Hedge Accounting; Payments Fraud; More

The Securities and Exchange Commission has given some new–but so far informal–guidance on how it wants companies to assess the effectiveness of hedge transactions to ensure that they qualify for favorable, highly complex derivative accounting treatment.

At a recent meeting of the Emerging Issues Task Force of the Financial Accounting Standards Board, Joe McGrath, a professional accounting fellow for the SEC’s Office of the Chief Accountant, told the EITF that the SEC will see its way clear to accepting effective but imperfect hedges as long as companies have done a quantitative analysis to support their assertion that a particular hedge is highly effective.

Starzecki

Rich Starzecki, a partner with Deloitte & Touche, says McGrath’s informal remarks at the EITF meeting focus on one specific type of hedging methodology, known as the “critical-terms-match method,” described in Financial Accounting Statement No. 133: Accounting for Derivative Instruments and Hedging Activities. Starzecki says the method is commonly used when companies are trying to hedge their risk to currency exposure in overseas purchase or sale transactions, or when companies are looking to hedge commodity purchases.

To qualify for the favorable hedge accounting treatment described in FAS 133 using the critical match method, companies are required to assure that the critical terms of the offsetting transactions match. “To apply this method, an entity is saying the terms of the hedging instrument match the terms of the hedged forecasted transaction,” Starzecki notes. “If that is accurate, this critical terms match essentially justifies assuming no ineffectiveness that gets recorded through earnings.”

At the December 2006 conference of the American Institute of Certified Public Accountants, SEC professional accounting fellow Timothy Kviz said the staff has seen the method misapplied in assessing whether the hedge transaction and the underlying transaction are perfectly matched. The settlement dates, for example, must line up perfectly, he added.

“The critical terms match approach wouldn’t work in a relationship where the settlement date of the forecasted transaction and the hedging instrument differed by several days,” Kviz said. “Even though the settlement dates differ by only a few days, the differences would create ineffectiveness that should be measured and recognized.”

Starzecki says Kviz’s remarks led the accounting and preparer communities to question the SEC staff for further clarification, which ultimately led to McGrath’s remarks at the recent EITF meeting. McGrath said that if companies are applying the critical-terms-match method, they need to use quantitative–not just qualitative–analysis to confirm that the terms are essentially matched and the hedge is highly effective. Starzecki says the SEC didn’t provide a prescriptive approach for how the analysis should be performed.

“The staff was clear that it was not going to be prescriptive about how the analysis should be done, but it must include a quantitative assessment to confirm your original assertion,” Starzecki notes.

Largay

Susan Hamlen, accounting professor at the University of Buffalo, and James Largay, accounting professor at Lehigh University, say the SEC staff announcement clarified that although the staff expects the critical terms match to signal high hedge effectiveness, some ineffectiveness will flow through to earnings unless all terms match, so a quantitative assessment is needed to evaluate effectiveness even when the critical terms match.

Separately, the SEC offered two additional, more formal bits of derivative guidance at the same EITF meeting in the form of proposed staff announcements: EITF Abstracts Topic No. D-109, Determining the Nature of a Host Contract Related to a Hybrid Financial Instrument Issued in the Form of a Share under FASB Statement No. 133; and Topic D-98, Classification and Measurement of Redeemable Securities.

Hamlen

In Topic D-109, the SEC staff clarifies that all of a host contract’s underlying economic characteristics and risks determine whether it is debt or equity for purposes of complying with FAS 133, says Hamlen. “For example, if the host appears to be equity, and the embedded derivative produces a return based on changes in interest rates, like debt, separate accounting is required,” she adds.

In Topic D-98, the SEC clarifies that even when redemption is not mandatory, all redemption features must be considered when deciding whether liability treatment is appropriate.

“Each situation is unique,” says Largay. “For example, securities redeemable only by vote of the board of directors appear to be under the issuer’s control, thus equity. But when investors in the securities dominate the board, redemption may not be within the issuer's control, and liability treatment may be appropriate.”

Related documents, speeches, standards, and coverage can be found in the box above, right.

PCAOB Inspection Trips Up Company’s SEC Filing

A former audit client of BDO Seidman said it would delay the filing of its 2006 10-K while it waited for word from the Securities and Exchange Commission regarding a disputed audit-inspection finding.

Presstek Inc. said the Public Company Accounting Oversight Board, upon inspecting BDO’s audit work, disagreed with the manner in which Presstek accounted for certain new product costs in fiscal 2005. Presstek said in a statement that the company asked the SEC to not object to the accounting and it was waiting for a reply from the SEC staff before filing its 2006 10-K.

In its notice to the SEC that its 10-K would be late, Presstek said it has consistently accounted for the new product costs in question by capitalizing them as intangible assets and that BDO supported the treatment when it served as the company’s auditor. The notice said if the SEC rejects the original accounting, the company “may be required to expense all or a portion of the costs capitalized, which totaled approximately $450,000 in fiscal 2005 and $509,000 in fiscal 2006.” In addition, Presstek said it may be required to restate historical financial statements to reflect the new accounting treatment, but it did not say how many periods might be affected.

None of the parties to the dispute responded to Compliance Week’s requests for comment. PCAOB spokesman Michael Shokouhi said the Board would not discuss an individual firm’s inspection beyond what is made available in a published inspection report. Inspection reports do not identify companies whose audits are questioned by name.

Shokouhi pointed out that Sarbanes-Oxley provides for a process by which audit firms can appeal a PCAOB finding to the SEC, but that process is reserved for an audit firm, not the company whose audit is in dispute. Shokouhi could not comment on whether BDO or any other firm has ever pursued such an appeal.

Payments-Related Frauds Rising, But Mostly At Small Cos.

Fraud related to payment processes within organizations of all types and sizes is on the rise, according to a recent survey by the Association for Financial Professionals.

Of the 414 entities that responded to the survey, 72 percent said they were victims of actual or attempted payment-related fraud in 2006, up from 68 percent in the prior year. Check payments remain the area most vulnerable to fraud, with 93 percent of respondents reporting they were victims, despite the declining use of paper checks as a method of payment, AFP said.

Roth

Kevin Roth, director of research for AFP, says the research shows that the increase seems focused more on smaller organizations. “We’re speculating there’s some targeting of smaller organizations,” he notes. “Smaller organizations tend to be less likely to fully utilize every tool available to them to prevent payments fraud.”

Roth says the dollar amounts involved in frauds that produce financial losses tend to be small–typically $25,000 or less per incident. “It may be that it’s difficult to justify the cost of the tools in a cost-benefit analysis,” he adds.

While Sarbanes-Oxley has increased the focus in recent years on internal controls intended to prevent and detect fraud, it’s not clear from the study’s findings what kind of impact it may be having, Roth said. “SOX is a little bit of a factor,” he said. “They’re doing a better job of detecting fraud in-house. It’s more about detection than anything else.”

AFP’s survey targeted cash managers, analysts, assistant treasurers, directors, and controls in a variety of organizations. The association said the typical respondent works for an organization with annual revenues of at least $2 billion in the manufacturing, retail, health, energy, and insurance industries.