Hedge Accounting and Derivatives Study for Corporates

Summary

Fitch Ratings has completed its first study of derivatives accounting and disclosure among corporate entities, excluding financial institutions. Derivatives have become an integral part of the risk management framework for major corporate issuers of debt, allowing active management of interest rate, foreign exchange, commodity price, and equity exposures. Moreover, the growing use of derivatives coincides with rapid developments in the derivatives market, including the availability of a broader range of derivative products.

Concurrently, accounting for derivatives has undergone a revolution since the implementation of Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, in 2001. Outside the U.S. market, the most controversial aspect of the pending implementation of International Financial Reporting Standards (IFRS) in the European Union has been the requirement to account for derivatives under International Accounting Standard (IAS) 39. What exactly one can expect from European corporate derivative accounting is really an open question currently, although most of the European companies in Fitch’s study either report under IFRS already or reconcile to U.S. generally accepted accounting principles (GAAP) for Securities and Exchange Commission (SEC) filing purposes, giving some idea of what is coming. Highlights of the study include:

• Hedge accounting can alter important debt and equity ratios, making period-to-period and company-to-company comparisons tricky. While hedge accounting may dampen income statement volatility, there are balance sheet consequences that should be recognized by investors and analysts. Moreover, there may be wide disparities in the income effects. Fitch believes it is often appropriate, for analytical purposes, to consider the core ratios it uses in its analysis with and without the effects of hedge accounting adjustments if the adjustments are material and provided there is adequate disclosure. Additionally, the financial reporting consequences of hedge accounting make earnings before interest, taxes, depreciation, and amortization (EBITDA) less viable as a cash flow measure.
• Fitch found wide disparities in disclosure across companies and industries. This is true for even the most generic instruments, such as interest rate and currency hedges. Similarly, lack of any requirements to disclose valuation adjustments, much less the sources from which they were derived, raises concerns of possible inconsistency and lack of comparability. For example, there is no requirement for disclosure of income derived from mark-to-market or mark-to-model valuation adjustments.
• Fitch is concerned with the potential for reporting and restatement risk across corporate sectors due to difficulties associated with hedge accounting. Allegations regarding Fannie Mae and other companies underscore the difficulties in correctly applying hedge accounting. Fitch’s study found a lack of consensus among companies with respect to disclosure and application of SFAS 133 and IAS 39, and this in turn may indicate an absence of uniformity or misapplication of hedge accounting rules. This does not bode well for the pending implementation of IFRS for most large European companies. Consistency will be achieved only if auditors insist on applying the rules rigorously and consistently.
• Based on the results of the study, it does not appear that participating companies are engaging in widespread speculation using derivatives. That said, a number of companies in certain industries appear to have taken positions with respect to future changes in the prices of commodities and equities in certain industries. Also, a number of companies appear to have used interest rate swaps to convert fixed-rate term debt into floating-rate debt. While this is not surprising at a time when interest rates have been at historical lows, sharp changes in interest rates, exchange rates, or commodities prices could cause unanticipated earnings volatility and/or skewing of key credit ratios, even in cases where hedge accounting rules are properly applied. This is especially relevant in light of Fitch’s current forecast that the U.S. federal funds rate will rise to 4% by 2006.
• Of the study participants, 11% had derivative positions in their own shares. Positions such as forward purchases or written puts on a company’s own shares have led to unexpected losses in the past. Further, equity derivatives can have unexpected effects on reported debt.
• There was limited use of credit derivatives among the surveyed companies. Concerns about self-referenced credit-linked notes and other forms of exotic derivatives were heightened following the collapse of Parmalat S.p.A. Investors and analysts should be alert to the presence of these types of instruments outside the survey, particularly among European corporations.
• Counterparty disclosure was also weak, with only 26% of survey respondents providing detailed information regarding counterparty credit risk. Additionally, 46% of companies surveyed have derivatives agreements containing rating-related triggers.

Study Overview

Derivatives have become an integral part of the risk management framework for many major corporations throughout the world. Corporate entities use derivatives to manage risks related to interest rates, foreign currency exchange rates, equities, and commodity prices. Recently, according to surveys conducted by the Bank for International Settlements and the International Swaps and Derivatives Association, the notional amount of over-the-counter derivatives was nearly US$170 trillion, with more than 90% of the largest corporations worldwide using derivatives to hedge their risk.

Concurrent with this spectacular rise in derivatives usage, accounting and financial reporting for derivatives have gone through a revolution with the advent of fair value reporting and hedge accounting in the U.S. and soon in the European Union. SFAS 133 became effective in the U.S. for the year ended Dec. 31, 2001. As a result, there are now three full years of data available from which to gauge results. Further, two of the 15 non-U.S. corporate entities included in Fitch’s study have adopted IFRS, which has similar requirements for derivatives and hedge accounting.

