By Helen Kane, HedgeTrackers
The ED on hedge accounting would represent a game-changer for many corporate hedgers.
Proposed changes to the Financial Accounting Standards Board’s derivative accounting carry good news and bad news for corporate hedge programs. For those companies that have been protecting their hedge programs by preparing statistical analysis to support their use of derivatives that are obviously highly effective there is great news buried in the May 26 exposure draft.
For those that have stubbornly clung to short-cut or matched-term accounting and tossed de minimis tests out to placate the auditors, the news in the exposure draft is devastating. For corporates that rely on hedging intercompany transactions as a proxy for 3rd party currency risk, the jury will remain out until the redline version is issued (now expected as late as September 1).
And for hedge programs that tried to squeeze highly effective results out of “overall” hedge relationships there is great news coupled with new opportunities to hedge. The draft shifts away from a focus on the potential of a relationship to be ineffective to a focus on precisely how ineffective is this relationship.
Qualification to measurement
Under the proposal, hedge relationships can be established by qualitatively evaluating the likelihood that the derivative will be “reasonably effective” in offsetting changes in cash flows or fair value of the hedged item, for the risk hedged. This qualitative discussion will in most cases replace the statistical analysis of historical or scenario relationships between the hedged item and derivative currently known as prospective and retrospective tests.
Although obvious relationships (e.g., a yen forward sale contract hedging anticipated yen revenues) will be able to circumvent quantitative assessments altogether, relationships that are less obvious (e.g., euro forward sales hedging USD oil revenues) would continue to require a quantitative analysis suggesting that the relationship would be valid over the hedge period.
This will directly impact audits of hedge programs replacing the rigor currently focused on R squares, beta slopes, T-tests, and sundry other quantitative exercises to a new rigor around the probability and the critical terms of the hedged item.
Hedged Items Become Focus
Under the proposal corporates can no longer assume that a derivative is a perfect match for changes in the hedged item. Wiped out are the simplest measurement strategies: short-cut and matched terms, where the underlying’s change in value was presumed equal to the derivative’s change in value.
This change will lead to a greater focus on the measurement of the change in value of forecasted transactions, as the debit/credit approach for cash flow hedging is fundamentally changed.
Current guidance approaches cash flow hedge accounting by recording the derivative as an asset/liability and then preserving the “effective component” of the derivative in OCI, until the hedged item is recognized in earnings. When this happens, that element of the derivative is reclassified to earnings, limiting period-to-period ineffectiveness to overperformance of the derivative.
The new debit/credit approach will record the derivative as an asset/liability, record the change in the hedged item as an OCI value until the underlying is recognized in earnings and capture any difference between the two in income.
This is a nuanced variation on current fair value hedge accounting in that fair value accounting anticipated the recording of changes in the derivative and underlying in both the balance sheet (asset/liability) and in earnings, whereas the proposed cash flow accounting records changes in the derivative and underlying to the balance (asset/liability/equity) and then the net to earnings.
For those that have stubbornly clung to short-cut or matched term, the ED is devastating.
With the hedged item driving earnings, there will be a new focus during audit on the precision with which the change in value of anticipated transactions are calculated.
In the spirit of simplification the guidance specifically allows the use of a single date for measurement of a group of forward transactions when the forward price difference between that date and the perfect date(s) are “minimal.” This may require increased analysis of the expected dates within the month or quarter that the transaction(s) will be recorded.
Given the focus on measuring amounts of ineffectiveness and not assuming perfect effectiveness, HedgeTrackers recommends those treasuries hedging groups of transactions happening over time be prepared to select and support a maturity date that differs from the derivative.
Hedged item value fun
One interesting measurement question that has not received much attention concerns the malleability of the hedged items inception rate or value.
