Editor’s note: This is Part 1 of a three-part series on FASB’s new hedge accounting guidance. Part 2 can be accessed here.
FASB approves early adoption of new hedge accounting upon issuance.
The Financial Accounting Standards Board (FASB) may have labored on new hedge-accounting guidance for years, but corporates only have a few months to prepare if they want to adopt it early, and some may have good reason to make the effort.
In early June, FASB decided to permit early adoption of its amended hedge accounting standard, Accounting Standards Codification (ASC) 815, when it is issued in the third quarter, likely in August. That’s several months earlier than the original early adoption date of Jan. 1, 2018, which still would have been a challenge, and more than a year before public corporates must adopt the new guidance at the start of 2019.
iTreasurer spoke at length with Dan Gentzel, head of Chatham Financial’s global accounting advisory team, about the benefits and challenges that lie ahead for corporates that use derivatives to hedge interest rate, foreign exchange (FX) and commodity risk, and apply hedge accounting to reduce volatility in their earnings. Chatham specializes in enabling corporates to hedge risk and is one of a limited number of firms, including the Big Four accounting firms, that have closely followed the amendment’s developments and provided advisory feedback to FASB’s staff.
Mr. Gentzel noted that the new guidance will facilitate hedge accounting in a wide variety of instances, such as swapping floating-rate debt to fixed rate and vice versa. It will dramatically impact companies with commodity exposures, because current accounting language requires them to include not just the specific commodity index they are seeking to hedge but ancillary costs such as transportation, insurance, and taxes. If the company only wants to hedge the commodity price, including those highly variable costs in the hedging relationship typically leads to hedge ineffectiveness being recognized in the financial statements.
“Being required to include the additional charges can significantly impact the effectiveness of the hedging relationships and whether the hedge qualifies for hedge accounting, and it sometimes can create a lot of hedge ineffectiveness that causes unwanted volatility in financial statements,” Mr. Gentzel said.
Under the amended language, companies will be able to hedge a commodity price component that is specified in the contract. So a firm hedging the cost of aluminum will be able, for example, to specify a London Metals Exchange benchmark price for aluminum in its contract to purchase the aluminum from a third party and hedge that price. Mr. Gentzel said the change may persuade some companies that have avoided seeking hedge accounting for commodity hedges because of the excessive ineffectiveness to reconsider. And supplemental footnotes in financial statements that companies have used to explain to investors why they’re employing “non-GAAP” measures may no longer be needed.
“Some companies have shifted to using non-GAAP measures to describe the results of their commodity hedging programs, but the changes put forth by the FASB may help to reduce the usage of non-GAAP measures in this area,” Mr. Gentzel said.
That’s the good news, and at least in theory companies will be able to take advantage of the new language for calendar year 2017, reducing any unattractive earnings volatility stemming from earlier this year. In practice, Mr. Gentzel noted, doing so will be very challenging if the company has not been closely following the hedge accounting developments on its own or working closely with a service provider such as Chatham or one of the big accounting firms.
For one, if the component it is seeking to hedge is not contractually specified, the company will have to renegotiate contacts before adopting the guidance to apply the new language to transactions in the third quarter. That means working closely with the finance executives in the company’s businesses who negotiate the actual contracts as well as persuading contractual counterparties to renegotiate. Those counterparties will likely incur an administrative cost and so may seek unattractive concessions, and if the company seeking contractual changes already has what it considers an advantageous contract, it may not want to open it up for renegotiation.
The new language would be applied to all outstanding hedging relationships as of the date a company adopts the new guidance and any new ones put on after that. However, if a company adopts the new guidance when it is issued, the first three quarters of 2017 will essentially have to be redone, and that means the company will have to adjust its opening retained earnings for the start of the year.
“They’ll have to take all hedging relationships outstanding at the adoption date and essentially start over the accounting from the beginning of those relationships, run it through the end of 2016, and figure out the difference between the original accounting results and what the accounting results look like under the new guidance,” Mr. Gentzel said. “Then the company must edit each quarterly set of financial results for 2017, and adjust those in its third quarter 10Q.”
Companies won’t have to restate the earlier quarters, but challenges will arise for those, for example, that put on and take off commodity hedges every month, since hedges that ended before September 30 won’t get restated back to the beginning of the year.
“Any trades that were there at the beginning of this year that matured before the new guidance was adopted won’t get adjusted,” Mr. Gentzel said. “So the company will have the less intuitive old accounting results for those hedges mixed with the much better results under the new guidance for the outstanding hedges.”
Even preparing to use the new guidance by year-end may be difficult, since that’s the deadline for complying with FASB’s new revenue recognition standard, which for many firms will take precedence of hedge accounting. Nevertheless, there are benefits that will be less operationally challenging to implement. For example, corporates often have floating-rate term loans or other credit facilities that allow them to choose the tenor of Libor to borrow at. Under current guidance, however, to retain hedge accounting companies must essentially choose a single tenor or perform ongoing quantitative testing for each tenor they borrow at.
“The new guidance permits a change in hedged risk to still be considered part of the original hedging relationship so long as the hedge qualifies as highly effective,” Mr. Gentzel said.
As a result, a company could borrow at three-month Libor and then switch to one-month Libor at a later date and still be considered part of the original hedging relationship if the swap is highly effective. Mr. Gentzel said that enables the company to avoid having to re-designate a swap in a new “off-market” hedging relationship.
Mr. Gentzel added that one of the biggest benefits enticing companies to adopt the amended standard early is the new financial-statement geography in which to report hedging results. “The way ineffectiveness impacts the financial statements going forward will be very different,” he said. “Companies are going to love it, and it’s one of the main reasons why companies would seek to adopt it right away.”
Today companies must quantify the present value of all the ineffectiveness that’s going to be recognized over the life of the hedging relationships and recognize it on day one—a number that’s hard to explain to Wall Street and investors and in many cases even understand. Going ahead, companies will only recognize ineffectiveness when it economically impacts the financial statements.
As a result, the term “ineffectiveness” will essentially be eliminated, and reporting will better reflect the difference between the cash settlement on the derivative and the item being hedged.
“They’re just going to have to recognize the cash settlement on the derivative and whatever line item is being hedged, and whatever the exposure is from a cash and accrual perspective will be what gets recognized in the financial statements,” he said.
If a hedging program isn’t doing a good job of offsetting the financial statement line item being hedged, that will be immediately apparent when it’s material and may raise questions from financial analysts and investors that will have to be addressed. However, it should be easier to explain than a large dollar number in “ineffectiveness,” Mr. Gentzel said.