By John Hintze
Accounting watchdog tries to tidy up lingering hedge-accounting complications.
The new hedge-accounting standard in the US that went into effect in January for public companies was favorable to corporates overall, but lingering ambiguities appear to have stalled some entities from taking full advantage of it. The Financial Accounting Standards Board (FASB) is now seeking to clarify the language to enable more nonfinancial hedges to qualify for hedge-accounting treatment and make it easier to change indices that hedges are tied to.
At its meeting May 8, FASB tentatively decided to develop an exposure draft (ED) for amendments addressing issues that have complicated the application of its accounting standards update (ASU), Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. Companies seek hedge-accounting treatment to reduce volatility in their financial statements.
Dan Gentzel, a managing director at Chatham Financial, which provides hedging-related services to corporate end users, said FASB is likely aiming to issue the ED as soon as possible, likely in the third quarter. Given EDs tend to provide 60 or 90 days to comment, the new language may be applicable by year-end, enabling companies to apply it retrospectively from the start of 2019, if appropriate.
The issue FASB discussed most at the meeting, Mr. Gentzel said, is the ability to change the hedged risk in a cash flow hedge. Companies forecast when they need to purchase certain quantities of a commodity, and those forecasts can change as their commodity, interest-rate, currency or other exposures change.
To then alter a hedge of that future commodity purchase under the old guidance often required de-designating it and then re-designating the hedge, a burdensome process exposing the company to some risk in the switch. Mr. Gentzel said the ED language is anticipated to acknowledge that such a change shouldn’t necessarily disrupt the original hedging relationship.
“If the original transaction hedged a future purchase of wheat based on a Chicago wheat index and the company ultimately decided to switch to a Kansas City wheat index, under the new guidance that change would not necessarily disrupt the hedge accounting,” Mr. Gentzel said.
That would also be the case for interest-rate hedges. Companies typically price floating-rate debt over one-month or three-month Libor, and in some environments it may be advantageous from a borrowing perspective to switch from one tenor to the other. Under the old guidance, Mr. Gentzel said, switching between different tenors of an index required companies to perform significant testing across the potential indexes to ensure hedge effectiveness, as well as a likely redesignation of the hedge. The ED language will likely aim to reduce those burdens and require testing only the company’s best current estimate of what the exposure would look like.
“That’s frankly more in line with how an entity thinks about hedging interest-rate exposures,” Mr. Gentzel said.
Another area the ED is anticipated to facilitate for corporates is enabling more nonfinancial hedges to qualify for hedge-accounting treatment. Prior to the ASU, companies tended not to apply hedge accounting to commodity exposures because they had to hedge the entire sales price of the commodity, including related costs such as transportation and storage. Consequently, the hedge often deviated enough from that sales price to become ineffective for hedge-accounting purposes, making that treatment unavailable.
“FASB tried to address that in the ASU by allowing companies to identify and hedge a contractually specified component, such as the commodity price” indicated by a commodity index, Mr. Gentzel said.
He added that the approach has worked to a degree, and Chatham has seen greater adoption of commodity hedging by corporates since the ASU’s arrival. However, he added, some hedging programs have been unable to qualify for hedge-accounting treatment because the guidance is unclear on what documentation, such as the contract itself, supporting documentation and side agreements, and receipts, qualifies as contractual evidence.
Another issue arises when companies forecast hedging a commodity and instead end up buying it from the supplier in the spot market. It hasn’t been clear whether those transactions qualify as a hedge. FASB’s ED will likely seek to clarify that issue, but it won’t be easy, especially for spot transactions.
“We believe FASB is going to indicate that spot transactions can be counted as the hedged transaction, and that will be positive and help clear up ambiguity that’s existed for last two years, since ASU was issued,” Mr. Gentzel said. “So that will provide some relief, but it will still be a challenge for certain spot purchases where the index isn’t specified in a receipt.”
For example, trucking companies typically allow their drivers to fuel up at gas stations along the way at the spot price. The receipts from those purchases may provide the price per gallon and total purchase price, but not the underlying index the price was based on. In such cases, Mr. Gentzel said, it would be helpful if FASB could craft the guidance to permit receipts for the spot purchases as evidence, even without the index being identified on the receipt—but that would be a significant change from the approach it has sought so far.
Ultimately, he said, FASB may have to adopt a model that’s similar to the International Accounting Standards Board’s (IASB) hedge-accounting model, which essentially permits financial-statement preparers to reasonably assume that a contract is priced on a certain index if it is a market convention.
“The FASB has moved a good distance, but if it wants to scope in those other types of hedging programs, it may have to consider a model more like the IASB’s,” Mr. Gentzel said.