Case of Interest Rate Swaps and Questions for the Pozen Committee
Why Ironclad Rules?
Stephen Bryan and Steven Lilien
- Companies commonly use interest rate swaps to hedge against
changes in interest rates. In 2006, the notional contract value
of interest rate swaps and options topped $286 trillion, a 34%
increase over the previous year (Scott Patterson, “Volatility
Jump Could Test Derivatives,” Wall Street Journal,
Aug. 2, 2007). Because of the magnitude of the market for these
products, accounting measurement, recognition, and disclosure
issues take on added importance. Even though the accounting for
these “plain vanilla” instruments is relatively straightforward,
accounting restatements involving these and other types of derivatives
are not uncommon among U.S. corporations.
In a press
release dated July 23, 2007, Tenneco Corporation announced a restatement
of its financial statements because of an error related to accounting
for interest rate swaps. Tenneco elaborated that in 2004, it entered
into three separate fixed-to-floating interest rates swaps with
two financial institutions. The agreements swapped $150 million
of 10.25% senior secured notes to floating-point interest rates
at Libor plus an average spread of 5.68 percentage points. Further
inspection of Tenneco’s 2006 Form 10-K revealed that the
swaps required semi-annual settlements through July 15, 2013.
by the Public Company Accounting Oversight Board (PCAOB), two
differences in the debt contracts and swaps contracts were identified:
the requirement of a 30-day notice to terminate the swaps, compared
to a 30-to-60 day notice to redeem the notes; and the fact that
the debt contracts permitted redemptions in $1,000 increments,
while the interest rate swaps could be redeemed only in their
full amounts. Under current accounting rules, these two differences
disqualified the company from applying hedge accounting. As a
result, Tenneco was forced to restate prior-year results and discontinue
hedge accounting and treat the swap as a speculative transaction.
of this article is to ask two relatively simple questions in the
particular context of the case of Tenneco, and more broadly in
the context of setting accounting policy. The case is timely for
the Pozen Committee, officially known as the SEC Advisory Committee
on Improvements to Financial Reporting. This committee represents
the thought leaders on all aspects of generation, production,
regulation, and use of financial information. The committee’s
charge includes examining “the U.S. financial reporting
system with the goals of reducing unnecessary complexity and making
information more useful and understandable for investors.”
The Tenneco case raises anew two questions that the committee
will undoubtedly want to ponder.
- Why do
some accounting standards contain bright-line rules and others
allow for interpretation and judgment?
- Who benefits
from accounting standards that contain bright-line rules?
would like to underscore that our use of the Tenneco case is meant
as a backdrop to a public dialog. We wish to continue and, if
necessary, restart, public debate about these questions in the
spirit of meeting the informational needs of the marketplace and
other constituencies. We also wish to raise awareness of the Pozen
Committee’s work and inform its members that this particular
case entails issues relevant to the committee’s deliberations.
accounting issues of the Tenneco case are as follows. Under the
current reporting system, debt is carried at (amortized) cost.
To the extent a swap is entered into as a hedge of a debt, however,
the carrying amount of a debt is adjusted for fair value changes
attributable to fluctuations in interest rates. The debt is not
adjusted for other changes, such as a change in credit standing.
assume a company borrows at a fixed rate and wishes to hedge its
borrowing cost by swapping the fixed rate with a variable rate.
(This would be classified as a “fair value hedge.”)
If interest rates happen to rise, the company must book an incremental
increase to interest expense and recognize a derivative liability.
When interest rates rise, however, the value of the debt falls.
The question becomes how to measure the change in the value of
the debt; that is, how to “mark-to-market” the debt.
Note that companies have the choice to mark-to-market debt under
SFAS 159, The Fair Value Option for Financial Assets and Financial
Liabilities—Including an amendment of FASB Statement No.
115. However, the estimates of fair value of debt under SFAS
133, Accounting for Derivative Instruments and Hedging Activities,
and SFAS 159 differ in two important ways. First, fair value adjustments
under SFAS 133 relate only to the specific hedged risk (e.g.,
interest rates), whereas fair value adjustments under SFAS 159
relate to more factors. Second, SFAS 159’s fair value option
is irrevocable, whereas SFAS 133’s fair value is terminated
under certain circumstances, as in the Tenneco case.
a “shortcut method” to mark-to-market the debt, but
only under certain circumstances. The shortcut method simplifies
the measurement and assessment of hedge effectiveness by allowing
companies to assume no ineffectiveness. Under the shortcut
method, the preparer may assume that the change in the fair value
of the debt is identical to, but in the opposite direction of,
the change in the fair value of the swap. FASB included the shortcut
method to accommodate preparers who commented on the burdensome
requirements to measure and assess hedge effectiveness on an initial
and ongoing basis for hedges of interest rate risk. A stylized
example of an interest rate swap using the shortcut method is
provided in Appendix
To the extent
that the criteria for use of the shortcut method are not met,
companies may use the “long-haul method” to estimate
the fair value of the debt. Because the revaluation of debt can
be complex in practice, companies try to avail themselves of the
shortcut method to obviate the need for financial modeling (see
SFAS 157 and 159). Moreover, under the long-haul method, any ineffectiveness
in the hedge is captured directly in current income.
