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Accounting & Disclosure

Adopting Hedge Accounting Rules Early Has Benefits

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June 02, 2017

But FASB leaves little time to take early advantage the new guidance.

Fri Reg and Accting - Law BooksIt’s already June, leaving corporates only six months to prepare for new hedge accounting guidance if they want to adopt it early, likely for many companies, especially heavy users of commodities but also those who want more control over other features of their hedges.

Chatham Financial updated members of the NeuGroup’s Assistant Treasurers’ Leadership Group (ATLG) toward the end of May at its headquarters in Kennett Square, PA, about major hedge accounting changes coming down the pike. The guidelines are scheduled to be published at the end of June, but for all practical purposes the language has been finalized. Although the amended rules will require substantial effort to follow, they will facilitate achieving hedge accounting treatment in several areas.

Aaron Cowan, head of Chatham’s corporate accounting advisory team, said that several advantageous provisions in the new guidance are likely to prompt some companies to adopt the guidance early. To do so, however, will require gearing up by year-end, since it is expected the guidance can be adopted at the start of companies’ fiscal years starting after December 31. Hence companies with a calendar fiscal year should be able to apply the new accounting Jan. 1, 2018 if they choose to early adopt.

“We expect some companies will opt for early adoption, given the changes to simplify the accounting and to make more hedging strategies available for hedge accounting treatment,” Mr. Cowan said.

In fact, the Financial Accounting Standards Board (FASB) decided to offer early adoption precisely because companies asked for it, Mr. Cowan said, adding that they will be able to elect to apply hedge accounting under the new guidance to existing deals already in hedge accounting or to get prospective treatment for deals that are not already in hedge accounting upon adoption.

One key area of change in the new guidance is hedged risk. Historically, financial risk was hedged using a benchmark interest rate—typically Libor, OIS or the Treasury rate. Mr. Cowan noted that was a problem for banks using prime to lend, because it was not an accepted benchmark. Consequently, banks have had to consider the total cash flows in the hedge, and changes to credit spreads or other factors created a large enough mismatch between the hedge and hedged item, known as ineffectiveness, to prohibit hedge accounting treatment or necessitated burdensome stratification of loan portfolios.

“Under the new rules, if prime is contractually specified, it can be hedged in isolation, and changes in credit spreads or other components of the cash flows do not need to be factored in – resulting in better or even perfect results in the P&L,” Mr. Cowan said.

The change to hedged risks is also very relevant for corporate users of commodities. A company purchasing aluminum as part of its production must now include the London Metals Exchange (LME) index price as well as highly variable processing and transportation costs in the economic relationship it uses to determine whether it qualifies for hedge accounting (i.e., total cash flows). The LME derivative contract, however, is not intending to hedge changes in those costs, which are generally managed via procurement processes and contract negotiations.

“It presents a situation where even though the company had a great economic hedge for the risk treasury wants to hedge, it wouldn’t qualify for hedge accounting and instead has to mark the derivative to market through earnings,” Mr. Cowan said.

He added that the new guidance enables companies to contractually specify components and hedge them separately, so the company would be able to isolate the LME price as the hedged risk to get a more accurate accounting result that is aligned with treasury’s objective in the economic hedge.

“Companies will be able to treat commodity hedges in the same way they’ve treated FX hedges in the past where the accounting and the economics have been more closely aligned,” Mr. Cowan said.

Treasury traditionally has looked at the index component while procurement has focused on transportation and other fees, negotiating reductions in those costs when possible, Mr. Cowan said.

“So this aligns more with the bifurcation of what treasury manages versus what procurement manages,” Mr. Cowan said. “For companies with commodity exposures, this would be one of the driving factors to adopt the guidance early and has been a long sought after provision.”

Mr. Cowan noted that while the new accounting makes hedging commodity risk much easier, treasury executives must think about whether contracts specify the components to hedge. If not, treasury must start thinking about renegotiating those contracts or finding other ways to specify those components in the contracts. One AT30 member questioned how willing counterparties would be to changing those contractual terms. Mr. Cowan said Chatham had sought to persuade FASB staff to adopt an approach more like the International Accounting Standards Board’s hedge accounting guidance, which allows isolating a “separately identifiable and reliably measurable” component to hedge, rather than a contractual one.

“A company may have advantageous terms that will be revisited if the contract is reopened,” Mr. Cowan said, adding, “There are a lot of commercial reasons why a company may not want to reopen a contract, but the FASB was concerned with this and ultimately not willing to go as far as the IASB’s approach.”

Another advantageous aspect of the new guidance, Mr. Cowan said, is the ability to change indexes used to hedge exposures. He said several clients that had locked in three-month LIBOR historically wanted to shift to one month LIBOR to save nine or 10 basis points, or those with floors in their debt wanted to shift to three-month Libor to pay less frequently and reduce the administrative burden.

Under the current guidance, depending on how the transaction was documented, the move could end hedge accounting treatment or result in other knock on effects. Not so under the new rules.

“The company can switch from one month Libor to three month Libor, or to the prime rate, and as long as it shows the hedge remains highly effective, it won’t discontinue hedge accounting,” Mr. Cowan said. “This gives a bit more flexibility to adapt to market conditions, which can be very valuable for corporates.”

He added that the same thing applies to commodities. A company can start purchasing based on one index and end up on a different index, and as long as they’re both highly effective it doesn’t impact hedge accounting treatment.

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