Hedge Accounting Snafus To Pile Up In 2006?

In the great restatement wave of 2005, much attention focused on problems in lease accounting. Now experts say hedge accounting errors deserve at least some blame for the volume of restatements—and more are likely on the way.

At least 40 companies with market capitalizations above $100 million restated financial results in 2005 to correct hedge accounting errors, according to research and advisory firm Glass Lewis & Co. Some were giants like General Electric and American International Group, whose restatements showed earnings increases of $538 million and $500 million, respectively. But a much larger number were small companies, many of them in the financial sector. What’s more, they were fairly evenly split in reporting either an increase or a decrease in their earnings.

The restatement still anticipated, however, is that from mortgage industry giant Fannie Mae, ordered by the Securities and Exchange Commission in late 2004 because of various departures from Generally Accepted Accounting Principles, including hedge accounting. Industry wags say the losses will be stated in billions.

Glass Lewis analyst Jason Williams, who authored the recent report on hedge accounting, says problems at Fannie Mae may have been the impetus that prodded other companies to look more carefully at their compliance with hedge accounting rules. AIG and General Re have also been high-profile subjects of hedge scrutiny, especially focusing on false reinsurance contracts. The SEC filed charges last week against executives of both companies.

Derivatives and hedge accounting cropped up periodically in inspection reports published by the Public Company Accounting Oversight Board for 2005 as well. The Board said in a number of its reports that it was examining high-risk areas, including derivatives.

Williams says hedge-related restatements are sure to continue into 2006. “The restatements really picked up fourth quarter 2005, which is when auditors are likely to do most work on a company’s financial statements for the year-end report,” he says.

“I don’t think the restatements have gotten the attention they deserve,” said Steve Howard, a partner with the law firm of Thacher Proffitt. “The investor and user audience has become somewhat inured to restatements because there have been so many of them lately.”

Gazzaway

Restatements in the case of hedge accounting may be getting a little more forgiveness in the marketplace. Trent Gazzaway, managing partner for corporate governance for Grant Thornton, says even considering the complexity of U.S. GAAP, the rules on hedge accounting are “extraordinarily complicated accounting standards,” accompanied by “tons and tons and tons” of interpretations, opinions and guidance.

Arlette Wilson, accounting professor at Auburn University, says companies deserve the benefit of the doubt over derivatives and hedge accounting rules. “I don’t think companies intentionally do these things wrong,” she says. “I feel for the people in the real world; I’m a relatively bright person, and I struggle with the complexity of the language in these standards. Everything has to match up perfectly.”

Following The Rules

Hedge accounting is primarily governed by Financial Accounting Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, which went into effect in late 1999. It established that companies must report derivative instruments as assets or liabilities at fair value.

Derivatives are securities or contracts based on underlying assets, such as stocks, bonds, commodities, currencies, or interest rates. The value of the derivative is set to fluctuate in some manner corresponding with the underlying asset, to offset the risk of adverse changes in value. The intent is to minimize big swings in asset values that brew volatility in the balance sheet.

SUMMARY

Excerpt From Glass Lewis Report

"While certain aspects of FAS 133 are complex, we believe the proper application of the shortcut criteria should not be that difficult for accountants with appropriate expertise. Paragraphs 20, 21, 28 and 29 of FAS 133 provide general guidelines regarding the requirements for hedge accounting and proper documentation. Guidance related to specific financial instruments is further provided in the standard.

We believe other companies may be re-examining their hedge accounting in light of recent publicity surrounding the issue. We also understand accounting firms may have accepted this erroneous accounting and are now subject to increased regulatory scrutiny for doing so. There may be a pattern similar to the recent lease-accounting restatements among retailers, as more companies discover they have not propertly applied hedge accounting."

