By John Hintze
FASB leaves little time to take early advantage of new hedge accounting guidance.
It’s already June, leaving corporates only six months to preparefor new hedge accounting guidance if they want to adopt itearly, likely for many companies, especially heavy users ofcommodities but also those who want more control over otherfeatures of their hedges.
Chatham Financial updated members of the NeuGroup’sAssistant Treasurers’ leadership group toward the end of Mayat its headquarters in Kennett Square, PA, about major hedgeaccounting changes coming down the pike. The guidelines arescheduled to be published at the end of June, but for allpractical purposes the language has been finalized. Althoughthe amended rules will require substantial effort to follow, theywill facilitate achieving hedge accounting treatment in severalareas.
Aaron Cowan, head of Chatham’s corporate accountingadvisory team, said that several advantageous provisions in thenew guidance are likely to prompt some companies to adoptthe guidance early.
To do so, however, will require gearing up by year-end, sinceit is expected the guidance can be adopted at the start ofcompanies’ fiscal years starting after December 31. Hencecompanies with a calendar fiscal year should be able to applythe new accounting January 1, 2018, if they choose to earlyadopt. “We expect some companies will opt for early adoption,given the changes to simplify the accounting and to makemore hedging strategies available for hedge accountingtreatment,” Mr. Cowan said.
In fact, the Financial Accounting Standards Board (FASB)decided to offer early adoption precisely because companiesasked for it, Mr. Cowan said, adding that they will be able toelect to apply hedge accounting under the new guidanceto existing deals already in hedge accounting or to get prospectivetreatment for deals that are not already in hedgeaccounting upon adoption.
One key area of change in the new guidance is hedged risk.Historically, financial risk was hedged using a benchmark interestrate—typically Libor, OIS or the Treasury rate. Mr. Cowannoted that was a problem for banks using prime to lend,because it was not an accepted benchmark. Consequently,banks have had to consider the total cash flows in the hedge,and changes to credit spreads or other factors created a largeenough mismatch between the hedge and hedged item,known as ineffectiveness, to prohibit hedge accountingtreatment or necessitated burdensome stratification of loanportfolios.
“Under the new rules, if prime is contractually specified, itcan be hedged in isolation, and changes in credit spreads orother components of the cash flows do not need to be factoredin—resulting in better or even perfect results in the P&L,”Mr. Cowan said.
The change to hedged risks is also very relevant forcorporate users of commodities. A company purchasingaluminum as part of its production must now include theLondon Metals Exchange (LME) index price as well as highlyvariable processing and transportation costs in the economicrelationship it uses to determine whether it qualifies for hedgeaccounting (i.e., total cash flows). The LME derivative contract,however, is not intending to hedge changes in those costs,which are generally managed via procurement processes andcontract negotiations.
“It presents a situation where even though the company hada great economic hedge for the risk treasury wants to hedge, itwouldn’t qualify for hedge accounting and instead has to markthe derivative to market through earnings,” Mr. Cowan said,adding that the new guidance enables companies to contractuallyspecify components and hedge them separately. Thismeans the company would be able to isolate the LME price asthe hedged risk to get a more accurate accounting result that isaligned with treasury’s objective in the economic hedge.
“Companies will be able to treat commodity hedges in thesame way they’ve treated FX hedges in the past where theaccounting and the economics have been more closely aligned,”Mr. Cowan said. Treasury traditionally has looked at the indexcomponent while procurement has focused on transportationand other fees, negotiating reductions in those costs whenpossible.
“So this aligns more with the bifurcation of what treasurymanages versus what procurement manages,” Mr. Cowan said.He also noted that while the new accounting makes hedgingcommodity risk much easier, treasury executives must thinkabout whether contracts specify the components to hedge. Ifnot, treasury must start thinking about renegotiating thosecontracts or finding other ways to specify those components inthe contracts.