Identical Companies, Different Financial Statements.

• Author: Adams, Jane B.
• Position: Brief Article

One purpose of financial accounting standards is to create comparability between companies to allow financial statement users to make evaluations and decisions based on the consistent presentation of useful information about a company. However, in some cases, accounting standards can be applied or modified in ways that make it more difficult to compare financial data or understand what it means, which could undermine the quality of the earnings presented. An analysis of the different ways companies might apply Financial Accounting Standards Board Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, provides a useful example.

Three Approaches

Statement No. 133, in codifying much of existing practice and acknowledging that risk reduction is in the eye of the beholder, permits identical companies to look quite different depending on what they say they are doing. For example, assume we have three companies, each with the same fixed-rate asset, variable-rate debt, and a pay-fixed, receive-variable swap. Each company makes a different choice.

* Company A designates the swap as a fair value hedge of its fixed-rate asset. The derivative is marked to market and the carrying amount of the fixed-rate is marked for changes in the benchmark interest rate. Line items on the balance sheet will fluctuate but, assuming no ineffectiveness, fluctuation will be by equal and offsetting amounts, and there might be no income statement effect. There are two reasons for this: No ineffective piece is reported in earnings and the effective yield need not be recalculated until termination of the hedge.

This approach--continuing to adjust the basis of the hedged asset without requiting recalculation of the effective yield and reported interest income/expense--allows companies to change what otherwise would have been recorded as interest income (varying with changes in the benchmark interest rate) into gain or loss on disposition of the asset. The discretion in choosing where the swap is classified on the balance sheet allows companies to put the best spin on solvency, liquidity or other ratios.

* Company B designates the swap as a cash flow hedge of its variable-rate debt. While the swap is marked to fair value, the debt is already at fair value--so there will be more balance sheet volatility. The change in the value of the swap is stored as part of comprehensive income.This company must report the swap's change in value by adjusting the...