Hedging Inflation and Other Risks

Complications loom as standard setters take different approaches

Companies use derivatives to hedge inflation and other risks, and they can employ hedge accounting to reduce the volatility those instruments may cause in their financial statements by matching hedging instruments against the items being hedged. However, accounting standard setters’ efforts to facilitate the reporting of financial instruments now appear headed in different directions, potentially creating a new set of complications.

U.S. and global standard setters started a joint project well before the financial crisis to give investors more timely and clearer depictions of companies’ use of instruments such as derivatives, and reduce reporting complexity. The crisis increased pressure on the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) to come up with a common reporting model for financial instruments.

Instead, the two are headed on different paths. Clark Maxwell, director of accounting policy and global accounting services at Chatham Financial, says FASB’s and IASB’s existing hedge accounting standards have differences but fundamentally are on the same page. FASB, however, is amending its existing framework, while the IASB is largely building a new one, potentially resulting in very different reporting approaches.

“A lot of companies and investors are concerned about having two substantially different hedge accounting models, because it would be increasingly challenging to compare the results of U.S.-based companies to their international competitors,” Maxwell says.

Users of a financial statement would also have a harder time comparing companies’ risk profiles and hedging strategies.

FASB intends to issue a final rule by the end of the second quarter but Maxwell says that timeline may be aggressive since the U.S. standard setter’s comprehensive proposal initially would have required a wide swath of financial instruments, including loan assets, to be measured at fair value, or the amount at which an asset can currently be bought or sold. After reviewing 2,800 comment letters, FASB went back to the drawing board. “Ultimately, it will probably look a bit more like the IASB model, where amortized cost will play a more important role,” Maxwell says.        

The IASB, instead, approached its financial instruments project in three stages, with the final portion, on hedge accounting, issued in exposure draft form in December.

One significant difference between the proposals is the types of exposures for which hedge accounting can be used. Under FASB’s proposal, only financial risks, such as fluctuating interest rates, foreign exchange rates, credit and overall prices, can be individually hedged. For interest-rate risk, hedge accounting can be used only for Libor and U.S. Treasury benchmarks.

“Inflation is difficult to hedge under the FASB’s proposal because it hasn’t been included as a specifically hedgeable risk,” Maxwell says.

The IASB proposal provides more flexibility, enabling companies to hedge components of both financial and nonfinancial items—for example, an inflation component that is contractually specified or the aluminum component of a product—as long as it is separately identifiable and reliably measurable, Maxwell says.  





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