A new US accounting standard that makes it easier to recognize hedges is likely to encourage more companies to hedge.
The Financial Accounting Standards Board voted last month to finalize the new hedge accounting standard, and the final standard is expected to be released in August.
Companies interested in using the new standard will not have to wait long. The effective date is early 2019 for state-owned enterprises and early 2020 for private enterprises, but companies are allowed to adopt the new standard early.
Peter Seward, vice president of product strategy for Reval, a treasury and risk management solution, said the new standard would be “very positive” for businesses.
“First, it will likely induce more hedging and second, it will produce better accounting results for existing and new hedging relationships,” Seward said. “Even though it’s rules-based, it’s very much in the spirit of IFRS 9, [the International Financial Reporting Standard that covers hedging], which aims to more closely align hedge accounting with the hedge economics.
The biggest benefit of the new standard for businesses will likely be better accounting results, Seward said. “That’s why our clients come to us to talk about early adoption. “
He cited cash flow hedges as an example. Under the old standard, if a cash flow hedge wasn’t perfect, it could mean some income statement volatility for the company, Seward said.
“This has been relaxed, provided you have good hedging,” he said, with any changes in the value of derivatives now to be recognized in other comprehensive income, or OCI. “There will be no inefficiency, no P&L noise,” Seward said. “It’s a big plus. The ability to treat forward points and the exchange base as an excluded component will also reduce the volatility of the income statement. “
Reza van Roosmalen, accounting change manager for financial instruments at KPMG, said he was starting to see interest in early adoption among financial institutions.
“Many of the banks that practice hedge accounting today have huge impacts on the income statement due to inefficiency,” said van Roosmalen, and noted that under the new FASB standard, “ you no longer have to save ineffectiveness on qualifying cash flow hedges ”.
He sees the standard encouraging more companies to use hedge accounting.
“One of the main reasons people didn’t apply hedge accounting is due to a high degree of compliance and sometimes very complicated to operationalize the processes,” said van Roosmalen. The FASB has attempted to mitigate this with its proposed new standard, which seeks “more alignment with the risk management activities that institutions already have in place.” The FASB’s new hedge accounting standard involves fewer mandatory compliance-based controls and fewer documentation requirements, he said.
Raw material coverage
Aaron Cowan, executive director and global leader in business accounting advisory services at Chatham Financial, a global risk management consultancy, said that while the new standard will provide “many opportunities” for businesses, its effect will more important will likely be how companies manage commodity risk.
“We have seen historically that punitive guidelines in the past were a stumbling block for coverage of commodity companies,” he said. “We believe that many more companies will start hedging commodities or increase the amount they hedged because of the new rules.”
Under the old FASB hedge accounting standard, companies were required to account for the total cash flows associated with hedged purchases of raw materials. This has posed a challenge for companies dealing with commodities, as the cost can include the cost of manufacturing and shipping the product. But changes in these cost components are not reflected in the financial derivatives used to cover the costs of raw materials.
Cowan likened it to a company that hedges interest rates, can borrow at a rate based on Libor, and then hedge that Libor exposure. “Now the products [hedging]is able to go into that area, where you can focus on a specific element of the price, ”he said.
To date, companies have been much less likely to use hedge accounting for commodity hedging. A benchmark study of deposits from more than 1,500 public companies that Chatham updated last year showed that while 80% of companies that hedged their interest rate risks applied hedge accounting, so did 90% of those that had cash flow hedging programs, only 45% of companies that hedged commodity exposures used hedge accounting.
With the arrival of the new standard, companies that have exposures to commodities but “let the accounting tail wag the dog may start covering commodities for the first time,” Cowan said. “Companies that hedge, but in a modest way, because they don’t get hedge accounting, will likely increase the hedge they do. “
Interest rate hedging
Cowan said the new standard will also be useful for companies hedging interest rate risks. For example, the new standard will reduce the amount of profit and loss volatility for companies that apply fair value hedge accounting to interest rate hedges, he said.
“Under current guidelines, you must include all of the contractual cash flows on your debt obligation,” Cowan said. “One important part is the credit spread, and when you include it, it results in more volatility in the P&L. But the new standard allows companies to focus on the Libor component of the interest rate.
The new standard will also be useful for companies that issue fixed rate debt and wish to swap part of the term of the debt issuance for floating debt. For example, a company may want to trade the first two years of a 10-year bond. Under the previous standard, a company that did so would have to compare the cash flows on the two-year swap to the cash flows on the 10-year bond, a comparison that would suggest that the hedge was ineffective.
According to the new standard, “if you only cover two years of cash flow, you’re only comparing two years of cash flow,” Cowan said.
At its June meeting, the FASB changed the way early adoption of the standard will work to allow companies to adopt at any time, rather than just at the start of a fiscal year.
Given the opportunities that the new standard offers roofing companies, “we think some companies will choose to adopt early,” Cowan said. “We expect some commodity hedgers to be keen to adopt early.”
He noted that the need to prepare for change might deter some companies. But since the FASB allows interim adoption, businesses that aren’t prepared by Jan. 1 of next year may be able to start Feb. 1, Cowan said.
Even companies that do not want to adopt the standard quickly need to start thinking about how they will manage the change, he said.
“There are many beneficial opportunities that businesses should consider utilizing,” Cowan said. “There are a lot of great elections you can make in the transition. Take the time to think about your transition plan.
Seward of Reval noted that companies need a system that can support the changes made by the new standard, some of which are complex to implement, and said they should work with their auditors on the transition. . “As with IFRS 9, some of the changes require a new historical hedge designation while other changes require a continuation of existing hedges,” he said.
Van Roosmalen of KPMG said that although the new FASB standard takes a different approach to hedge accounting than the revised IFRS 9 standard, the FASB standard also represents “a major change”.
“The misapplication of hedge accounting was one of the main contributors to financial restatements in the 2000s,” he said, adding that it had probably scared a lot of people to try to use it.
“This may be an opportunity to go and re-evaluate your actual risk management strategies against what is new and permitted here,” said van Roosmalen. “Maybe there is actually an opportunity to do hedge accounting with a lot less operational complexity. “