The SEC has
decided that when a company incorrectly applies the shortcut method,
the error should be corrected by assuming that there was no hedging
relationship whatsoever. This means that the debt is carried at
amortized cost. The lack of offset to interest expense converts
an economic hedge to a speculative transaction. This was precisely
the case at Tenneco.
of the criteria that must be met for firms to use the shortcut
method (see Appendix
B for other criteria) is that “the expiration date of
the swap matches the maturity date of the interest-bearing asset
or liability” (SFAS 133, para. 68). The Derivative Implementation
Group (DIG) Issue E4, Question 1, states: “The verb match
is used in the specified conditions in paragraph 68 to mean be
exactly the same or correspond exactly.” Thus, the DIG and
the SEC take a literal view of the term “match” and
strictly limit the circumstances under which the shortcut method
may be used. This is clearly an example of rules-based accounting
with no wiggle room, to which questions of “why?”
and “who benefits?” become relevant.
rate swap at Tenneco appears to have been a routine swap issued
by the financial institution. The attorneys and accountants for
both sides could have ensured that the terms were exactly mirrored,
but it would appear that they instead considered the differences
and their assumed effects on the value of the debt to be de minimis.
Various practices and accommodations are typically put in place
to set de minimis boundaries, and management and the auditor conceivably
signed off that the matching indeed was nearly perfect and therefore
concluded—incorrectly, as it turned out—that the instruments
the SEC and DIG regard any deviation from “match”
as an accounting error, the authors still find it instructive
to show the magnitude of the effects of the restatements (both
from the swap separately and in conjunction with other errors)
on Tenneco’s interest expense over the affected time periods
accounting errors required the company to warn the investment
community not to rely on prior years’ financial statements.
Furthermore, the auditor had to withdraw its audit opinions and
re-audit the years in question. The business press tended to focus
on any audit failure by a Big Four firm (e.g., Stephen Taub, “PCAOB
Review of Deloitte Prompts Restatement,” CFO.com, July 24,
2007). The negative publicity was due in part to the fact that
the PCAOB had selected Deloitte & Touche’s audit of
Tenneco’s financial statements for review.
came with significant costs. In addition to the cost of re-auditing
prior years’ financial statements and the cost to its reputation,
Tenneco’s share price fell almost 5% on the day following
the announcement (July 24, 20007), as shown in Exhibit
2, and fell another 8.8% over the days around the filing of
the amended 10-K (Aug. 14, 2007). (As a benchmark, the S&P
500 index fell 1.98% and 2.88% over the same two time periods.)
the markets to ignore the restatement:
rate swap transactions provide effective economic hedges and
this change in accounting method will in no way affect our cash
flow or minimize the benefits from this risk management strategy.
The accounting standards for interest rate swaps are complex
and we are disappointed in having to restate our financial results.
(Tenneco press release, Aug. 23, 2007)
From a review
of nine of the 10 equity research analysts that cover Tenneco
(plus a Fitch report on Tenneco’s debt), no analysts reported
on the restatement. Additionally, no analyst reports were filed
on or around the date of the 10-K/A filing, according to Investext.
the Questions of ‘Why’ and ‘Who Benefits’
to the Tenneco case, among others, the Big Four have jointly prepared
a “White Paper on Hedge Accounting when Critical Terms Match,”
and FASB issued an exposure draft clarifying the application of
the shortcut method of hedge accounting.
As the Pozen
Committee contemplates changes to the financial reporting system,
the authors would like to raise the questions of “why”
and “who benefits” in restatement cases like Tenneco.
For example, Tenneco’s earnings announcement, which occurred
two days after the press release, contained information about
global revenue growth, geographic mix, EBIT, gross margin, gross
cost increases, and other information. These measures clearly
incorporate important financial information, material judgments,
and estimations, none of which seem to have been challenged by
the PCAOB’s review. With this in mind, the authors are particularly
struck by the end result, namely forcing Tenneco to withdraw financial
statements, convert the hedge to a speculative investment, and
re-employ the auditors to re-audit prior financial statements.
submit the following questions for readers to consider in the
context of Tenneco’s restatement:
the “punishment fit the crime”? In addition to the
costs to Tenneco noted above, it is significant that other companies
that have an accounting error due to incorrectly using the shortcut
method may not convert to the long-haul alternative without
first completely undoing the hedge and reporting as if the derivative
- For rules-based
standards, does “exact” preclude judgment with respect
n If accounting standards become more principles-based in the
future and, presumably, move away from situations like Tenneco,
what will be the implications for assessing compliance with
there be a benefit to having a body such as the PCAOB devote
more resources to challenging the basis of prospective statements
and estimates that companies often make during their earnings
announcements? Markets move on new information about the future,
but most regulatory resources are devoted to monitoring the
have no clear answers to these questions, but we hope that they
provoke thought in the minds of readers, and we invite comments.
Bryan, PhD, is an associate professor of accountancy at
the Babcock Graduate School of Management of Wake Forest University,
Steven Lilien, PhD, CPA, is the Weinstein Professor
of Accounting at the Zicklin School of Business of Baruch College
and a member of The CPA Journal Editorial Board.