Corporate Comment Letters Seek Clarity

By Joseph Neu

Corporate comment letters on hedge accounting portions of proposed update to Financial Instruments accounting look for more clarity and the continued ability to voluntarily de-designate hedging relationships.

Over 2,800 comment letters on the proposed update to financial instruments accounting have now been posted on the FASB’s web site. The comment period ended September 30, but it is taking a while for all the comments to find their way to the site. It’s easy to see why they aren’t in much of a hurry, since few are endorsing the proposed Accounting Standards Update (ASU), officially known as Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities—Financial Instruments (Topic 825) and Derivatives and Hedging (Topic 815).

Banks, which represent the vast majority of the comment letters (along with individuals representing banks) are quite vocal in their opposition to the FASB’s effort to extend fair value accounting at a time when everyone should be focused on fueling economic growth.

Multinational corporations are less opposed by comparison, but the impact to their investment portfolios and the volatility introduced by the mismatch between potentially measuring their own debt (along with other financial instruments on the balance sheet) at fair value while non-financial instruments are carried differently draws ire.

Also, almost all MNCs are quick to point out that the proposed FASB guidance creates further divergence with IFRS standards; and, with the SEC supposed to decide on global convergence by 2011, greater convergence is advised. Divergence with the IASB is also seen with the proposed updates to hedge accounting, which by comparison to the other elements of the Exposure Draft (ED) drew less and more favorable comment.

Hedge comment highlights

To follow are highlights drawn from a selection of corporate comment letters to the hedge accounting portions of the ED (see “Understanding FASB’s Proposed Changes to Hedge Accounting,” IT, August 2010, for more information).

• Allowing voluntary de-designation of hedges to continue. This is an issue pointed out by almost all corporate comment letters, citing the unnecessary inconvenience and transaction costs of disallowing de-designations of hedges.

In some cases, it was the only hedge accounting issue highlighted. For example, Apple stated in its letter: “While we believe the changes made to hedge accounting overall are an improvement and provide a simplification to existing literature, we are concerned about the proposed requirement that precludes an entity from de-designating and re-designating fair-value or cash-flow hedges.”

Depicting a common practice example, Gilead‘s letter asked that FASB affirm that the proposed guidance would not supersede the automatic de-designation of a derivative hedging an anticipated transaction that becomes realized. Like most companies, Gilead would like the ability to use the same derivative for an anticipated cash flow-hedge and firm- commitment balance-sheet hedge when realized:

“At Gilead, we enter into forward contracts (for periods up to 18 months) to sell local currency and buy USD. The forward contracts are designated as cash-flow hedges for the first 17 months (in the case of an 18 month contract). When revenue is recognized the cash flow relationship is terminated through de-designation and the derivative is handed over to our balance sheet hedging program [i.e., re-designated as a hedge of the receivable].”

• Wanting more clarity on what is meant by “reasonably effective.” Almost as broadly highlighted was the lack of clarity on what constitutes “reasonably effective.” As DuPont noted in its comment letter: “Without additional guidance companies are likely to continue using the current highly effective range and continue to perform quantitative analysis in order to avoid any problems.” It points to the Proposed ASU’s assertion that “a quantitative assessment is necessary if a qualitative assessment cannot establish compliance with the reasonably effective criterion” as a source of such problems.

Reval, which supports hedge accounting for its MNC customers, wants something downright programmatic: “We believe the Board should follow in the steps of the IASB and provide guidelines on how to interpret and assess ‘reasonable effectiveness’ (i.e., R2>0.60; slope 0.6 -1.667; ratio 60% to 166.7% , etc.).”

• Wishing for short-cut and critical-terms match to be continued in the name of the “simplicity objective.” Pepsi finds fault with the notion that “difficulties in complying with the strict criteria in the Critical Terms Match and the Short Cut method led to numerous practice problems and restatements. Our experience has indicated that both of these approaches provide a simple, low-cost and effective framework for assessing hedge effectiveness for plain-vanilla derivatives.”