Take a case where a perfectly effective hypothetical derivative is established at the outset and assigned a rate or value (e.g., a 3.5 percent fixed rate on an interest-rate swap calculated to achieve zero fair value at inception). If during the life of the transaction the actual cash flows on the underlying debt change from quarterly to monthly, should ineffectiveness be calculated based on the 3.5 percent originally established for the relationship? Or should one return to the inception model and recalculate an inception value (perhaps 3.45 percent) that recognizes the instrument as quarterly for the first few years and monthly thereafter?
In other words, does the originally established hypothetical derivative change in response to the underlying or must the hypothetically perfect derivative set at inception be the benchmark against which the P&L impact is measured?
It is rare, but possible, to encounter auditors with the view that the inception model should be refreshed; however, as firms refocus on measurement, this operationally difficult approach may grow in popularity.
Inception Doc Changes?
Speaking of inception model changes, the ED proposes ongoing amendments to hedge designation documentation.
The ED makes clear that the FASB continues to be concerned about companies designating, dedesignating and redesignating hedge relationships. However, far and away the greatest application of dedesignations and redesignations are related to adjusting hedge relationships or documentation to avoid “failures.”
In the current environment announcements of restatements (positive or negative) attributed to hedge accounting failures are met with yawns or even annoyance by investors, and frustration and resentment by issuers.
The FASB has learned from these experiences that when companies fail hedge accounting and restate financials or record one-time adjustments, the usability of the financial statements is reduced. As a result one of the key objectives of the proposed draft is ”to provide consistent accounting for instruments in the financials over time.”
Inserting the ability to update and modify hedge relationship documentation over time is necessary given the FASB proposal to disallow dedesignation of relationships and their objective to maintain hedge accounting for consistency in reporting.
The good news in general seems to outweigh the bad in this latest ED, unless the interco edit finds its way into the redline draft.
The proposal to eliminate dedesignation and the ability to update documentation will need to be further explored, especially for companies with de/redesignation programs currently employed to modify the proportion of an underlying hedged, generally in net investment and fair value relationships.Will companies simply change their hedge documentation to reflect proportion changes daily, or quarterly?
The ability to modify documentation is mentioned in the draft but not elaborated on, so it remains to be seen how substantial an improvement this represents.
A Sticky Edit
Still unsettled is the 2008 ED edit that precluded intercompany hedge accounting that does not survive consolidation (oxymoron?). The FASB has indicated that this edit would not be considered a change in hedgeable transactions but rather a clarification of the existing standard.
If reinserted the first we will learn of it will be in the redline version of ASC 815, now due out in “late August.” With a September 30 comment-period deadline, this won’t leave much time for digesting the impact and reaching out to the FASB. The good news in general seems
to outweigh the bad in this latest ED, unless the intercompany edit finds its way into the redline draft.
We encourage corporates to explore the vagaries with their audit firms, push the FASB for clarification and tool up for the new rigors around measuring changes in hedged items.
Options still some trouble
As the FASB approaches convergence, one substantial difference has been, and might remain, accounting for the time value in options. US GAAP has allowed the effective changes in premiums to be recorded in income together with the hedged item’s earnings effect. International GAAP captures all changes in time value as either ineffective or excluded depending on designation— an anathema of volatility for US reporting companies.
In the Exposure Draft the FASB is offering a compromise: allow “effective” changes in the time value to amortize to income in a reasonable fashion over the life of the derivative.
A palatable compromise?
This makes for a confusing but palatable result for US constituents who will likely be willing to lose the “match” of recording the option premium and the hedged item together, for another “predictable” method.
Under this method, HedgeTrackers believes an entity would model a perfectly effective hypothetical option, capture changes in the hypothetical in OCI and separately calculate a (straightline?) amortization of the hypothetical premium that would be recorded in income over the life of the option.
For interest-rate or other cap/floor strategies this would require each caplet to be amortized over the caplet life because amortizing the entire premium would result in amounts associated with the very first caplet being recognized in periods after the exercise date. Again this will be operationally messy.
Helen Kane is the Founder and President of HedgeTrackers, LLC. She can be reached at (408) 350-8580 or [email protected].