A V Rajwade: Hedge accounting

WORLD MONEY

The hedge must have the same accounting treatment as the underlying, fair value or accrual accounting.

Accounting for derivatives designated as hedges is in the news "" both domestically and in the US. In the US, Fannie Mae, the giant quasi-government housing finance company, was recently fined $400 million (Rs 1,800 crore) for incorrect and indeed fraudulent accounting including of derivatives designated as hedges. Nearer home, it seems the Reserve Bank of India has asked for full details of swap contracts used purportedly for hedging banks' rupee liabilities towards tier-I and tier-II bonds (Economic Times, June 5). Before looking at some of the issues involved, it may be useful to discuss the principles underlying accounting for derivatives: one is forced to use US and international accounting standards since there are no Indian standards. But such technicalities apart, the basic principles are clear:

As a rule, derivatives should be recorded at fair value, with changes reflected in the profit and loss account;

In certain circumstances, hedge accounting can be used. In that case, the hedge will have the same accounting treatment as the underlying "" fair value or accrual accounting as the case may be. For this purpose, the hedge and the hedged item will have to meet certain stringent, specific criteria as to hedge effectiveness and documentation, at the inception of the hedge;

A hedged item is an asset, liability or firm commitment exposed to a risk of change in value ("fair value hedges"), or changes in future cash flows ("cash flow hedges"). Thus, for instance, since investments in the held to maturity category are not subject to mark-to-market valuations, they cannot be a hedged item;

It seems that several Indian banks have entered into derivative contracts (receive fix, pay floating) in relation to their fixed rate, tier-II bonds. If this be the case, the derivatives would not qualify for hedge accounting under the above principles, and will need to be marked-to-market. The reason is that the tier-II bond is not accounted at fair value and, therefore, does not qualify as a hedged item. Again, in as much as the interest rate is fixed, there is no risk, or uncertainty, about future cash flows. The bonds may have become costly, but "high cost" is not the same thing as "risky" "" by definition, risk is the uncertainty of outcome either because of the item being required to be marked-to-market, or subject to changes in future cash flows. For example, for a company with LIBOR-linked loan, a receive LIBOR, pay fixed swap is a hedge subject to accrual accounting "" but if the company has a fixed rate loan, a receive fix, pay floating swap is a trading position, subject to mark-to-market with the difference going to earnings.

If the Indian banks seem to have got involved in the complexities of hedge accounting because of a lack of clarity on the subject, Fannie Mae seems to have indulged into a rather liberal interpretation of hedge accounting, with the stated objectives of "minimising earnings volatility". While this can be a legitimate objective, the problem is that volatility in reported earnings arises from derivatives that do not qualify for hedge accounting for any reason. Hence, the need for a liberal interpretation of the rules, in which the auditors also seem to have joined, and designation of many derivatives as "perfectly effective hedges" even when they were sometimes not qualifying as hedges, let alone being perfectly effective.

The unstated objective of creative accounting seems to have been different as the Office of Federal Housing Enterprise Oversight (OFHEO) report on the accounting policies of Fannie Mae makes clear: it was to achieve the earnings number which allowed the senior management to claim the full bonus, year after year! Even internal audit, supposedly the watch-dog, was not free from these considerations. The head of the company's Office of Auditing exhorted the troops under him that "By now every one of you must have 6.46 (the target EPS number) branded in your brain ... you must be obsessed on 6.46 ... Remember, Frank has given us an opportunity to earn not just our salaries, benefits, raises, ESPP, but substantially over and above if we make 6.46. So it is our moral obligation...." When the brake is not as powerful as the accelerator or, indeed, acts as an accelerator; when audits have to keep profit targets in mind; major accidents will happen. As indeed they did.

Tailpiece: In the late 1960s, Indira Gandhi's government promoted Sahakari Bhandars. The belief was that the lala or the baniya gouges the middle-class with sky-high margins, and the Sahakari Bhandars would make the necessities available at reasonable prices. Recently, the theme has come full circle with Reliance Retail taking over the supply management of the Bhandars in Mumbai, which have been renovated and made smarter to suit the Reliance Brand.

Email: avrco@vsnl.com