Market indicators seem to point toward the potential for increased volatility in the near to intermediate term with respect to interest rates, currency exchange rates, and commodities prices. This type of volatility in the past has resulted in isolated cases of “surprise” losses. While bringing derivative instruments onto the financial statements greatly mitigates this risk, the complexity of current derivative accounting standards and the low level of transparency create a new set of anxieties for investors and analysts. Further, any income statement volatility that has been smoothed out through hedge accounting now appears on the balance sheet, potentially skewing important credit ratios.

With these facts in mind, Fitch determined it is an appropriate time to take a fresh look at corporate derivatives accounting and usage. In conducting the study, Fitch sought to: ascertain the degree to which current disclosure practices provide insight into how corporate entities are using derivatives and for what purpose; assess the progress that corporations have made in successfully implementing SFAS 133 or its equivalent under IFRS, IAS 39; determine the effect of derivatives on the financial statements of surveyed entities; and compare disclosures across companies and industries to see if, with three full years of experience behind them in the case of those reporting under U.S. GAAP, corporate entities have achieved transparency, consistency, and comparability in disclosures related to derivatives.

Fitch surveyed 57 companies from a range of industries representing nearly US$1 trillion in aggregate debt. The survey focused on the types of derivatives used, hedge accounting, financial reporting, valuation and disclosure practices, and counterparty risk. Fitch accounting analysts reviewed the survey responses and reconciled them to the financial statements and related disclosures in the companies’ annual reports. A database of more than 50 separate derivative measures was created, containing all available derivative information from the surveys and financial statements. The compiled data were examined in conjunction with company-level qualitative data in the survey responses to characterize financial statement impact, disclosure practices, and valuation of derivatives.

Accounting for Derivatives: A Hedge Accounting Primer

Before discussing results from the study, a brief review of hedge accounting is needed. This is highly relevant to the study, as 96% of participants met the accounting requirements to achieve hedge accounting for at least a portion of their derivatives portfolio. Both SFAS 133 and current IFRS rules (IAS 39) require all derivative instruments to be fair value accounted (essentially marked to market; the terms fair value and mark-to-market are used interchangeably in this report). Absent hedge accounting, this can cause volatility in income because small changes in underlying economic factors – interest rates, exchange rates, and commodity prices – can have a large effect on the fair values of derivative instruments. Despite the fact that short-term volatility can obscure the true economics of derivatives usage over the duration of a hedging transaction, the standards allow no exception to the mark-to-market rule.

Derivatives are commonly used to hedge against specific risks, such as the effects of rising interest rates on a variable-rate debt instrument. When derivatives are used in this manner, both U.S. GAAP and IFRS allow the use of hedge accounting. Hedge accounting is a procedure under which the change in the value of the derivative, or hedging instrument, is counteracted with an equal and offsetting adjustment to the asset, liability, or future cash flow being hedged, or hedged item. By marking to market both the derivative and the hedged item, the net effect on income is zero, assuming a perfectly effective hedging relationship. By requiring the marking to market of derivatives through income but allowing hedge accounting for “effective” hedges, SFAS 133 and IAS 39 discourage companies from speculating in derivatives and provide full recognition of the financial impact of derivative positions.

Effectiveness is simply the extent to which gains and losses on the derivative offset changes in the fair value of the hedged item. SFAS 133 and IAS 39 require that hedge effectiveness be documented at the inception of the hedge and then monitored on a quarterly basis. Effectiveness is often demonstrated through modeling. For SFAS 133, in the case of plain-vanilla interest rate swaps, perfect effectiveness can be assumed if certain restrictive requirements are met (the so-called shortcut method). For hedges with terms matching those of the hedged item, certain assumptions may be made about effectiveness, but again there are severe restrictions and a requirement to monitor the effectiveness of the hedge through quarterly assessment. The shortcut method is not permitted under IAS 39.

All other hedges generally require mathematical modeling, such as regression analysis or Monte Carlo simulation. Again, all hedging relationships, other than plain-vanilla swaps, must be monitored for effectiveness. Further, the derivative must be within the range of 80%-125% in terms of effectively offsetting the changes in value of the hedged item (i.e. the increase/decrease in the fair value of the derivative must offset 80%-125% of the increase/ decrease in the hedged item). Any portion of the hedge mark-to-market value that is deemed to be “ineffective” must be recognized immediately in income.

As recent events related to Fannie Mae and other companies whose hedge accounting has been challenged underscore, demonstrating effectiveness is probably the most challenging aspect of achieving hedge accounting and may present the highest level of restatement risk. This being the case, Fitch believes there is a significant amount of accounting risk in this area. Also noteworthy is the fact that while hedge accounting may eliminate income volatility associated with marking derivatives to market, at the same time it creates volatility in certain balance sheet accounts. This volatility can have important consequences for credit analysis.

