What Analysts Need to Know about Accounting for Derivatives

By the end of 2002, public companies in the United States were required to comply with a new set of accounting rules related to corporate use of derivative instruments. Financial Accounting Statement (FAS) No. 133 has subsequently become widely recognized as the most complex set of accounting rules yet to be promulgated. And just as those who prepare financial statements had to learn how to accommodate to the new requirements, analysts also must understand this standard in order to interpret derivative results appropriately. Despite the added transparency of FAS No. 133, a lack of familiarity with it can easily lead analysts to erroneous conclusions. Financial Accounting Statement (FAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, and subsequent amendments (FAS Nos. 138 and 149) reflect the Financial Accounting Standard Board's effort to add transparency and consistency to corporate accounting for derivative instruments and hedging transactions. Despite the objectives, these relatively new rules (initially adopted in 2000) have been the subject of much criticism.Under FAS No. 133, a derivative contract must be recorded as an asset or liability on the balance sheet and marked to market. Exactly how changes in value are treated, however, depends on whether the derivative was used for hedging purposes or not. If it was not used for hedging, the gains or losses flow through earnings. If it was used for hedging (and assuming the qualifying criteria are satisfied), special hedge accounting generally is to be applied. This treatment assures that the income effects from both components of the hedge relationship (i.e., the hedged item and the hedging derivative) affect earnings in a common accounting period, thereby minimizing income volatility.Many entities that are affected by FAS No. 133 consider it to be overly complicated and difficult to implement—at least insofar as qualifying for special hedge accounting. The alternative treatments that companies may choose and the uncertainty associated with qualifying for special hedge accounting (whether because of substantive issues or deficiencies in documentation) have resulted in a less-than-hoped-for level of consistency in accounting practices. Some companies apply hedge accounting; others with virtually the same kinds of exposures and derivative transactions do not.In comparing two companies that apply different accounting treatments, analysts should recast the reported results of at least one of these companies to assure that the comparison is of apples to apples. This issue brings up the question of which presentation is more appropriate. Is the hedge accounting approach the more meaningful depiction of the company's performance, or is the nonhedge treatment a better representation? Although this determination is best left to the analyst, hedge results should be assessed, not in isolation, but relative to the exposures of the company.This article makes a distinction between, on the one hand, the assessment of the derivative's gains or losses relative to the changes in value associated with the hedged item and, on the other hand, the derivative's results relative to the overall exposure of the business entity—a distinction that is ignored by the rules of FAS No. 133. The first of these comparisons is certainly central to the evaluation of the hedging relationship, the question of whether or not hedge accounting may be applied, and the determination of hedge ineffectiveness, which must be disclosed. But the derivative's results relative to the company's overall exposure is much more relevant for the analyst who is seeking to project coming performance of the company or to value its stock. For either of these objectives, the analyst needs to determine the magnitude of risks (and opportunities) the company bears (or enjoys) and, presumably, must make a judgment about the relative probabilities associated with the market conditions that could occur.The article highlights the fact that a proper valuation must go beyond merely examining financial statements, because much critical information related to derivatives transactions may not be reported in these statements in a transparent way. For instance, for an analyst to evaluate the company, the analyst should know the nature of the company's price risks (including the hedging positions used) and how the hedges tend to be managed. In many situations, however, a complicating factor is that companies may be protective of this information for fear that its release could jeopardize a competitive advantage.The caution offered by the article is that whereas FAS No. 133 is responsible for much new information that had not been publicly reported, this new information is easily misinterpreted unless the analyst fully appreciates the hedging objectives and capabilities of the companies being analyzed.