FASB’s reconsideration of hedge accounting could ease corporates’ burden.
Few multinationals view the current hedge accounting in the US as anywhere near perfect, and indeed revising parts of the existing standard has been on and off the docket of the Financial Accounting Standards Board (FASB) for years. The board decided last November to revisit the standard once again, and in several meetings so far this year it has indicated pursuing areas impacting corporates, especially those hedging commodity risk.
Under US Generally Accepted Accounting Principles (GAAP), companies can hedge the total sale or purchase price of a commodity but not the price of nonfinancial components, such as the petroleum in jet fuel.
“As a significant consumer of commodities for our product processes, disallowing the separation and hedging of nonfinancial risk components places a significant burden on our hedging effectiveness which we feel is unwarranted as our risk components are clearly identifiable and separately measurable in our contracts,” wrote Shawn Barker, controller at Ball Corp., in a comment letter to FASB.
That letter was sent in 2010, when the standard setter last tackled the issue, but the issue persists today. The hedging effectiveness Mr. Barker refers to is the change in the values or cash flows of the hedging instrument and the hedged item, which must remain within 80 percent and 125 percent of each other. The price of Brent crude or heating oil, for example, is sufficiently correlated with the price of jet fuel to provide an economically effective hedge, fitting within that range. But since the purchase price—the hedged cash flows—may also include costs such as transportation, taxes, and insurance, the change in values is likely to step outside those boundaries. For that reason, many companies never bother seeking hedge accounting with commodity hedges.
“The derivative itself is actually doing a good job hedging the risk [from an economic standpoint], but the accounting standard today requires the company to include in the commodity exposure being hedged more items than just the commodity-price financial risk,” said Dan Gentzel, managing director for hedge accounting at Chatham Financial.
One solution the FASB has discussed so far is widening the threshold, perhaps to 67 percent and 150 percent. However, rather than making hedge accounting reflect the economics of the hedge more accurately, it is simply enabling more commodity hedging relationships to get hedge accounting.
Another approach may be to identify the nonfinancial component so that it can be hedged specifically.
“If you can isolate that risk as it pertains to the nonfinancial component, then you could just hedge that and perhaps qualify for hedge accounting,” said William Fellows, a partner in Deloitte’s advisory practice who heads up derivative and hedging services.
Indeed, Mr. Barker at Ball Corp. noted that his company believes the risk components of the commodities it buys are clearly identifiable and separately measurable. For that reason, he added, the company strongly supported the IASB’s proposal that had been issued earlier and established those criteria to achieve hedge accounting. It became a final standard in 2013 and will become effective in 2018.
Mr. Gentzel said some companies outside of the EU and the UK are already considering adopting the IASB’s “separately identifiable and reliably measurable” threshold for achieving hedge accounting. However, he added, FASB seems to be considering a somewhat more restrictive threshold that will allow contractually specified risks to be designated as the hedge risk. With respect to hedging commodity risk, a contractually specified risk approach will likely enable many more hedging relationships to qualify for hedge accounting compared to what qualifies under current US GAAP.
For example, if a company’s purchase contract to buy jet fuel states the price of the fuel is based on a specific jet fuel or other highly correlated index, hedging the fuel’s price with a derivative based on that index would remove the peripheral costs and most likely achieve hedge accounting.
However, under current US GAAP this structure may not qualify for hedge accounting if there are significant additional costs, such as taxes, insurance and transportation, that are included in the purchase price and have to be considered when assessing the effectiveness of the hedging relationship.
Achieving hedge accounting is important for corporates because otherwise the entire change in fair value of the derivative is recorded directly to the income statement each period, which does not typically reflect what the company has done economically by entering into the hedge. It also distorts financial results reported to investors. In addition, corporates typically seek to enter into hedges that offset their financial risks in order to minimize the difference in value between the hedge and hedged item, the so-called ineffectiveness in the hedging relationship. That ineffectiveness must be reported in earnings and can result in volatility that investors tend to frown upon.
Another issue of importance to corporates that FASB has discussed is the process to determine the effectiveness of hedges. Under current US GAAP, companies must quantifiably demonstrate quarterly, typically using a quantitative approach, that their hedges and the hedged items remain within the “highly effective” threshold.
There are several approaches to measure effectiveness, and in recent years many companies have migrated to using a quantitative “long haul” method. “As a result, it requires a lot of bookkeeping and effort to maintain a hedging relationship for accounting purposes,” especially for companies with a lot of hedges in their portfolios, Mr. Fellows said.
FASB’s goal is to make it less burdensome in many cases to satisfy the ongoing effectiveness assessment requirements that exist in Accounting Standard Codification (ASC) 815.
“What’s been discussed so far is to require in many instances that hedging relationships have a quantitative effectiveness test performed at inception, and if the critical, key terms of the hedging relationship don’t change, then a company wouldn’t have to do another quantitative test,” Mr. Gentzel said, adding, “If the critical terms do change, then additional quantitative testing would likely need to be performed.”
Instead, the company would qualitatively assess every quarter that the key terms haven’t changed.
“Is there some sort of quantitative measure, or, on the other hand, is it more of a qualitative analysis, where a company looks at variety of indicators, and based on those indicators management determines whether or not the hedge is effective for a given period,” Mr. Fellows said.
For companies with hedging relationships in which the terms infrequently change if at all, the amount of quantitative testing required from then would drop, while corporates that have mismatches in their hedging relationships would see less relief.
At its last meeting, on June 10, Mr. Gentzel said, the FASB staff said it would present the board on July 1 with several “packages” providing broader hedge accounting solutions, and each proposal related to hedging nonfinancial risk, such as commodity exposures, likely would remove the recognition of “ineffectiveness” from financial statements.
As a result, companies would record the entire change in fair value of a highly effective derivative designated in a cash flow hedging relationship to Other Comprehensive Income (OCI) on the balance sheet and this amount would be reclassified to the same income statement line item where the hedged exposure is being recorded at the time the exposure is recognized in earnings. This differs from treatment under current US GAAP, where ineffectiveness is recognized as it occurs over the life of the hedging relationship and is not required to be recorded in a particular financial statement line item.
For fair value hedging relationships, the entire change in fair value of the derivative and hedged item would likely be required to be recorded to the same line item in the financial statements. This differs from the treatment under current US GAAP, where the change in fair value of the derivative and hedged item are not required to be recorded to the same financial statement line item.
As a result of these possible changes, investors will likely lose the ability to monitor how much ineffectiveness exists in a company’s nonfinancial hedging program. However, the entire cost of hedging will now be reflected in the line item where the hedged exposure is also recorded.
Along similar lines, the FASB is also considering changes to the documentation requirements to designate a derivative in a hedging relationship. Today, that must be done contemporaneously with the actual trade execution. This is sometimes problematic for corporates, as treasury and accounting groups in US companies may not always work together closely, and the accountants may find out about a transaction days or weeks after execution. In addition, a company may prepare its documentation for a hedging strategy it plans to execute but then may encounter challenges getting other parties like auditors involved in a timely manner to review the documentation before execution.
FASB has already removed the contemporaneous requirement for private companies in hedging relationships where pay-fixed interest rate swaps are used to hedge floating rate loans. In this specific situation, private companies have until their next financial statements are completed to finalize their hedge documentation, which could be almost a year in some cases after the execution of the hedge.
“I don’t think FASB would go out as far as a year for public companies, but maybe within a few days or even the current quarter,” Mr. Gentzel said. “Certainly relaxing the documentation requirements a bit is something they’re considering.