New Derivatives Accounting Rules May Require Changes in Hedging

The latest accounting proposals for derivatives transactions could force the industry to come up with new risk management products to replace some commonplace interest rate swaps, experts warn.

Under a proposed rule issued last week by the Financial Accounting Standards Board, contracts in which a fixed rate is swapped for a floating rate would not enjoy the full benefits of hedge accounting treatment, while floating-to-fixed-rate swaps would.

In hedge accounting, gains and losses on a derivatives contract need not be reported immediately in the income statement.

The new rules are the latest step in a broad effort to improve derivatives disclosure in the wake of high-profile trading debacles. They represent a step back from an earlier proposal, which was unpopular in the industry, to require that the value of derivatives contracts be marked to market.

"The board felt it was too radical a change to make in one step and decided on an approach that would return much of hedge accounting rules," said Jane Adams, project manager for derivatives accounting with the board. "It's not the solution, but it is part of an evolutionary ladder."

In a tersely worded statement, the International Swaps and Derivatives Association, the trade group for the custom derivatives industry, said the board has "a long way to go yet," and added: "What is needed is further refinement and not new departures."

Fred D. Price, a principal at Sandler O'Neill & Partners, said banks would have to find alternatives to the swaps to hedge the risk of treasury securities and other interest sensitive holdings. One approach might be to offset the risk through other cash market transactions, he said.

To get hedge accounting treatment under the new proposals, contracts must be considered "forecasted" transactions. A forecasted transaction is one in which the cash flows from the derivative are expected to offset changes in the cash flows of the hedged transaction.

By contrast, the proposal denies hedge accounting for "firm commitment transactions" in which changes in the fair value of the derivative are expected to offset changes in the fair value of the hedged asset or liability.

Marjorie Marker, a derivatives specialist with Arthur Andersen in New York who acts as ISDA's accounting adviser, said such distinctions will create different accounting treatment for different interest rate swaps.

"From what I've seen so far I don't see the need for a change where a company doesn't get the same accounting treatment when it swaps a debt from fixed to floating as it does when swaps from floating to fixed," she said.

Even if the swap gets hedge treatment - as in a floating to fixed-rate swap - the rule would require the company to record accumulated gains or losses from the derivative contract in shareholder equity until the hedge is reversed. Then the gain or loss will be recorded in the income statement, instead of amortized over the life of the hedged transaction, as current rules require.

Recording derivatives on the balance sheet of the company at fair value is one of the goals of the accounting board, Ms. Adams pointed out, adding that the goal is one that some observers think would benefit derivatives end-users.

Mr. Price at Sandler O'Neill said the earlier proposal to require companies to mark their derivatives to market would have made sense for some companies and is the direction the accounting profession is heading.

"It seems that that is a bridge that is going to have to be crossed at some point," he said. "Otherwise we're just going to continue with this piecemeal mark to market and the distortions that come with it."

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