And DuPont again: “These methods are valuable and practical when applied to common and “plain vanilla” transactions. Elimination of these methods is contrary to the Proposed ASU’s objective to simplify the accounting for derivatives.”

• A desire to keep even more of a component-based hedge approach (bifurcation of risk). Pepsi commented: “For a non-financial contract, the FASB should consider allowing hedging a specific component of the price, when the component is clearly defined and identifiable and the amount purchased is consistent with the production requirement of a business.” As Pepsi goes on to note, “there are many contracts that are based on a ‘cost plus’ formula or have multiple price components,” and the company would like to see hedge accounting allowed when it hedges a particular price component without introducing “financial statement volatility related to un-hedgeable costs.” Finally, allowing firms to hedge the market-indexed component of the hedged item’s price would make it easier to match a derivative.
• Disagreement on ineffectiveness due to underhedges impacting the P&L. Because the hypothetical perfect hedge determines the deferral amounts in a cash flow hedge, an imperfection in the actual hedge creates earnings volatility. HedgeTrackers, a provider of hedge accounting support to corporates, noted concern about the impact this would have on “audit fees and possible Type 3 valuation disclosures” to support the earnings and OCI effects of cash flows hedges that have “noisy, illiquid and non-transparent components of the change in value.”

As an example, Reval’s comment letter included an illustrative table of a commodity cash-flow hedge, showing how the proposed guidance would create “‘phantom’ earnings and an inflated OCI balance when the change in fair value of the hypothetical derivative is greater than the change in fair value of the actual derivative.”

• Asking for further assurances that FX hedges of intercompany cash flows continue to be allowed. A big fear even after the release of the ED was that the FASB would find a way to reinsert language restricting FX hedges of intercompany transactions, including those that do not represent exposures on a consolidated reporting basis. Accordingly, several comment letters asked for clarification. For example: “Dell requests that the Board make it clear in the final standard that intercompany hedge transactions remain qualifying hedgeable risks as a part of the Board’s hedge accounting framework.”

Gilead described its practice of designating forecasted intercompany sales by the manufacturing company (to the sales subsidiary) as the hedged exposure. It encourages the FASB to continue to allow such practices: “The intercompany transactions are the only non-functional currency (and therefore the only hedgeable) transactions between our manufacturer in USD and our sale in foreign currency… In essence we are protecting our margin.”

HedgeTrackers isolated the functional currency component of this issue in its suggestion that the FASB consider a “functional currency election holiday,” which would allow the majority of US firms with local currency functional subs, like Gilead, to change them to USD functional. This would allow them to continue to hedge margins against currency risk, in the event that the FASB disallows non-functional intercompany transactions from being eligible for hedge accounting.

• Tweaks to the G20-compromise on option hedges.This was more of an issue in the service providers’ letter than the corporate comments, which is perhaps a reflection of its tactical complexity. At issue is the proposed guidance’s compromise that would allow deferral of the option premium, but require that the ineffectiveness due to time value changes be amortized into earnings “in a rational manner.”

HedgeTrackers asked the FASB to provide an example, presumably to point out to them the potentially pointless complexity. Using the example of a six-month cap, HedgeTrackers asked how the amortization of the cap premium would be calculated. For example: “would the premium amortization for that cap at the end of first month equal 1/6th of the 6th month caplet, 1/5th of the 5th month caplet, 1/4th of the 4 month caplet, 1/3rd of the 3 month caplet, 1/2 of the 2 month caplet plus the first month caplet?”

Further, as Reval noted: “Due to the fact that the net periodic changes in time value and overall periodic reclassification amounts are likely to be small relative to the total time value and total periodic change in time value, it seems this proposed change adds an unnecessary element of complexity to the accounting treatment under ASC 815-20-55 (G20)“

G20’s compromise avoided allowing intrinsic value-only offset, but instead allowed deferral of the effective portion based on an option’s terminal value (when time value is nil). And, as Reval noted, it is hard to see the value add in performing the amortization bookkeeping (see a new IFRS approach below).