When FAS 133 was first discussed in conceptual terms, it included a basic trade-off: More emphasis on effectiveness, documentation and transaction-level focus, in return for greater flexibility in hedge practices (see here).

Whether this was a good or bad deal overall may be a matter of ongoing debate. Yet somehow over the early years of its actual implementation, for some companies the flexibility “payoff” in FAS 133 simply has been lost.

This report examines this issue in three parts:

(1) Part 1: What are the reasons for the misapplication of FAS 133;

(2) Part 2: How can treasurer/risk managers negotiate with their auditors for more favorable accounting treatment; and

(3) Part 3: What are some of the most common misconception about FAS 133's hedge accounting mandate.

Part 1: The origins of 'confusion'

Some of the misapplication of FAS 133 may be the auditors’ “fault.” Some of it may be treasurers and FX managers “fault.” Regardless, it behooves treasury practitioners to rediscover (and insist) on that lost flexibility, in order to ensure that their hedge programs get the best possible accounting treatment (or, in some cases, get anywhere at all).

At many companies still, the written (or unwritten) policy is that if a hedge does not get favorable FAS 133 treatment, it’s not going to get done. And those companies that care less (i.e., mark to market) often do it only because the positions are immaterial enough as to not to affect their bottom line.

EPS volatility may have been a hot topic in late 1990, when FAS 133 was issued. Today, it’s as hot if not hotter. Plus, the emphasis on the integrity of earnings in the wake of Sarbanes-Oxley, is causing even more pushback on hedge strategies, which involve derivatives and/or smell anything like earnings manipulation.

This has caused a resurgence of sorts, of FAS 133 debates between companies and their auditors, as they continue to wrestle with issues of hedge accounting and earnings recognition.  FAS 133 today is not only a matter of concern for small companies, with little resources or limited access to auditor resources. This issue prevails the risk management shops of large MNCs as well, with billions in annual derivatives trading.

Many FX managers still view FAS 133 as the reason that they cannot execute certain, economically sound strategies. It’s an ongoing source of frustration.

In some cases, there may be no way to account for the hedge under FAS 133 hedge accounting guidance, e.g., in certain competitive hedges where there isn’t an actual cash flow at stake. Yet in more cases than not, there’s a misunderstanding of what FAS 133 actually allows.

“Unfortunately, many companies and their auditors still do not have a full understanding of some of the important aspects of FAS 133. There are certainly areas of interpretation where audit firms will differ,” he concedes, ”but FAS 133 and the accompanying DIG guidance,  often provide explicit language on some points of the accounting that continues to be ignored,” says Matthew Daniel, Director, FX Analytics and Risk Advisory, with ABN AMRO (and formerly with Deloitte & Touche),

"Probably the most important section of FAS 133 is Appendix C – Background Information and Basis for Conclusions,” says Mr. Daniel. This is where the FASB explains many of the principles behind the Standard that are critical to understanding this particular accounting model. “It is clear that many companies and their auditors have never read this section,” Mr. Daniel says.

Whether lack of knowledge, lack of resources, or an auditor “smokescreen” to mask lingering discomfort with certain corporate hedge practices, there are several misconceptions about what FAS 133 disallows, or more precisely, what sorts of hedge practices cannot get hedge accounting (or the ability to time the release of hedge gain/loss from OCI into income, to mimic the exposure).

The FAS 80 legacy

One common area of misinterpretation concerns the timing of the hedge vs. the exposure. The two do not need to “perfectly” match, for the hedge to qualify for hedge accounting. Rollover strategies, where a hedge instrument can have a shorter duration than the exposure, are explicitly allowed by FAS 133 (see box).

Another area where companies may have some misconception about what’s allowed is the matter of “active” trading. Again, there is explicit language in FAS 133 that outlines the FASB staff’s view on this type of risk management activity.

In paragraphs 357-359, not only is there explicit language that allows dynamic hedging activities (see box) to qualify for hedge accounting, but also a description of the FASB staff’s thinking on why they allowed it.  The bottom line is that it does not matter whether a hedge has been cash settled prior to the timing of the underlying exposure, as long as the underlying exposure is still probable of occurring, the hedge gains/losses stay in OCI.

Some of the confusion about what FAS 133 allows (or not) is a product of the FAS 80 legacy, or the Enterprise Risk approach to hedge accounting. Under that rule (which made sense on many levels), the hedge’s eligibility for favorable accounting treatment was whether it reduces overall enterprise risk, not whether it offset a particular, transaction-level exposure. 

“One of the main reasons for this degree of specificity is to prevent companies from manipulating earnings,” notes Mr. Daniel. The other is that it creates the framework for companies to define what they are hedging and therefore “set up” their effectiveness testing approach.

A hedge is a “hedge” if it meets the designation criteria in FAS 133’s opening paragraphs. And a hedge is “effective” as long as it achieves the objective of the hedge strategy, as defined by the company. If a hedger’s objective is to eliminate risk above 50 and be locked-in below 25, then a purchased 50 call combined with a short 25 put would be a perfectly effective hedging tool.

Part 2: Managing the audit relationship

Some treasurers/FX manager may wholeheartedly agree. But they still face opposition from their auditors. What then?

Do the homework. The first step for risk managers seeking accounting guidance on a particular issue, is to do the homework. “It’s best to go in with a researched view of proper accounting treatment,” says Mr. Daniel. “It is always better to have an auditor react to the client’s understanding of the specific issue, than to go ask the question: ‘how do we account for this?’”

Going in empty handed can indeed be risky.
(1) It may well generate a conservative, canned response;
(2)  The field audit folks may or may not escalate the question to the national-office level, or the resident FAS 133 experts (to get a real answer); and
(3)  The response is likely to follow the path of least resistance (the auditors would say what they already know, instead of trying to be innovative).

Independent review. Also, against the background of the revived focus (as per Sarbanes-Oxley) on auditor independence, asking the auditor to advise on the accounting may be bad practice.  Gone are the days of “opinion letters.” And while in the past, it was common for the risk management advisory practice of an audit firm to help set up the hedge program policies, controls and accounting approach (which made it highly likely that the audit partners would sign off), that sort of approach may not work under the new, SOX directives.

Can (and should) risk managers challenge the auditor’s accounting guidance?

The answer is absolutely ‘yes,’ if done properly, but it does require that the company understand how the auditors has come up with the accounting guidance:

Know the source. Did this particular accounting guidance come from the local audit team, or from a specialist in the local office? Or perhaps it came from a specialist from one of the consulting groups, or from a National Office partner?

If it’s a local opinion, perhaps by escalating to a specialist and/or national office, the company can attain a “better” answer.

A matter of fact or of opinion. Was the guidance based on explicit guidance from FAS 133 or is it interpretative? It’s futile to argue over matters that are explicitly addressed in the standard.

Fresh vs. “old” issues. Was this a new issue for the auditor, or is this something that had been discussed previously? (It may be easier to change the auditor’s mind if they have no yet “embedded” this opinion in multiple corporate clients.)

One firm vs. market practice. Has your auditors discussed this particular issue with other audit firms or perhaps with the FASB staff?  (If different audit firms are giving significantly different advice on a similar issue, it makes it easier to initiate discussion. In most cases, a member of your auditor’s National Office should be willing to solicit the views of their peers or even approach the FASB staff if need be. )

Of course, there’s a potential risk to pointing out to the auditor, that a peer company with another auditor has gotten the green light on a strategy/accounting. The auditors may talk directly and come to a conclusion that the more flexible treatment is indeed, wrong.

But more often than not, firms do have a difference of opinion (on matters of interpretation).  For example, one auditor may require that forecasted transactions should be identified down to the very name of the customer on the contract; another may say that the first $50 million worth of euro sales are the designated probable transactions.  You might not like it, but they may not budge on a particular issue.

The FAS 133 treatment of certain exposures/hedges was a big issue, for instance, when ex-Anderson clients went “auditor shopping.” Yet in general, it’s unlikely that a FAS 133 disagreement would, by itself, prompt a corporate to quit using a particular auditor. This just means it’s more important that FX managers and other treasury practitioners become intimately familiar with the standard, since often it’s their best defense against unkind rulings by the audit partners.

Part 3: Popular misconceptions

At a recent gathering of FX Risk Managers, three areas of disagreement around FAS 133 guidance for hedge accounting surfaced; the three are indeed representative of common FAS 133 misunderstandings.

(1) Misconception #1: The hedge and the underlying have to be of similar duration, i.e., short-term hedges of long-term exposures cannot be effective, leading to potential earnings volatility.

This is not entirely true, notes Matt Daniel with ABN AMRO.

First, the relevant guidance, or paragraph 468 in FAS 133:

 “The Board decided to remove the maturity criterion and thus to permit hedge accounting for rollover strategies. Respondents asserted that those strategies are a common, cost-effective, risk management practice that may achieve results similar to the results of using a single long-term derivative as the hedging instrument.  Although the Board notes that a rollover strategy or other hedge using a derivative that does not extend to the transaction date does not necessarily "fix" the price of a forecasted transaction, it decided to accede to respondents' requests to permit hedge accounting for rollover strategies.  The Board also decided that removing the maturity criterion was acceptable because it makes the qualifying requirements for fair value and cash flow hedge accounting more consistent.  Prohibiting hedges of a portion of a forecasted transaction term from qualifying for cash flow hedge accounting would have been inconsistent with permitting fair value hedge accounting for hedges of a portion of the life of a hedged asset or liability.”

The implication. From a practical standpoint, this guidance allows hedgers to use futures (or forward) contracts that are in liquid months rather than be forced to hedge transactions with less liquid and longer-dated contracts.

Maintaining effectiveness. From an effectiveness standpoint, there may be issues if the assessment and measurement of effectiveness is based on changes in forward values of both the hedge and the underlying exposure.  Mr. Daniel notes that Paragraphs 63-68 allow an entity to exclude certain components of a hedge’s fair value from the assessment and measurement of effectiveness.  “So a simple fix would be to change the hedger’s objective,” he says, “such that the objective is to hedge the variability of the forecasted transaction based on the spot rate, exclude the impact of forward points from the assessment and measurement of effectiveness, and only book the spot to spot change in fair value through OCI.”
The forward points, once excluded, would be booked directly to earnings. The forward contract would then be assumed to be 100% effective consistent with DIG Issue G9.

(2) Misconception # 2: You cannot trade in/out of hedge, and maintain hedge accounting treatment.

This, too, is not accurate.

First, the relevant guidance, found in paragraph 358 in FAS 133:

“This Statement also places no limitations on an entity's ability prospectively designate, dedesignate, and redesignate a qualifying hedge of the same forecasted transaction.  The result of those provisions is that this Statement permits an entity to exclude derivative gains or losses from earnings and recognize them in other comprehensive income even if its objective is to achieve a desired level of risk based on its view of the market rather than to reduce risk.” (Also see paragraphs 357 and 359).

The implication. FAS 133 allows companies to trade in/out of a hedge, as long as at each step of the process, the hedge meets the requirements for designation. “In general, there should be no prohibition regarding the number of times that an FX managers can enter into or close out a derivative transaction. FAS 80, with the notion of enterprise risk reduction, has been superseded by FAS 133.

The real potential for earning manipulation occurs not when a hedge is re-designated, but when a company concludes that the underlying is no longer probable and books gains/losses to income; hence, the “worrisome” pattern for auditors is not active trading, but frequent discontinuation of hedges because forecasted transactions have failed to materialize and are no longer probable.

Misconception # 3: It’s impossible to get hedge accounting for hedges of intracompany FX loans.

In general, under FAS the FX ponent of any intercompany transaction can be designated as a hedgeable item, since changes in interest rate do not affect the consolidated results of the organization.

Specifically for loans, whether the FX exposure can be hedged (and hedge accounting achieved) depends on the underlying accounting for the loan itself. And that, in turn, is a function of whether the loan is considered to be “permanent.”

Alternative #1 – a “temporary loan.” If the funds are not permanently invested (an accounting designation under FAS 52, see below), which means that the parent expects them to be repaid, both principal and accrued interest would be remeasured, with changes recorded in earnings. Under this option, a company can hedge the FX component (but not the IR) as either a fair value hedge (and make appropriate designations and meet effectiveness requirements) or simply mark to market both loan and derivative/hedge in income, effectively achieving the same offset.

Alternative #2: Permanently invested. If the funds were permanently invested, then any changes in value (due to FX shifts) would flow through the CTA and not income.  That reduces income-statement volatility, of course. And whether or not the CTA is the  “right” place for the re-measurement is not a FAS 133 issue, but a FAS 52 issue.

