Material Weaknesses in Internal Control in Relation to Derivatives and Hedge Accounting

• Author: Hakjoon Song,Sang Mook Lee,Keun Jae Park,Li Wang
• Date: 01 July 2018
• DOI: http://doi.org/10.1002/jcaf.22341
• Published date: 01 July 2018

Refereed (Double-Blind

Peer Reviewed)

Material Weaknesses in

Internal Control in Relation to

Derivatives and Hedge

Accounting

Sang Mook Lee, Keun Jae Park, Hakjoon Song and Li Wang*

INTRODUCTION

Companies can use

derivatives to reduce

their risk exposure and

avoid large fluctuations

in earnings and cash

flows due to changes in

commodity prices, for-

eign exchange rates,

and interest rates. The

notional amount of

outstanding over-the-

counter derivatives con-

tracts has reached $542

trillion by the end of

June 2017 (Bank for

International Settle-

ments, 2017). To

improve the transpar-

ency on public compa-

nies’use of derivatives,

the Financial Account-

ing Standards Board

(FASB) issued the

Statement of Financial Account-

ing Standard No. 133 (FAS133),

Accounting for Derivative Instru-

ments and Hedging Activities,in

1998 (FASB, 1998) that estab-

lished the accounting and report-

ing standards for derivatives, and

FASB has since issued additional

guidance and accounting standard

updates related to hedge account-

ing which are all codified as ASC

815 Derivatives and Hedging.

Under ASC 815, companies are

required to report derivatives as

assets or liabilities on

balance sheet at fair

value. The gains and

losses on certain deriva-

tives (e.g., effective cash

flow hedges) can be

deferred in comprehen-

sive income until matu-

rity if companies can

prove that the deriva-

tives are used to effec-

tively hedge risk rather

than for market specu-

lation. Risk-averse

investors prefer compa-

nies with less volatile

earnings and cash flows

and reward these com-

panies with higher mar-

ket valuations and

lower cost of capital.

By utilizing ASC

815, companies can

communicate to the

market of their effective

use of derivatives in reducing

exposures to commodity prices,

foreign exchange rates, interest

rates, and decreasing volatility in

earnings and cash flows. However,

because of the onerous cost of

testing and documentation

We examined 173 internal control reports

containing material weaknesses (MW) in internal

control over financial reporting related to

derivatives and hedge accounting issues (FASB

codification ASC 815). We found that a majority

of the companies (122) did not properly

implement the ASC 815 accounting rules,

followed by inadequate monitoring and review

(72), insufficient resources (61), incomplete

documentation for hedge effectiveness (49), and

inaccurate valuation (32). We also found that

companies with MW mostly fixed their problems

by process and procedure improvement (205),

training expansion (60), engaging external

specialists (53), and increasing staffing (52). Our

review and discussion of the MW in internal

control related to ASC 815 should benefit external

auditors, management, and regulators. © 2018 Wiley

Periodicals, Inc.

© 2018 Wiley Periodicals, Inc.

Published online in Wiley Online Library (wileyonlinelibrary.com).

DOI 10.1002/jcaf.22341

24

The manuscript originally appeared online on 10 September 2018 without complete author

corrections. The article was corrected in both HTML and PDF versions on 29 October. The

publisher of the Journal of Corporate Accounting & Finance regrets the error.