Reducing earnings volatility by using the Financial Accounting Standards Board (FASB)’s hedge accounting standard has always been challenging and limited, especially for companies looking to hedge commodity-related risk. The amended guidance will facilitate obtaining hedge accounting—early birds can adopt it in fiscal year 2017—as well as provide significantly more flexibility in how it can be applied.
The requirements in the new guidance are rigorous. Joseph Soviero, executive director in Ernst & Young Global’s Financial Accounting Advisory Services, said that benefits to financial statement preparers are threefold: it improves existing guidance to reduce operational complexities, enables new strategies, and modifies existing financial statement presentation and disclosures.
“When treasury sits down with accounting and tax, they should be thinking about those three buckets and how these changes can impact existing or future risk management strategies,” Soviero said.
One major change is that companies will now be able to hedge components of commodity and other nonfinancial risks, allowing for more effective hedge accounting relationships and making it easier to obtain hedge accounting treatment. Hedging commodity risk, for example, has always been problematic because the derivative must be highly correlated to the commodity index or market price referenced in the forecasted purchase or sale—the exposure the company is seeking to hedge—as well as other elements of total price risk. Those can include transportation costs, quality, and basis and grade differentials related to location.
Including those other elements, however, can lead to the recognition of ineffectiveness and, in some cases, the failure to qualify for “special” hedge accounting. No longer.
“The standard will allow hedging of a contractually-specified component of the purchase or sale of a financial item. A contractually-specified component is a price that is linked to an index or rate that is expressly stated in the contract,” said PwC in a recent note to clients. “This is good news for manufacturers who buy raw materials and lock in the prices with derivatives.”
For example, a company may want to hedge purchases of natural gas by using a derivative tied to the NYMEX price of natural gas at Henry Hub in Louisiana. Under existing guidance and in order to apply hedge accounting, the company would be required to designate the risk as the total price variability in the purchase contract, including the NYMEX index plus other variable costs such as basis and grade differentials.
The new guidance, instead, allows the hedge to point specifically to risk in the forecasted purchase of the NYMEX index, as long as it is contractually specified. The company can exclude all other elements of price risk related to that forecasted purchase, potentially resulting in a more effective hedge and better aligning the hedging strategy with the risk the company intended to hedge in the first place.
In addition, companies with several supply contracts that each specify a certain market price or index will be able to consolidate that risk and use fewer derivatives to hedge it.
“Before companies may have found it difficult to identify homogeneous buckets of various supplier contracts because there may be different basis or differential elements contributing to the overall price in the various physical contracts,” Soviero said.
On the flip side, he added, companies that can’t identify a contractually specified component and reference it in an agreement won’t be able to benefit from the new language. Nevertheless, many companies forego hedging commodity risk because of the poor accounting treatment today, so this change potentially opens up new hedging strategies. And for those already hedging commodity risk, the change facilitates their hedge accounting efforts.
Permission to change
There’s a similar benefit for financial hedges. Under current guidance, companies essentially must choose which tenor they plan to borrow at and stick to it in order to reduce the ongoing testing they need to perform to demonstrate the hedge remains effective. The new guidance permits a change in hedged risk to still be considered part of the original hedging relationship, so long as the hedge continues to qualify as highly effective.
“This means that a company could borrow at three-month Libor originally and then switch to one-month Libor at a later date, and it could still be considered a part of the original hedging relationship if the swap is highly effective,” said Dan Gentzel, head of Chatham Financial’s global accounting advisory team. “This is important because it avoids having to re-designate a swap in a new off-market hedging relationship.”
Likewise, companies may find fair value hedges used to convert fixed-rate cash flows to floating rate more attractive under the new guidance. Today, companies must include the credit spread in their assessment of the effectiveness of a fair value hedge. “This is not something they are trying to hedge by entering into an interest-rate swap; typically they literally just want to hedge the benchmark component of their cash flows,” Gentzel said.
The new guidance allows companies to focus on just the benchmark component of the debt’s cash flows, and that makes most of the ineffectiveness go away. “Because this is how companies think of the economics of the hedge, hedge accounting will more closely align with their risk management activities,” PwC said.