Current hedge account rules give imperfect information leading to several disconnects when it comes to reporting, according to a report from PwC. Specifically, companies often seek to hedge “a specific portion of the overall risk” within a contract, but current guidance only permits hedging part of the risk under particular circumstances. But the Financial Accounting Standards Board will propose fixes to these issues soon.
“The inability to hedge components more broadly may drive differences between how companies manage risk internally and how the current accounting model allows them to report it in the financial statements,” PwC says in its report. Further, some economic hedging relationships “do not qualify for hedge accounting at all, or qualify with some ineffectiveness recognized in earnings.” That’s because the ineffective parts of the derivative might have an impact in different reporting periods, which ultimately could limit transparency in one particular period’s financial statement.
PwC gives the example of a manufacturer that enters into a 12-month natural gas contract at “prevailing market prices” on the delivery date:
“The contract is based on the price at a specific location (e.g., the Henry Hub distribution hub) plus the transportation cost to the delivery point. The manufacturer wants to mitigate the risk of fluctuations in natural gas prices, and is willing to accept the price risk related to the transportation from Henry Hub to its plant. It enters into a derivative indexed to the price of natural gas at Henry Hub for the delivery date. Under today’s guidance, the manufacturer has to hedge the total price risk of obtaining natural gas at its plant, which reflects both the Henry Hub price risk and the transportation cost. It could not hedge just the natural gas component. Depending on market conditions, the differences between price movements for natural gas at Henry Hub and for natural gas delivered to the plant location may cause the relationship to fail to qualify for hedge accounting or to be partially ineffective. The company may have to recognize the ineffective portion of the change in value of the derivative through earnings each period, before the actual natural gas purchases take place.”
Another example: “Risk managers may seek to hedge interest payments for a period of time, such as swapping the first five years of interest payments in a 10-year fixed-rate bond into floating interest payments. However, today’s accounting guidance effectively precludes partial-term fair value hedging.
PwC says FASB in the second quarter of 2016 will propose new rules that would “allow more derivative hedging relationships to qualify for hedge accounting.” New rules would also change the way that companies measure ineffectiveness which could result in “more accounting hedging relationships being more effective.”
“The changes are also expected to simplify the accounting model, enhance presentation, and alleviate some of the administrative burden of hedge accounting,” PwC says. Still, says PwC, there needs to be balance “between expanding the risks that may be hedged and setting parameters to limit potential abuse.”
See the full report here.