It was discussed at a January 1982 meeting of the FAS 52 Implementation Group (the “FIG”?).  Back then, Mr. Daniel notes, “the conclusion then was that the term the foreseeable future is not meant to imply a specific time period.”  Instead, this is an intent-based indicator. A parent company may qualify for the paragraph 20b exception in FASB 52 (hence changes in value flow through CTA), if: (1) There have been no repayments, and
the parent company can represent that it does not intend to require repayment of an inter-company account; and (2) that  the parent company’s management views the inter-company account as part of its investment in the foreign subsidiary.

If the loan is “permanent,” then “it essentially becomes a part of the net investment in that foreign operation,” Mr. Daniel explains. It therefore cannot be hedged under the FAS 133 cash flow or fair value hedge accounting approaches, since the “the loan becomes indistinguishable from the rest of the entity’s net investment in that foreign operation.”

The hedge would qualify as a hedge of the entity’s net investment, and the appropriate guidance for net investment hedges can be found in DIG Issues H6 to H11. The most important DIG Issue is Issue H8.

A wrinkle and a caveat

So far so good, but in some cases, some auditors have allowed interest on intercompany loans to be repaid , without jeopardizing the underlying designation of the loan’s principal as permanently invested, i.e., the change in value of the notional principal is booked to  CTA.  In this situation, the accrual of FX-denominated interest would be remeasured each period, based on changes in spot rates, with the change in value booked to earnings each period.

Here, as in the case of the first alternative (the entire loan gets remeasured through income), companies can either hedge the remeasured FX asset/liability arising from the interest accrual as a fair value hedge, or else simply mark to market in income, both hedge and exposure (and avoid designation, documentation and effectiveness requirements).

Caveat: Any area of accounting that is based on an entity’s intent is difficult to define and is subject to the judgment of an entity’s auditor or a SEC reviewer. Documenting that an inter-company account is long term and then at some point later reversing this treatment has the potential for tainting an entity’s ability to receive this treatment in the future.

As always, these issues should be discussed with your auditors in great detail in order to understand the ramifications of these changes in treatment.

There are also rules governing when gains and losses booked to CTA are reclassified into earnings. The relevant guidance can be found in FASB Interpretation No. 37, Accounting for Translation Adjustments Upon Sale of Part of an Investment in a Foreign Entity, an Interpretation of FASB Statement No. 52.

For example, repaying a loan that was once documented, as being long term would not require the translation gains or losses associated with that loan booked to CTA to be reclassified to earnings unlessnet investment has not been sold or substantially or completely liquidated.

Conclusion: Flexibility is where you find it

Those who are not yet convinced that the “F” in FAS133 truly stands for “flexibility” need only review the FASB Staff’s own actions.  That flexibility is clearly in evidence in some of the most notable Staff and DIG implementation guidance that has been issued, post FAS 133.

Perhaps one of the best examples is DIG issue G20.  The FASB staff was struggling to find a way to resolve the quandary of how options can be 100 percent effective.  They found their answer by relying on the flexibility that FAS 133 allows for defining the method used for assessing and measuring hedge effectiveness based on a hedger’s stated risk management objective. 

The premise for G20 treatment for option premium depends on a hedger stating that their hedging objective is to hedge the variability of forecasted cash flows based on the cash flows’ terminal value, that is, their ”expected future pay-off at maturity”.   Since an option’s fair value is calculated based on its expected pay-off, the fair value of the option therefore mimics the variability of the exposure’s cash flows. (Voila, 100% effectiveness. ).

Even more recently, the Staff issued temporary guidance on how to handle FIN 46-triggered disruptions to FAS 133 hedge relationships.

In this case, the Staff came up with not hypothetical derivative but with a “surrogate” hedge. The point was made, clearly, that as long as the new hedged item and the old (pre-FIN46) hedge can be made to “meet” the designation requirements, there’s not need (indeed, it’s not permissible) to run any accumulated gains or loss from OCI into income. The guidance reflects two of the core FAS 133 principles: That the hedge/hedged item pairing needs to stand on its own, and that the primary focus is to prevent earnings manipulations.