Guidance Galore On Hedging, Fair Value

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he Financial Accounting Standards Board is taking a stand on how companies can designate a risk being hedged under existing accounting rules if the interest rate on that instrument is not based solely on an index.

Financial Accounting Standard 133, Accounting for Derivative Instruments and Hedging Activities, addresses the precise circumstances under which derivatives qualify for hedge-accounting treatment and the methods for applying such treatment. Issued in 1998, it is widely regarded as one of the most complex areas of Generally Accepted Accounting Principles, says Thomas Rees, a director at financial consulting firm FTI with an expertise in derivatives and securitizations.

FASB recently issued proposed implementation guidance, No. G26 “Cash Flow Hedges: Hedging Interest Cash Flows on Variable-Rate Assets and Liabilities That Are Not Based on a Benchmark Interest Rate,” to answer questions about how to treat instruments such as auction-rate notes, where the interest rate is not specifically based on a benchmark rate.

“The question is whether an interest rate that is reset based on a period auction can be considered a benchmark rate,” Rees says. “FASB is saying ‘No, that’s not what we mean.’ FASB is saying you can’t hedge pure interest rate risk for variable rate financial instruments whose rates are set by an auction process. For such instruments, you must hedge the entire change in cash flow.”

Ten Eyck

Ernie Ten Eyck, a senior managing director at FTI and a former assistant chief accountant at the Securities and Exchange Commission, says FASB’s guidance narrows the universe of financial instruments that can qualify for hedge treatment to a degree that may squeeze demand for such instruments.

Brokerage houses “will write a financial instrument that will hedge most anything, but you pay a pretty penny for it,” Ten Eyck says. “The practical effect may be to narrow the potential universe of buyers because the accounting tail sometimes wags the financial dog.”

Guidance On Mortgage-Backed Securities And FAS 155?

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ASB plans to discuss at its meeting this week whether to issue further implementation guidance regarding FAS 155, Accounting for Certain Hybrid Financial Instruments, to clarify how FAS 155 relates to instruments like mortgage-backed securities and collateralized mortgage obligations.

FASB issued FAS 155 in February to amend derivatives rules in FASB statements No. 133, Accounting for Derivative Instruments and Hedging Activities and No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. FASB’s intention was to allow certain fair-value elections and to establish a system under which similar financial instruments would be accounted for similarly, regardless of the form of the instrument.

After finalizing FAS 155, FASB began receiving comment letters such as one from the American Bankers Association, which said the statement seemed unclear about how it applied to certain types of investments in securities, including mortgage-based securities and collateralized mortgage obligations.

Fisher

“It is our understanding that some who have studied the release, including possibly some board members, believe that MBSs or CMOs will be subject to SFAS 155,” wrote Donna Fisher, director of tax and accounting for the bankers’ professional group. “If an exemption for MBSs and CMOs is not, in fact, what the Board intended, the result will be the potential to increase volatility in earnings for security holders. Widespread aversion to this volatility, due to negative market perception and a higher cost of capital for investing companies, will likely lead to either a decreased appetite for these securities and reduced liquidity or significant changes in risk management by investors. Either of these events could hamper the ability of banks and others to manage risk.”

Fisher believed that if the Board wanted MBSs and CMOs to be subject to the more complex breakdown accounting and fair-value requirements of FAS 155, it isn’t clear to preparers and users of financial statements.

Thomas Rees, director at financial consulting firm FTI, says practitioners are confused and hopeful FASB will clarify its intentions. “There’s a lot of uncertainty about whether FASB is saying you have to mark to market a simple mortgage-backed security,” he says.

The market is particularly jittery over derivatives rules for a variety of reasons. “The rules are really complicated,” Rees explains. “The Securities and Exchange Commission has been focusing on it a lot. There have been a number of restatements and comment letters from the SEC asking for clarifications. They’ve talked about it frequently in speeches. And the external accountants are not giving independent advice and adhering to strict interpretations.”

The result, Rees said, is “sometimes more form over substance, and that gives you an illogical outcome.”

AICPA Gives Exposure Draft On Valuation Standard

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he American Institute of Certified Public Accountants has issued an exposure draft of a valuation standard that would help accountants establish a market value for a business, a partial interest in a business, a security, or an intangible asset.

The standard encourages consistency and disclosure in valuation development and reporting, says Michael Crain, chair of the AICPA’s Business Valuation Committee. It would apply when AICPA-member accountants are asked to establish values for purposes of taxes, mergers and acquisitions, litigation, financial planning, and fair-value measurements in financial reporting.

Crain

“The valuation standard does not change any commonly recognized analytical valuation approaches that are in wide practice by trained valuation specialists,” Crain explains. “It codifies those widely recognized valuation approaches and practices into a single document. It mandates a standard of practice when valuing one of these types of assets.”

FASB recently issued FAS 157, Fair Value Measurements, providing the market with more guidelines about how to establish fair value in instances where Generally Accepted Accounting Principles already requires it. Crain says the AICPA’s proposed rule doesn’t create any new GAAP literature, but it codifies the valuation approaches that should be followed in complying with FAS 157, especially in establishing valuations where there’s no liquid market.

“FAS 157 does not articulate any valuation theory in detail,” Crain says. “That’s where the AICPA standard could be relied upon in doing fair value measurements.”

The current exposure draft is the AICPA’s second exposure of the standard; the first was issued in 2005. The association is open to comments on its proposed valuation standard through Dec. 15.