Coming FASB Proposal Helps Hedge Accounting

The Financial Accounting Standards Board plans to issue its proposal to matching hedge accounting guidance more closely with corporate hedge strategies in early September, providing several benefits, a bit of uncertainty, and perhaps some remorse that the guidance doesn’t go a step further.

Overall, the guidance is anticipated to be highly beneficial to many corporates – the FASB lists on its website nine ways in which it will facilitate hedge accounting. The first one is permitting hedge accounting for contractually specified risk components in hedging relationships involving nonfinancial items, a big plus for companies relying on commodities, although some may want to push the standard setter to go a step further in their comment letters.

Under current hedge accounting guidelines, notes Aaron Cowan, head of Chatham Financial’s corporates accounting advisory team, companies have to hedge all changes in cash flows, a punitive approach because components of the cash flows may have little to do with the risk treasury is seeking to hedge. FASB’s proposal would allow companies to hedge components in hedging relationships involving nonfinancial items, as long as they are contractually specified.

“That’s a huge benefit for commodity hedgers, where they’ve got contracts that contractually specify an index that the commodity pricing is based on,” Mr. Cowan said, adding, “That’s more in line with the risk treasury is trying to manage, since they’re trying to manage the financial risk defined by that index.”

Although a big improvement over the current guidelines, the proposal would still leave some strategies subject to the current guidance. For example, a company’s vehicles may purchase diesel fuel at the pump. “It’s such a common scenario for companies to purchase diesel fuel at the pump, where there’s no contractually specified component, even though there are pretty widely acknowledged indices built into the pricing that most people would use for financial hedges,” Mr. Cowan said.

He added that the International Accounting Standards Board’s (IASB’s) hedge accounting guidance does allow for such hedges, since it permits hedging of risk components if they are separately identifiable and reliably measurable—broader parameters than the proposed guidance from FASB. Under the IASB’s guidance, if a company is buying diesel fuel from pumps all over the U.S., for example, it could define Gulf Coast diesel as a component of diesel fuel and hedge it, even though it’s not contractually specified.

Another proposal benefit listed by FASB is an update of fair value hedges, which corporates typically apply to fixed-rate debt issuances, investment grade as well as junk bonds. A common strategy for companies, Mr. Cowan said, is to reduce risk by swapping into floating for the first two years of a 10-year fixed-rate bond issuance. Under current guidance the two-year swap must be matched against 10 years of fixed-rate cash flows, which prevents hedge accounting.

The proposed guidance does allow for such matching. It also permits hedgers to hedge the benchmark interest-rate component, without having to look at the total contractual cash flows, reducing the P&L volatility stemming from fair value hedges.

“We think both of these proposed changes are nice accommodations that reflect the strategies companies are trying to use, and they align the accounting well with these kinds of strategies,” Mr. Cowan said.

Another goal of the proposed guidance is to simplify hedge accounting and make it more straightforward. Mr. Cowan said a good example of that effort is requiring an initial quantitative assessment of how closely the hedge matches the underlying exposure being hedged, followed by qualitative assessments. However, the relationship between hedges and the underlying commodities can change over time, and the proposed guidance appears unclear on when another quantitative assessment should be performed.

Mr. Cowan noted that Southwest Airlines used West Texas Intermediate (WTI) crude in the past to hedge jet fuel purchase, but over time the price of WTI crude and jet fuel became less correlated, and the company lost hedge accounting. Under the proposed guidelines, he added, it’s unclear whether a new quantitative test would be required in this scenario. That could have a broad impact, since qualitative testing would continue hedge accounting, while quantitative testing would eliminate it.

“We’re eagerly awaiting that language in the exposure draft,” Mr. Cowan said. “We think companies have to take a look at the guidance itself and whether it affects their hedging programs and if there are elements where it’s unclear how to apply them. If it’s not clear to them how to apply the new guidance on a day-to-day basis, then they should comment on that.”

FASB’s proposed improvements to hedge accounting will include: