The Case of Interest Rate Swaps and Questions for the Pozen Committee
Why Ironclad Rules?

By Stephen Bryan and Steven Lilien

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JUNE 2008 - 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.

Under review 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.

The purpose 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?

The authors 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.

Examining the Issues

The basic 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.

For example, 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.

FASB allows 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 A.

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.

An example 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.

The interest 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 were sufficient.

Even though 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 (Exhibit 1).

Tenneco’s 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.

The events 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.)

Tenneco urged the markets to ignore the restatement:

The interest 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.

Answering the Questions of ‘Why’ and ‘Who Benefits’

In response 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.

The authors submit the following questions for readers to consider in the context of Tenneco’s restatement:

  • Does 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 were speculative.
  • For rules-based standards, does “exact” preclude judgment with respect to materiality?
    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 standards?
  • Would 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 past.

The authors have no clear answers to these questions, but we hope that they provoke thought in the minds of readers, and we invite comments.


Stephen Bryan, PhD, is an associate professor of accountancy at the Babcock Graduate School of Management of Wake Forest University, Winston-Salem, N.C.
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.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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