Source: "The Hocus Pocus Of Hedge Accounting—Now You See It, Will You See It Again?" Glass Lewis & Co. (Jan. '06)

FAS 133 specifies when a derivative qualifies for hedge accounting treatment, and provides calculation shortcuts. According to Glass Lewis, most of the companies that restated in 2005 used hedge accounting where they didn’t qualify, used the shortcut method where it wasn’t allowed, or failed to properly document the hedge treatment. Some also failed to value derivatives properly.

Contrary to the traditionally feared loss of earnings, a restatement resulting from hedge accounting problems might just as likely result in an increase in earnings. That’s because hedge accounting treatment doesn’t necessarily boost earnings, but instead it reduces volatility.

“The earnings impact shown in our report is the cumulative impact of the restatements,” Williams says. “Most of these companies restated for a number of periods. If you were to look at all the quarters for which they restated, you would see swings in earnings from quarter to quarter. Properly applied hedge accounting reduces such swings and provides stability to earnings.”

That split between increases and decreases, Williams says, makes it hard to tell whether companies were working the rules to their advantage or simply not applying them properly.

Thomas Linsmeier, an accounting professor at Michigan State University, says companies might find themselves restating because they and their auditors took a materiality approach to FAS 133.

Auditors and preparers typically apply a materiality analysis to accounting rules to determine how precisely a given rule should be observed. If the company and its auditors deem compliance with the spirit of an accounting rule as having the same material impact as compliance with the letter of an accounting rule, they will deem compliance with the spirit of the rule adequate for reporting purposes, Linsmeier said.

“The hedge accounting rules are very specific about the criterion that must be met, and that they must be met completely to qualify for the special hedge accounting treatment,” Linsmeier said. “FAS 133 gives no bounds for materiality. It says the criteria must be met completely.”

Linsmeier says concerns have long existed that hedge accounting rules might be exploited to achieve better or smoother earnings. When FASB issued FAS 133 in 1998, he says, the agency intended it “as an interim step toward measuring all assets and liabilities at fair value,” Linsmeier said.

In FAS 133, FASB said, “The Board agrees that financial statements would be even more useful if all financial instruments were reported at fair value, and that is its long-term goal.”

The Auditor Angle

When widespread accounting problems arise, attention often turns to the auditor. Williams says his analysis shows that KPMG was linked to slightly more than half—21 of the 40—restatements Glass Lewis tracked in 2005 for companies with a market cap of at least $100 million. None of the other Big Four firms worked on more than eight of the 40 (see related links above, right.)

WEAKNESSES

Compliance Week makes available to subscribers a database of "internal control" disclosures; namely, Item II 9A on Form 10-K and Item I 4 on Form 10-Q, titled "Controls and Procedures." Below are excerpts from companies that have recently disclosed material weaknesses or significant deficiencies related to hedge accounting:

Compass Bancshares

"In the course of regular review procedures, our accounting staff

identified errors with respect to Compass' use of hedge accounting for

certain transactions in accordance with generally accepted accounting

principles, including Statement of Financial Accounting Standards No. 133

("SFAS 133") and its related interpretations..."

Source: Controls And Procedures Section Of Compass Bancshares Form 10-KA Filed Jan. 11, 2006

Provident Bankshares

"This evaluation

included consideration of a deficiency in the disclosure controls and

procedures relating to the accounting for derivatives. As a result of this

deficiency, errors occurred in the Corporation's application of the

"short-cut" method of fair value hedge accounting under Statement of

Financial Accounting Standards No. 133, "Accounting for Derivative

Instruments and Hedging Activities" ("SFAS No. 133") to certain of its

derivative securities..."

Source: Controls And Procedures Section Of Provident Bankshares Form 10-Q Filed Nov. 17, 2005

Ceridian

"This assessment identified deficiencies in

our internal control over financial reporting, and management has

determined that each of the following deficiencies individually

constitutes a "material weakness" ...in our internal

control over financial reporting as of December 31, 2004 [including:]... Our

interest rate and fuel price derivative instruments did not satisfy the

requirements of FAS 133 and, as such, did not qualify for hedge accounting

treatment. The correction of this accounting error impacted revenue and

(gain) loss on derivative instruments in our consolidated statements of

operations for fiscal 2001 through 2004..."

