear contracts in particular often fail to meet requisite hedge effectiveness tests and only qualify for hedge accounting to the extent that they have changes in intrinsic value but not time value.
The famous derivatives loss incurred by Procter and Gamble provides a good case study of sub optimal instrument selection. The management opted to use exotic interest rate swap instruments, rather than option instruments, to hedge interest rate exposure. The rationale for their choice was that option instruments had greater difficulty in qualifying for hedge accounting (Gastineau et al, 2001). This case is also discussed in section 2.3.2 covering the speculative use of derivatives.
SFAS 133 and earnings volatility
As described in the analysis of derivatives accounting rules (Trombley, 2003 and Park, 2004), relative to the preceding period, the adoption of SFAS 133 is likely to increase earnings volatility due to a) unqualified hedges b) interim hedge ineffectiveness and c) discontinued hedges. I further elaborate on these below:
a) Unqualified hedges. The ineligibility for hedge accounting of certain derivatives instruments used for risk management purposes results in unqualified hedges and hedge accounting ineligible derivatives instruments. Therefore the general application of fair value measurement for all derivatives causes earnings volatility when the corresponding hedge (e.g. bond being held-to-maturity) is accounted for on a historical cost basis. That is when there is an accounting mismatch between the hedge and hedging instrument.
b) Interim hedge ineffectiveness of hedging instruments. Hedge ineffectiveness could result in interim volatility of derivatives instruments used for risk management purposes and accounted for on hedge accounting basis. Interim volatility could for example arise due to
Exclusion of the time value parameters for option instruments when determining eligibility for hedge effectiveness. The value of an option consists of intrinsic value plus a time value element while forward contract prices consist of spot price plus a forward discount or premium. Companies can choose to exclude the
time value component for either options or forward contracts, and most companies do so in order to meet the hedge effectiveness tests. However, should a derivatives be eligible for hedge accounting (i.e. gains and losses are recognised on realisation or unwinding of the position), the excluded time value of either options or forward contracts will nevertheless be recognised in the income statement on a periodic basis and this will result in earnings volatility.
Basis risk: This can occur when managers initiate hedges, where there is a significant mismatch between the changes in value of the derivatives instrument and the changes in value of the underlying exposure. Ineffective hedges also arise due to application of cross-hedging strategies (i.e. the use of derivatives that have an underlying commodity, currency or index that is different from the hedged item). The hedge ineffectiveness could result from notional/principal differences, for example a debt of $1million could be the underlying hedge for an interest rate swap of $1.5million. Basis risk, in this example, could arise from maturity or re-pricing date differences between the hedging instrument (i.e. interest rate swap) and hedged exposure (i.e. debt). It could also arise from creditworthiness differences, for example, a company may hedge a high yield BB-rated debt using an A-rated derivatives (Hague, 2004). Finally they could arise due to quantity, location or delivery differences for commodity exposures. For example Brazilian coffee beans exposure hedged with an instrument based on Colombian coffee prices (Hague, 2004).
Valuation error: For example when derivatives are valued based on internal models to determine fair value of derivatives. This could occur for complex, illiquid derivatives instruments that are not exchange traded. Enron provides an illustrative case study of the opportunistic application of fair value principles when managers relied on internal models to determine derivatives fair values. It could also happen for embedded derivatives.
c) Discontinued and de-designated hedges: Discontinued hedges occur when a derivatives instrument is designated as a cash flow hedge accounting but thereafter the anticipated future transaction is terminated. In this situation the deferred gains or losses are posted back to the income statement from the AOCI. De-designation of derivatives is the revocation of hedge accounting eligibility during the holding period. It can occur when a derivatives is found to be ineffective, for example, if its value falls outside the 80 to 125% permissible range of hedge effectiveness, compared to the hedge, then a reversal of derivatives gains and losses that had been recorded in the
other comprehensive income statement needs to occur. This process is described as recycling of hedge accounting and tends to mainly apply to cash flow hedges. The problem with recycled hedge accounting adjustments, is that they effectively represent gains and losses relating to earlier reporting periods, and hence their inclusion can be create unforeseen and significant fluctuations in reported earning numbers.
The incremental earnings volatility due to SFAS 133 can in turn influence managerial incentives to smooth earnings using alternative means such as accruals, especially as managers tend to be averse to earnings volatility and prefer reporting smooth earnings trends (Graham et al, 2005).
Empirical evidence on the impact of SFAS 133 on earnings volatility
There is mixed empirical evidence on how SFAS 133 influences earnings volatility. Richie, Glegg and Gleason (2005) conducted a study on whether hedging (with derivatives and with operations hedges) would affect earnings volatility after implementing SFAS 133. They found that SFAS 133 does increase earnings volatility. Li and Stammerjoan (2004) find similar supporting evidence.
However, Zhang (2009) and Park (2004) find that earnings volatility remains unchanged after SFAS 133. In addition, Li and Stammerjoan (2004) note the limitation of evidence pointing to the increase in earnings volatility due to SFAS 133. They point out that earning volatility changes could be attributed to factors other than this specific accounting standard, such as the prevailing volatile macroeconomic environment.
See