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Community Bancshares: Another Failed Shortcut
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Posted by: Jack Ciesielski 2/28/2006 8:06 AM
Toss another log to the building bonfire of backtracking derivative shortcutters. Community Bancshares filed a non-reliance 8-K yesterday describing the restatement effects arising from its termination of the use of the "shortcut method" of testing for hedge effectiveness. (Refer here if you're new to the subject.)

The restatement covers quarterly and year end 2004 results for 2004, plus the already-reported financials for the first three quarters of 2005. The revision's total impact will reduce earnings by $0.01 per basic share, for the nine months ended September, 30, 2005; $0.02 per basic share, for the full year of 2004. (No material impact on the 2003 financial statements.)

To its credit, the firm "intends to hold this swap until its maturity date on June 8, 2007, [which will] completely offset the impact on 2004 and 2005 as the fair market value increases to zero up until its maturity date notwithstanding quarterly fluctuations. If the swap is held to maturity as is intended, there will be no overall effect on book value per share as a result of fluctuations in the swap's fair market value over its 3.5 year life."

It's admirable because the company is choosing to go "fair value" with the hedge, and let the fluctuations hit earnings as they occur; they could just as easily go the hedge route by entering into new contracts to cover the hedged item and the derivative, with the proper effectiveness testing. There would be costs to do that, which would be borne by shareholders - and for what? As the company makes clear, there's no effect on equity over the life of the swap.

Less admirable: the firm seems to be blaming the restatement on a shift in rules by the SEC, rather than as their own fault. To wit: "In light of recent interpretations of SFAS 133 within the industry and discussions between the Company's officers and its independent accountants in consultation with the Chairman of the Company's Audit Committee, the Company's officers reevaluated this transaction and determined on February 1, 2006 that the swap did not qualify for the short-cut method in prior periods."

And they're not the only ones. Remember last week's restatement by Bank of America for their incorrect use of shortcut testing? Note this from the press release contained in the 8-K:

"“The interpretations of how to apply SFAS 133, a quite complex standard, continue to evolve,” said Alvaro de Molina, Bank of America chief financial officer. “We monitor interpretations of accounting standards by regulators and accounting professionals as well as recent industry practices to evaluate our accounting practices. In light of recent interpretations, we reviewed our accounting treatment of certain hedge transactions and determined a restatement would assure that our financial statements adhere to the most recent guidance for accounting treatment of hedge transactions under SFAS 133.”

... An interpretation in the fourth quarter of 2005 addressed how companies should apply the “short cut” method for derivatives used as hedges under SFAS 133. Under the “short cut” method, if a company meets certain strict criteria, it permits the user to assume no ineffectiveness and then ongoing effectiveness testing is not required. If those criteria are not met in their entirety, companies must use the “long haul” method, which requires extensive documentation, analysis and testing at inception and during the life of the hedge."

Let's check this out. There were no FASB Staff Interpretations issued by FASB in the fourth quarter related to shortcut effectiveness testing. There were no Staff Accounting Bulletins issued by the SEC that related to shortcut effectiveness testing. The only thing that happened in the fourth quarter was a speech by SEC practice fellow Mark Northan, in which he described the flaws that the SEC had been seeing in applying the shortcut method of effectiveness testing. Northan's comments did not constitute an interpretation; he was saying that the staff had noted that firms had failed the already-existing tests to qualify for shortcut accounting. For example:

"... they failed to meet one or more of the criteria necessary to qualify for the shortcut method. The staff has therefore objected to the use of the shortcut method in these and other situations in which the specific criteria in Statement 133 were not met. In other words, the staff does not believe that the shortcut criteria have a "spirit" or a principle that can be met without strictly complying with the stated requirements..."

Or:

"... Companies have argued that the fair value must have been zero since no cash was paid or received when the swap was entered into. [Note: one of the undebatable requirements to qualify for shortcut testing is that the fair value of the derivative must be zero at the outset. Period.] The staff has rejected this argument because there were multiple components involved in the transaction with the financing element causing the swap to have a fair value other than zero at inception."

One last comment by Northan dealt with error quantification. In other words, once the goof has been discovered, firms have to decide if it's material enough to warrant restatement. Firms have tried to quantify the mistaken accounting by comparing it to the accounting that should have been used, and the difference between that result and the wrong accounting drives how they approach the materiality decision. Sounds good, but it's wrong: recreating the long-haul effectiveness testing after the fact can make it easy to come up with a difference that might not be very material and not require restatement. Northan's remarks:

"The staff has often objected to this approach for quantification of errors for these hedging relationships because it assumes that the error only concerned the measurement of ineffectiveness and that the requirements for hedge accounting were still met... if a company has been relying on the application of the shortcut method, these tests may very well not have been performed. As such, the provisions to allow hedge accounting under other methods may not have been complied with."

There wasn't anything terribly interpretive in Northan's remarks that had to do with Statement 133; it was pretty much a statement that the Commission was having problems with firms not complying with the accounting standards as written. (And if you want to go out on a limb and say that the last remark was an interpretation, go right ahead. But that dealt with how to quantify an error, not how to read Statement 133).

It's always easy to trash the rulebook when you don't like the results. But you have to wonder why investors sometimes feel like their being given the mushroom treatment when there's corporate dissembling like this. Why not just 'fess up? Everyone knows it's a mind-numbingly difficult standard.
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