Reliant Resources to Change Accounting Treatment for Hedges

Updated from 11:32 a.m. EST

Reliant Resources ( RRI) will mark to market various gas and power transactions it entered into last year and had been carrying as cash flow hedges. The change in accounting will boost 2001 earnings but lower its expected results in 2002 and 2003.

Shares of Reliant Resources fell sharply on the news, losing 14% to $11.95. Investors are increasingly jittery about accounting irregularities in the wake of the Enron blowup, and after several companies have said they will restate their earnings in the past week due to accounting errors.

Reliant Resources said its accounting department discovered the accounting errors while preparing 2001 financial statements. The company delayed release of those statements while it corrects the mistake and calculates restatement of its second and third quarters, when the transactions were entered.

The Houston energy marketer now expects to earn $1.80 to $2 a share in 2002, down from previous guidance of $2.05 to $2.15. In addition to the restatements, the revised estimates reflect "the current outlook for the company's business activities and steps taken or planned by the company to strengthen its balance sheet in response to evolving rating agency standards for liquidity and credit criteria," it said. In addition, Reliant Resources said it no longer plans to sell its European business after failing to receive an acceptable offer for it.

The company's owner, Reliant Energy ( REI), will also delay release of its year-end results while it restates second- and third-quarter results to reflect the situation at Reliant Resources. It also expects improvement in 2001 earnings and lowering of expected 2002 and 2003 results.

Reliant Resources originally accounted for the relevant gas and power transactions as cash flow hedges in its conventional accrual accounts, but now believes that the transactions didn't meet all of the criteria for hedge accounting set out in Statement of Financial Accounting Standard No. 133.

Instead, the transactions are being counted as fair value hedges, or "derivatives designated as hedging the exposure to changes in fair value of a recognized asset or liability or a firm commitment," according to Standard No. 133. Cash flow hedges, by contrast, are supposed to hedge the "exposure to variable cash flows of a forecasted transaction." Gains and losses on fair value hedges have to be recorded on quarterly income statements as they occur, whereas cash flow hedges do not.

The downside of treating such transactions as fair value hedges rather than cash flow hedges is that it might make your net income more susceptible to fluctuations in the market, said Jeff Brotman, adjunct professor of accounting at the University of Pennsylvania Law School. "Unless its Enron and weather futures and you make the market, you lose your ability to manage your earnings at all."

But Brotman said he doubts the error was intentional.

"The counterparts were independent third parties. They originally intended them as cash flow hedges, but then realized that they didn't meet exact GAAP requirements. They went back and said, we can't take the risk of not having complied," said Brotman. "It jibes. It makes sense."

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