By Joseph Neu
Freddie Mac’s 2001 decision
to report pro-forma “Operating Earnings” to reverse FAS
133 effects—given its restatement scandal—should
generate new questions about accounting and disclosures
for hedging.
Accordingly, companies that have
legitimately foregone hedge accounting to pursue
economic hedges that are ineligible for such accounting
(and Freddie Mac may still belong to this group) will
have a lot more explaining to do if their hedges result
in a material earnings impact.
And ironically, this was precisely
what Freddie Mac was attempting to do, by creating its
FAS 133-adjusted “Operating Earnings” concept.
Unfortunately, as a result of the failed Freddie Mac
example, treasurers will be under increasing pressure to
pursue only those hedging strategies that will be
eligible for hedge accounting (or go through the mental
and documentation gymnastics to make them
eligible).
Background: “On January
1, 2001, Freddie Mac implemented SFAS 133, which
requires the corporation to recognize on the balance
sheet all derivatives as either assets or liabilities
measured at their fair value . . . . Beginning with its
first quarter 2001 reporting, Freddie Mac began
providing a supplemental performance measure known as
Operating Earnings. Management believes that results
presented on an operating basis, while not a defined
term within GAAP nor comparable in many cases to
supplemental performance measures used by other
companies, are beneficial in understanding and analyzing
Freddie Mac’s financial performance because they better
reflect the economic effect of Freddie Mac’s risk
management activities.
Freddie Mac’s operating
earnings, along with corresponding ratios, reflect
adjustments for certain income statement effects of SFAS
133.These adjustments relate primarily to the timing of
derivative income and expense recognition” (Freddie
Mac’s 2001 Annual Report).
What happened? During
a conference call last Wednesday,
Freddie Mac offered more details about its restatement
—i.e., an expected increase in retained earnings of $1.5
billion to $4.5 billion and an increase in the fair
value of shareholders’ equity for year-end 2002 over
2001. Much of this restatement is due to improperly
avoiding implementation of fair value accounting: 1)
improper classification of a significant portion of its
$260 billion of mortgage securities as “held to
maturity” instead of “available for sale;” and 2)
improper application of FAS 133 to some of its
derivatives (totaling $866.8 billion at year end
December 2002, from $1.05 trillion in 2001) used in
hedging activities.
With respect to hedge accounting,
Freddie Mac shot itself twice in the foot. First, it did
not properly apply FAS 133 to the GAAP reporting that
“Operating Earnings” were supposed to adjust. Either it
improperly classified hedges it deemed eligible for
hedge accounting, or it failed to document/test these
hedges for effectiveness appropriately (or both). In so
doing:
1) It tainted its noble
“Operating Earnings” concept. As Freddie Mac’s Chief
Executive Officer, Greg Parseghian, announced on the
call: “We will neither restate nor provide ‘Operating
Earnings’ in our periodic financial reporting due to
changes in accounting policies.” But, he added: “In the
place of ‘Operating Earnings’ we are evaluating and
expect to provide a new supplemental
disclosure.”
2) It called into question that
it was engaged in hedging at all. To counter this
point, Martin F. Baumann, Freddie’s CFO stressed: “the
changes in accounting treatment do not impact the
effectiveness of our economic hedges, as demonstrated by
our consistently low levels of portfolio market value
sensitivity and narrow duration gap.”
Questions emerge. Analysts
asked about both points in the conference call Q&A.
“If this hedging is so effective, is Freddie still
‘hedging’ with the same approaches?” one analyst asked.
It is. And, asked another, “if Operating Earnings were
essentially the pre-FAS 133 impact of economic hedges,
aimed to help analysts with their model forecasts, why
not go back to it?” Here the answer was less
straightforward.
Apparently, some of the
“complicated adjustments” made for Operating Earnings in
the past don’t look so good in hindsight. Accordingly,
the new supplemental disclosure will focus on options
only.
For now, analysts seem to prefer
deferral of hedges to protect their forecast models.
However, there is now a greater risk that an analyst
looking for a “Freddie Mac story” will dig into your OCI
and make his or her own “earnings” assumptions about
hedge gains and losses being deferred
there.