Aggregate Financial Statement Effects

Perhaps as expected, most derivatives used by the companies included in Fitch’s representative survey, in terms of both notional and fair value, are interest rate swaps, commodity derivatives, or currency derivatives (see table above and chart below). The commodity hedges are concentrated in the energy and oil sectors, but both interest rate and currency derivatives are spread relatively evenly across sectors.

Balance Sheet

The table above shows the aggregate balance sheet effects of derivatives mark-to-market adjustments for the 57 participating companies. The derivative asset and liability amounts are simply the amounts by which the fair values of derivatives are in either gain or loss positions, respectively, at Dec. 31, 2003.

Accumulated other comprehensive income (AOCI) for cash flow hedges is the net amount of derivative gains that have been deferred in equity through hedge accounting. These gains will be reclassified into earnings as the hedged cash flows occur. For example, in the case of a manufacturer using a cash flow hedge against increases in future commodities prices, gains associated with an effective hedge would be offset by adverse prices of commodities as the company purchases materials for production, ultimately neutralizing the profit and loss (P&L) effect in cost of sales. Fitch notes that most of the cash flow hedges in the survey are pay-fixed swaps, which tend to be underwater in the current low rate environment. However, two large auto companies had deferred gains on cash flow hedges of nearly US$5 billion. The SFAS 133 fair value adjustment is the net amount of derivative gains that have been offset to the assets, liabilities, or firm commitments they are hedging, again through the magic of hedge accounting.

In this survey, the SFAS 133 adjustment was predominantly to hedged debt; because this debt is generally fixed rate and rates have fallen, the amount shown is the aggregate increase in balance sheet debt. The majority of the fair value hedges included in the study consist of receive-fixed swaps, which have the effect of converting fixed-rate debt to floating-rate debt. The mark-to-market value of the hedging derivative is an asset effectively matching the increase in value recorded on the debt. This is significant considering the low interest rate environment of 2003. If interest rates were to increase sharply as Fitch has predicted, the SFAS 133 fair value adjustment could reverse, possibly leading to a downward adjustment in reported debt. (For Fitch’s forecast of interest rate movements over the next two years, see Fitch Research on “Sovereign Review: Autumn 2004,” dated Sept. 15, 2004, available on Fitch’s web site at www.fitchratings.com.)

SFAS 133 also contains a provision for hedges of the foreign exchange risk associated with net investments in foreign subsidiaries. This is similar to older provisions of U.S. GAAP relating to accounting for net investments in foreign subsidiaries that have been carried over largely unchanged. Gains and losses as a result of these “portfolio” hedges and the translation adjustment on the underlying investment are recorded in equity until the investment in the subsidiary is sold, at which point the cash gains or losses pass through the P&L.

Income Statement

The effect of hedge ineffectiveness on income is one of the few disclosures required by SFAS 133. IAS 32, on the other hand, calls for much more extensive disclosure. Disclosure of the P&L effect for derivatives not designated as hedges (i.e. nondesignated) is not required and is not routinely provided. Fitch obtained this information from survey responses. The table below shows the income statement effects of marking to market derivatives of the participating companies. The total P&L effect for nondesignated instruments is a net amount, as some derivatives that were not in hedge accounting relationships were out of the money. Fitch noted that in no case did companies provide roll-forward information for their derivatives balance sheet positions. Therefore, it is difficult to determine with certainty from current disclosure the effect of derivatives mark-to-market adjustments on income.

The largest P&L impact was that of Ford Motor Co., which had gains of US$2.9 billion from nondesignated derivatives. Fitch noted that this amount included results from Ford’s finance subsidiary. Ford included this disclosure in its annual report. Also notable was Liberty Media Corp.’s US$650 million loss from derivatives. Ford also had the largest P&L gain for hedge ineffectiveness: nearly US$600 million. Ford’s total P&L from derivatives mark-to-market adjustments was US$3.5 billion, or approximately 14% of EBITDA.

Hedge Accounting Impact on Ratios

Accounting principles for derivatives can lead to poor comparability, both between periods and across companies. This is not solely attributable to P&L volatility arising from mark-to-market valuation adjustments for nondesignated derivatives and hedge ineffectiveness. In addition, financial ratios can be distorted by the effects of hedge accounting due to the potential balance sheet volatility alluded to previously. Aware of these potential distortions, Fitch analysts try to ensure that they have sufficient information to consider whether it is appropriate to remove the effects of hedge accounting from balance sheet accounts. The examples that follow highlight some of the ways in which hedge accounting can affect credit analysis.