Source: Controls And Procedures Section Of Ceridian's Form 10-Q Filed Nov. 9, 2005

Kilroy Realty

"On October 19, 2005, the Company determined that it is required to restate

previously issued financial statements of the Company for the fiscal years

ended December 31, 2002, 2003 and 2004 and for the related interim

periods. The restatement is necessary because the Company determined that

its hedge designation memos do not meet the technical requirements to

qualify for hedge accounting treatment in accordance with Statement of

Financial Accounting Standards No. 133, "Accounting for Derivative

Instruments and Hedging Activities" ("SFAS 133")..."

Source: Controls And Procedures Section Of Kilroy Realty's Form 10-Q Filed Nov. 8, 2005

Click Here To Find For More Hedge Accounting Disclosures In CW's "Controls & Procedures" Search

“A lot of these restatements were financial sector companies, which usually make significant use of derivatives and hedge accounting,” Williams says. “KPMG is the largest auditor of financial sector companies.”

For its part, KPMG disputes any implication that it is associated with a disproportionate number of hedge-accounting restatements. In response to this article, KPMG provided a statistical analysis of its own showing 62 companies restated in 2005 citing FAS 133 problems, and that KPMG was the auditor at disclosure for only 25 of those companies, or 40 percent.

KPMG says its research showing 62 restatements compared with the Glass Lewis list of only 40 companies may represent a difference in timing, as many companies on either list may fall just above or just below the $100 million market-cap threshold at any given point in time. The Big Four firm also contends that its market leadership in the finance sector —auditing 25 percent of all publicly traded companies in banking and finance, according to industry statistics—gives it greater exposure to the complex standards surrounding derivatives and hedging.

Accounting experts differ on whether the statistics have any meaning. Williams sees it as significant. “Obviously one would question their competence relating to hedge accounting if so many companies they audited are restating,” he says. He was quick to note, too, that KPMG was Fannie Mae’s auditor when a federal oversight body first exposed the mortgage lender’s accounting problems. It has since been replaced by PricewaterhouseCoopers.

Wilson at Auburn University is troubled to hear that a disproportionate number of the restatements are associated with one audit firm.

Wilson

“You can’t really say if the accounting firm is checking its clients now and suggesting they restate or if the accounting firm was advising its clients wrong in the first place,” she says. Regardless, “if it’s coming from one major firm, I’d say that major firm needs to brush up on its standards.”

Linsmeier said KPMG’s contribution to the restatement wave depends on whether KPMG took a “materiality” view of the standard. “The issue is whether or not the audit firm required their clients to meet each and every of the criteria to permit hedge accounting,” he said. “If yes, the number of restatements would be expected to be minimal. If not, the number of restatements might be proportional to the size of the client base.”

KPMG said in a written statement, “In an area where accounting practices continue to evolve, we work with our clients to ensure that accounting principles are appropriately applied and consistent with current regulatory interpretation.”

Carney

John Carney, a partner with Baker & Hostetler, says speculation about the significance KPMG’s role in the restatements is premature. “That can only be answered after the dust has settled to see if it was a systematic failure within one firm,” he said. “I don't think you can draw a conclusion without knowing more about the cause of the underlying violations.”

And, Carney adds, no audit firm should be scapegoated when it comes to compliance with accounting rules. “The primary responsibility for ensuring GAAP financial statements remains with company management, and can't be shifted to the outside auditors,” he says.

Grant Thornton’s Gazzaway says KPMG’s market position and increased exposure to the accounting standard create a logical expectation of an increased incidence of restatement. He likened it to the expected mortality rates for a brain surgeon compared with a foot surgeon.

“When you’re dealing with the most complex accounting standard out there, there’s a greater level of risk because it’s more difficult to get it right,” he says.