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Regulatory Watch

Awareness of New Hedge Accounting Benefits Grows

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October 25, 2018

New hedge accounting a boon for today’s net investment hedges

Leatherbound booksIf investment bankers haven’t already come knocking at your company’s door to explain how new hedge accounting guidance can make net investment hedges even more attractive, then you may want to give them a call.

Jon Howard, senior consultation partner for financial instruments at Deloitte & Touche, said multinational corporations (MNCs) that haven’t been aware of hedge accounting benefits are eagerly adopting the new guidelines and learning about applying the spot method to net investment hedges.

“Forward rates compared to spot rates, specifically for the euro, Japanese yen, and pound sterling, are just so beneficial now compared to the US dollar,” Mr. Howard said. “Companies that weren’t entering into these transactions and applying hedge accounting at all are now interested.”

Exchanging euros for USD, for example, provides those entering into a forward contract to make that exchange in a year with significantly more dollars than if the exchange were done today. In addition, Mr. Howard noted, the cross-currency basis spread, wider due to the limited number of parties enabling such transactions, has made pursuing these net investment hedges even more attractive.

That differential has been accretive to the bottom line. However, until the arrival of new hedge accounting guidance, which becomes effective for calendar year companies January 1, 2019 and been available for early adoption since the start of 2018, that income was volatile over the life of the hedge. In fact, Mr. Howard said, it could at times be negative if the cross-currency basis spread grew.

“It was very unpredictable, so entities would just follow what’s called the ‘forward method,’ and put all fair value changes in equity. Now they can amortize it,” Mr. Howard said, adding that under the new guidance, “they can effectively amortize the forward points (the difference between the forward rate and the current spot exchange rate) over the life of that trade.”

Bill Fellows, a Deloitte risk and financial advisory partner, explained that for a currency swap that is a part of a net investment hedge, the new accounting rules only place the amount recognized as interest settlements in profit and loss (P&L). Before, he added, all changes in the value of the swap that were outside changes in the spot price went through P&L.

Now, those excluded components go to other comprehensive income (OCI), the changes associated with the spot price go to cumulative translation adjustment (CTA) in the comprehensive income statement, and the accruals for the interest component go to the P&L.

“That’s how they’re effectively amortizing the forward points over the life of that trade,” Mr. Fellows said. “That creates a very predictable income stream, and because the currency basis currently exists between USD and the other foreign currencies, that recognition of interest income is typically accretive to the bottom line.”

Nevertheless, Mr. Fellows said, he doesn’t anticipate a wholesale shift of companies to the new hedge accounting standard, but rather companies that already use derivatives to take advantage of the elections available to them will incrementally migrate over. “And for those that already engage in derivatives, it opens up more transactions available to them and enables them to look at different types of hedge relationships,” he said.

In a survey of 3,000 business professionals about their companies’ hedge-accounting implementation plans, Deloitte found that 18.4% of respondents see the biggest benefit to the guidelines as adopting new hedge accounting strategies. That was followed by decreased operational burden (18%) and better alignment with current risk management (17.4%). The biggest obstacle to implementation was developing an efficient process evaluate existing hedging instruments and strategies against the new standard, followed by educating their staff about hedge accounting (20.7%), and navigating gray areas of the standard (20.2%).

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