Editor’s note: This is Part 3 of a three-part series on FASB’s latest hedge accounting guidance. Part 1 can be accessed here, Part 2 here.
Also permits partial-term hedges; changes may draw more corporates to fair value hedging.
The Financial Accounting Standards Board’s (FASB) ASC 815 guidance now facilitates hedge accounting for fair-value hedges. Although corporates are not big users of those hedges today, some may want to reconsider.
The first two parts of this series (Part 1 and Part 2) addressed hedges of corporates’ cash flows, commonly referred to as cash-flow hedges. In fact, fair-value hedges are really just a type of cash-flow hedge, but in the case of interest rates they are converting fixed-rate cash flows to floating-rate, while the cash flow version does the opposite. Dan Gentzel, head of Chatham Financial’s global accounting advisory team, noted that ultimately the difference lies in how the results of each type of hedging relationship modify cash flows and are ultimately reported in the financial statements.
For a cash-flow hedge, the changes in fair value of the swap are recorded on the balance sheet, and the changes in the hedged cash flows also end up on the balance sheet in the form of other comprehensive income (OCI). Those changes are reclassified to earnings when the hedged cash flow impacts earnings—when hedged interest payments occur. In a fair-value hedge, the changes in the fair value of the swap go straight to earnings as do the changes in fair value of the fixed-rate instrument being hedged.
“They’re very similar, and economically they’re both hedging cash flows, especially when it comes to interest rates,” Mr. Gentzel said. He added that corporates rarely apply fair value hedge accounting to FX or commodity exposures, because marking to market the derivative typically offsets the exposure well enough in the financial statements, without having to apply hedge accounting. For example, balance-sheet hedges, in which a corporate, say, books European sales on its balance sheet in euros, generally employ a currency forward that is marked to market every period and offsets the spot change that’s being recorded to earnings on the receivable that’s on the balance sheet.
“It typically provides great, although not perfect, offset,” Mr. Gentzel said. “But on the whole if people are hedging their balance sheet receivables and payables, they’ll just mark to market the derivative because it typically offsets the vast majority of the change in value of the receivable or payable being re-measured.”
Hedging interest-rate risk is a different story. For one, entering into a fair-value hedge today requires looking at the contractual cash flow when doing the hedge-effectiveness assessment, and that includes the credit component of the cash flow. Economically, however, corporates are not seeking to hedge the credit spread with an interest-rate swap; rather, just the benchmark interest rate component of their fixed rate cash flows.
“Companies with fair-value hedges have recognized ineffectiveness simply because they’ve had to compare the change in fair value of the swap to the change in fair value of the debt, including its total cash flows,” Mr. Gentzel said. “And that comparison creates hedge ineffectiveness because the change in fair value of those two instruments don’t perfectly offset each other.”
The new guidance allows the company to focus just on the debt’s benchmark component of the cash flows, resulting in a much better offset in the hedging relationship and significantly reducing the ineffectiveness recognized in the financial statements. Mr. Gentzel called that the “biggest benefit off the bat” in terms of fair-value accounting in the new guidance, and one of three benefits that can be blended together for “fantastic results” with respect to reducing the total amount of ineffectiveness.
Another benefit centers around prepayment options. Companies with pre-payable debt must factor into their hedge effectiveness analysis the option to call the debt. Corporates decide whether to call debt they’ve issued based on their swap rate and credit spread. Those that can issue new debt at a lower all-in rate typically will proceed to do so after calling the old debt. However, the benchmark rate and the corporate’s credit spread don’t always move in the same direction, and one could get worse while the other improves.
“Credit spreads can be so wide and volatile, due to the company’s credit risk, that its callable debt either will not qualify for fair value hedge accounting under the current guidance or it results in significant amounts of ineffectiveness being recognized,” Mr. Gentzel said.
The new guidance permits the company to focus the hedge only on the benchmark risk and ignore the credit risk when it considers the prepayment option in a fair value hedge.
“That’s huge and will reduce a lot of ineffectiveness and allow a lot of fair value hedging relationships to qualify for hedge accounting in the context of callable debt,” Mr. Gentzel said.
The third benefit FASB’s new guidance provides is enabling partial term hedges. Today, if a company issues 10-year debt and expects to call it after five years, it nevertheless must match the swap’s maturity to the full maturity of the debt to receive hedge accounting. If it calls the debt, the change in value of the swap will continue to be recorded in earnings. Under the new language, companies are permitted to hedge their debt to whatever date they choose prior to its contractual maturity date.
“Corporates are always evaluating their capital structure and thinking about where they will raise money, which is the best place to borrow, and how much fixed-rate vs. floating-rate debt the company should have,” Mr. Gentzel said. “They use derivatives to manage that mix. Corporates typically try to issue as much fixed-rate debt as possible to lock in interest rates, but if their credit quality is low they’ll have to pay a higher fixed interest rate to investors, he added.
The rate for floating-rate debt may be more attractive, and in that case, they’ll load up on bank and other floating-rate debt. Companies routinely analyze their mix of fixed-rate and floating-rate debt in the short-term, perhaps out a quarter, as well as annually out three to five years, and sometimes out even further. They may find that the optimal mix requires more fixed- or floating-rate; if it’s the former, they can use cash-flow hedges to swap some floating-rate debt to fixed-rate, and under the new guidance FASB has made it easier for them to swap fixed-rate debt to floating-rate.
Mr. Gentzel said corporates have shied away from fair-value interest-rate hedges in part because the fair value of the swap and the fair value of the bond don’t change in the same way—they are two different types of instruments and the math to determine fair value is different, which leads to hedge ineffectiveness.
“Interest rate swaps and fixed rate bonds are different types of financial instruments and are valued slightly differently, which also creates ineffectiveness. Differences will still exist, but due to the FASB changes, ineffectiveness in fair-value hedging relationships should have less of an impact on the financial statements” Mr. Gentzel said. And that frustrates corporate treasury executives. They may want to embed a call option to give the company the ability to call the debt after five years, with the hope that the firm’s credit profile improves and it is able to issue new debt at a lower rate.
“Today, there may be so much ineffectiveness that the hedge won’t qualify for hedge accounting, or they may not issue the derivative, and sometimes they won’t issue the debt and choose to do something different instead,” Mr. Gentzel said. “So the changes FASB is making to fair value hedging will provide another arrow in the quiver from a risk management perspective.”