A new U.S. accounting standard that makes it easier to account for hedges is likely to encourage more corporates to hedge.
The Financial Accounting Standards Board voted last month to finalize the new hedge accounting standard, and the final standard is due out in August.
Companies interested in using the new standard won’t have to wait long. The effective date is the start of 2019 for public companies and the start of 2020 for private companies, but businesses 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 will be “very positive” for corporates.
“One, it’s likely to induce more hedging and secondly, it’s going to produce better accounting results for existing and new hedge relationships,” Seward said. “Even though 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 the accounting for hedging with the economics of hedging.”
The biggest benefit of the new standard for corporates is likely to be better accounting results, Seward said. “That’s the reason our clients are coming 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, that could mean some P&L volatility for the company, Seward said.
“That has been relaxed, provided you’ve got a good hedge,” he said, with all changes to the value of derivatives now to be posted under other comprehensive income, or OCI. “There will be no ineffectiveness, no P&L noise,” Seward said. “That’s a big plus. The ability to treat forward points and currency basis as an excluded component will also reduce P&L volatility.”
Reza van Roosmalen, accounting change leader for financial instruments at KPMG, said he has begun to see interest in early adoption among financial institutions.
“A lot of banks that do hedge accounting today, they have massive P&L hits from ineffectiveness,” van Roosmalen said, and noted that under the new FASB standard, “you no longer have to record ineffectiveness on eligible cash flow hedges.”
He sees the standard encouraging more companies to use hedge accounting.
“One of the main reasons that folks were not applying hedge accounting is due to a high degree of compliance-driven and sometimes very complicated to operationalize processes,” van Roosmalen said. FASB tried to alleviate that with its proposed new standard, which is aiming for “more of an alignment with risk-management activities institutions already have in place.” The new FASB hedge accounting standard involves fewer mandatory, compliance-based checks and fewer requirements around documentation, he said.
Aaron Cowan, executive director and global leader of corporate accounting advisory services at Chatham Financial, a global risk management advisory firm, said that while the new standard will provide “a lot of opportunities” for companies, its biggest effect is likely to be on the way that companies deal with commodities risk.
“We’ve seen historically that the punitive guidance in the past was a stumbling block to corporate hedging in the commodities arena,” he said. “We believe a lot more companies will start hedging commodities or increase the amount they were hedging because of the new rules.”
Under the previous FASB hedge accounting standard, companies had to consider the total cash flows associated with the hedged purchases of commodities. That posed a challenge for companies dealing with commodities because the cost can include the cost of fabricating and shipping the commodity. But changes in those components of the cost aren’t reflected in the financial derivatives used to hedge commodity costs.
Cowan compared that to a company hedging interest rates, which can borrow at a rate based on Libor and then hedge that Libor exposure. “Now commodities [hedging] is able to move into that realm, where you can focus on a specific component of the price,” he said.
To date, companies have been much less likely to use hedge accounting for commodities hedging. A benchmark study of the filings of more than 1,500 public companies that Chatham updated last year showed that while 80% of companies that hedged their interest rate exposures applied hedge accounting, as did 90% of those with cash flow currency hedging programs, only 45% of companies that hedged commodities exposures used hedge accounting.
With the arrival of the new standard, companies that have commodities exposures but “let the accounting tail wag the dog may start hedging commodities for the first time,” Cowan said. “Companies that are hedging but in a small way, because they don’t get hedge accounting, will likely increase the hedging they do.”
Interest Rate Hedging
Cowan said the new standard will also be helpful for companies that hedge interest-rate exposures. For example, the new standard will reduce the amount of P&L volatility for companies that apply fair-value hedge accounting to interest rate hedges, he said.
“Under the current guidance, you have to include the full contractual cash flows on your debt obligation,” Cowan said. “A big component is the credit spread, and when you include that, it results in more P&L volatility.” But the new standard enables companies to concentrate on the Libor component of the interest rate.
The new standard will also come in handy for companies that issue fixed-rate debt and want to swap some portion of the debt issue’s term to floating. For example, a company might want to swap thefirst two years of a 10-year bond. Under the previous standard, a company that did that 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 the hedge was ineffective.
Under the new standard, “if you’re only hedging two years of cash flows, you only compare two years of cash flows,” Cowan said.
To Do Lists
At its June meeting, 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 the new standard provides corporate hedgers, “we think that there will be some companies that choose to early adopt,” Cowan said. “We would expect that some commodities hedgers will absolutely want to early adopt.”
He noted that the need to prepare for the shift might deter some companies. But since FASB is allowing interim adoption, companies that won’t be prepared by Jan. 1 of next year might be able to start Feb. 1, Cowan said.
Even companies that don’t want to adopt the standard early need to start thinking about how they will handle the change, he said.
“There’s many advantageous opportunities that companies should be thinking about using,” Cowan said. “There’s a lot of great elections you can make at transition. Spend some time thinking through your transition plan.”
Reval's Seward noted that companies need a system that can support the changes under 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 historical hedge redesignation while other changes require a continuation of existing hedges,” he said.
KPMG’s van Roosmalen said that while FASB’s new standard takes a different approach to hedge accounting than the revised IFRS 9 standard, FASB’s standardalso represents “a major change.”
“Misapplication of hedge accounting was a main contributor to financial restatements in the 2000s,” he said, and added that that likely scared a lot of people away from trying to use it.
“This may be the opportunity to go and reassess your actual risk management strategies against what’s new and permissible here,” van Roosmalen said. “Maybe there’s actually an opportunity to do hedge accounting with much less operational complexity.”