Even the FASB concedes that the lack of consistency and clarity may need to be redressed. "The fact that people can't–or don't–seem to be applying it in the same way is an issue. It is a problem," says Ron Lott, senior technical adviser at Norwalk, Conn.–based FASB. So where should companies, regulators and auditors go from here–and how fast? As things stand, FAS 133 brings derivatives onto corporate financial statements by requiring them to be marked to market–any changes in the value of the derivative flow through the income statement as profits and losses–with the exception of hedges that are proved to be effective. This was an FASB accommodation for companies that did not want to inject what Lott calls "artificial volatility" into the balance sheet–a natural consequence of a rule that marked a derivative to market value but not the hedged item. To allow companies to avoid this situation, the FASB allowed a "hedge accounting" option–and it's here that the questions about interpretation begin.

Hedge accounting allows a company to offset derivative gains and losses against gains and losses in the value of the hedged item and report these in the "accumulated other comprehensive income" section of the statement–keeping it out of quarterly P&L. But to qualify, hedges must pass an obstacle course of tests–the most problematic of which is the requirement that a company must demonstrate that the hedge will be effective.

WHEN JUST EFFECTIVE ISN'T ENOUGH Proving the effectiveness of a hedge is not easy, and FAS 133 is not forgiving towards hedges that fail the effectiveness test–just look at the $9 billion penalty hitting Fannie Mae. Jiro Okochi, founder of a New York–based software vendor, Reval Inc., says that a more lenient approach to the hedge accounting provisions of FAS 133 would appease critics of the standard and "make a lot of people happy." It would also make it less likely companies would fall afoul of the rule since qualifying for hedge accounting is not only the most complicated section, it is also the most expensive with which to comply. Take, for instance, FAS 133′s requirement that a hedge must be "highly effective." The rule then fails to offer a quantitative threshold on which to judge effectiveness. Auditors have uniformly fixed upon a range of 80% to 125%, notes Reval's Okochi. If changes in the value of a hedge offset changes in the value of the hedged item within those boundaries, the hedge is deemed effective, Okochi explains. But an FASB staff member confirms that this range has never been endorsed by the FASB, which "didn't want to draw any bright lines. We didn't want to be saying that an 80% offset was effective, but 79.9% was not."

The FASB staff member explains that the 80%-to-125% range first came to be widely adopted after the SEC made public comments about hedge accounting prior to FAS 133′s introduction. Since then, it has been the consensus view in practice, although "SEC comments are not U.S. GAAP," the staffer notes. Not only is hedge accounting confusing, qualifying for it is also technically demanding. The best-practice method for testing the effectiveness of a hedge is to employ stochastic modeling, which requires intensive and time-consuming calculations.

In the context of the Fannie Mae case, arguably the biggest problem arose with respect to something called the "shortcut method." Because the work involved in qualifying for hedge effectiveness is so onerous, smaller hedgers complained to the FASB that the testing requirements would discourage companies from managing risk. The shortcut method allows hedgers to assume effectiveness–and dispense with the need for quarterly effectiveness testing–if the hedged item and the derivative match up at the inception of the hedge.

THE TEMPTATION OF SHORTCUTS

But, hey, who doesn't like to take the shortcut? Over time, larger derivative users began to find loopholes that allowed them to use the shortcut as well, leading to a loosening on the restrictions that FASB placed around its use. In particular, the requirement that the derivative and the hedged item should match up perfectly has been interpreted differently.

Reval's Okochi says that he has seen very different standards applied to the use of the shortcut. "I've seen some companies get the shortcut when using six-month LIBOR to hedge three-month LIBOR," he says. "On the other hand, I've seen hedges where the roll date on the derivative is the 16th of the month and the roll date for the hedged item is on the 15th–and it didn't get the shortcut. Although the shortcut rule is very specific, auditors might look at the materiality of incorrectly complying."

FASB's Lott accepts that there has been an assault on the shortcut method. "I have been told that some organizations find it difficult to prove and test effectiveness without the shortcut. People either don't understand it, or they don't have the right people to do statistical analyses–so they have tried to stretch the shortcut method because that was a safe harbor."

The standard is pretty clear on when the shortcut can be taken, according to the FASB staff member. He says that the shortcut method is only applicable to interest rate swaps, for hedges where the asset or liability being hedged was already on the company's books. Further, all of the "matching" criteria have to be met: The principal amount has to match the derivative's notional amount; the reset date on the hedge has to match the reset date on the hedged item. "When we say 'match,' we mean it has to match exactly," he says. "If the date is out by a day, you don't get the shortcut. If the principal is out by $1, you don't get the shortcut. I think we've made that clear."

Nevertheless, says Reval's Okochi, "there are companies out there who are using the shortcut method and know they're not applying the letter of the law."

But the muddied water does not end with the question of whether a hedge is deemed effective or whether a shortcut was employed. Finance executives will tell you that the definition of what qualifies as a derivative is also unclear. Back in the olden days a decade or so ago, derivatives were futures, options and swaps on commodities, interest rates and currencies. But the derivatives industry is nothing if not innovative, and today's instruments range from inflation options to structured credit. Many common financial instruments also contain embedded derivatives: Convertible debt, for example, gives the holder an option to switch bonds for equity, and that option falls under the aegis of FAS 133 and must be marked to market as well. "I understand from what people tell me that a big issue with FAS 133 is that people don't know what a derivative is," says FASB's Lott. "Anecdotally, I've heard of people suddenly discovering that an instrument they've been holding for two or three years is actually considered a derivative, and they've been [incorrectly] accounting for it."

The standard itself defines derivatives in terms of a list of characteristics, since the FASB didn't want to simply list instruments and enable the industry to bypass the standard by creating new products that weren't on the list. But, as Lott notes, using a list of characteristics to classify a financial instrument can be tricky. Okochi concludes that the lack of certainty on such major questions as hedge accounting and the definition of derivatives leads to the current confusion and inconsistency: "To an outsider, it might seem that if you have rules in place, it's got to be black or white," he says. But with FAS 133, "there's wiggle room in how you might comply with those rules."

The Education

Jeffrey Osman, CEO of the NASDAQ-listed York Water Co., was taking no chances when it came to his first interest rate swap. Osman actually took the time to attend a training course to get up to speed with the requirements of FAS 133. York Water's swap, which started on Dec. 9, does not perfectly match the exposure from the variable-rate debt that it is trying to hedge, which means the company will have to go through the rigmarole of effectiveness testing. Still, says Osman, the transaction overall makes good business sense and, after seeking input from a consultant, he feels that he has been well advised on how to deal with FAS 133. "With the consultant, I was able to be very specific about the company's wants and needs and what we're trying to achieve," he says. "I think I got solid information."