Interest Rate Swaps: Accounting vs. Economics

With interest rate swaps being the most widely used of all financial derivative contracts, financial analysts and engineers should be keenly interested in any regulations that could influence how these tools are used. This article addresses one such regulatory aspect—namely, the accounting rules. In certain cases, these rules can result in financial reports that do not accurately represent the economic intent of derivative transactions. This essay strives to explain this disconnect and suggest (1) how accounting standard setters might consider adjusting their requirements or, independently of that adjustment, (2) how companies might want to accommodate to the current rules.In June 1998, the Financial Accounting Standards Board (FASB) issued new accounting rules for derivatives and hedging transactions—Statement of Financial Accounting Standards (FAS) No. 133, Accounting for Derivative Instruments and Hedging Activities. Even now, after more than eight years of experience with the standard, it remains controversial. For hedgers who use derivatives directly related to some associated economic exposure, under the “regular” accounting rules, the derivative’s results and the hedged item’s income effects are often recognized in earnings in different calendar periods. For these hedgers, the resulting income volatility obscures the economics of the hedging activity. The FASB accommodated to this perspective by providing for “special hedge accounting’ procedures, in which these two income effects may be recorded concurrently, but special hedge accounting is not automatic, and qualifying for it requires satisfying a host of preconditions.One special accommodation was made for the use of interest rate swaps. This “shortcut” method was authorized for use when swaps are designed to perfectly address the risk being hedged. In these instances, shortcut treatment minimizes some of the obligations relating toeffectiveness testing and measurement. However, a number of reporting entities have applied the shortcut procedure but apparently not satisfied the requirements to do so—because of technical violations or, perhaps, more willful misrepresentations. Therefore, auditing firms have taken to broadly discouraging their clients from applying the shortcut method.The implications of applying hedge accounting without following the shortcut treatment has little consequence for hedgers who use swaps to convert from floating-rate exposures to fixed-rate exposure (i.e., cash flow hedgers). However, for hedgers who seek to do the opposite (i.e., fair value hedgers who want to convert from fixed to floating rates), forgoing the shortcut procedure means that they cannot realize an accounting result that accurately represents the economics of the hedge. Moreover, without shortcut treatment, there is even a chance that hedge accounting could, at some point, be disallowed—even if the ideal swap is being used.The primary objective of this article is to motivate a reassessment of the shortcut rules, with the hope of encouraging the FASB to liberalize some of the prerequisite requirements. I also suggest ways in which reporting entities can accommodate to the rules as they currently stand.