Fair Value Hedge of Fixed-Rate Debt

Fair value hedges on fixed-rate debt are the most common type of hedge in the study and are typically accomplished through receive-fixed, pay-variable interest rate swaps. Proceeds from the receive portion of the swap are passed through to the bondholder, converting the debt to variable rate. While this allows the company to benefit from falling interest rates, it also implicitly means there is a willingness to assume greater exposure to rising interest rates at a time when rates are at or near historical lows. Many observers, including Fitch, are predicting relatively sharp interest rate rises over the next two years.

Because interest rates generally fell over the period from Jan. 1, 2001-Dec. 31, 2003, receive-fixed swaps identified in the survey tended to have positive fair values. Fair value hedges also affect reported debt. The offset to the fair value gain on these derivative contracts is an upward adjustment to reported debt (the FAS 133/IAS 39 adjustment). As shown in table at the top of page 5, at Dec. 31, 2003, the SFAS 133 adjustment for fair value hedges was a positive US$2.4 billion, having the effect of increasing the aggregate debt by US$2.4 billion on the balance sheets of companies in the representative survey. The example in the box above demonstrates the effect of the SFAS 133 adjustment for fair value hedges on debt ratios. Cash Flow Hedges for Commodities Survey participant Amerada Hess Corp. uses forward-settled commodity contracts and commodity swaps to hedge future cash flows. When these out-of-the- money derivative positions are marked to market, the off-setting debit or credit is booked to AOCI, a component of equity, rather than to expenses (see Example 2).

Examples 1 and 2 demonstrate the somewhat counterintuitive nature of the interaction between hedge accounting and credit analysis. In the case of Example 1, IBM Corp. has benefited from low interest rates, which have put its receive-fixed swaps in the money. However, the hedge accounting procedure has created phantom debt, which makes it appear as if IBM has more leverage. In Example 2, Amerada Hess has entered into derivatives contracts that are out of the money, making it appear to be more highly leveraged as well. In fact, Amerada Hess has lowered its risk by locking in future costs. In summary, hedge accounting effectively neutralizes artificial income statement volatility that would otherwise be caused by marking the derivatives to market, but does so by shifting that volatility onto the balance sheet. The effects of this shift on credit ratios must be analyzed carefully. Mark-to-Market Accounting Affects Certain

Equity Derivatives

In another example of how mark-to-market accounting can affect financial statements, certain companies use equity derivatives to hedge and monetize equity positions they hold in publicly traded companies. This is particularly prevalent in the cable and media sector, where companies have received publicly traded shares as part of strategic mergers and acquisitions. Marking to market of equity derivatives under SFAS 133 can create large swings in reported debt, as well as income, as shown in Example 3 above right.

The Case for Removing the Effect of Material Hedge Accounting Adjustments

Examples 1, 2, and 3 focus on the effects of mark-to-market derivatives adjustments. In the case of hedge accounting adjustments, as illustrated in Examples 1 and 2, it may be appropriate to remove the adjustments when calculating ratios. This is because the mark-to-market adjustments have no real effect on the amount of debt or equity, but are merely accounting entries to offset movements in the fair value of the derivative hedge. As the derivative and the hedged item move toward maturity, cash settlements, combined with time decay, will reduce the value of the derivative to zero as the fair value of the hedged item converges with its amortized cost. Fitch analysts assess the effects of derivative settlements on income and cash flows.

In situations like those described in Example 3, where hedge accounting does not apply, it is generally appropriate to consider the debt net of the embedded derivative, provided there are no restrictions on the shares in question.

Accounting standard-setters continue to layer accruals onto the income recognition model, with hedge accounting another example. While this may be entirely appropriate for purposes of income determination, it has made the use of EBITDA as a cash flow proxy unwieldy. This is certainly the case when SFAS 133 and IFRS are applied, which may create unrealized mark-to-market gains and losses that should be adjusted out of EBITDA to obtain a closer approximation of cash flow. However, in many cases this may be impossible, as the amounts are not disclosed. For these reasons, cash flow from operations measures are generally preferable.

In summary, analysts should deconstruct the often complicated effects of derivative accounting to normalize the impact on reported financial results and ratios. In order to make necessary adjustments to remove the effects of hedge accounting, it is necessary that companies provide adequate disclosure of derivative positions (notional and mark-to-market value), realized and unrealized gains and losses taken through income, and gains and losses offset through hedge accounting. As further discussed in the following section, disclosure of key derivative and hedge accounting measures in publicly filed financial statements is inconsistent and often incomplete.

Disclosure: In Search of Consistency

As noted, disclosures in publicly available financial statements are varied. The table above right gives the percentages of s