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Accounting & Disclosure

New Accounting Guidance Won’t Always Be Easy

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July 05, 2017

Editor’s note: This is Part 2 of a three-part series on FASB’s latest hedge accounting guidance. Part 1 can be accessed here.

Exposures key to treasury will still require ongoing work.

Accounting with BenjaminsFASB’s amended hedge accounting standard will facilitate obtaining hedge accounting for many companies, but it won’t always be easy, and at times it will still be very challenging.

There are a number of common situations Chatham Financial has identified where hedge accounting will continue to be very challenging under the new guidance—and it performs the accounting for hundreds of corporate clients—including situations when the price a company is paying for a commodity just can’t be specified in a contract.

For example, said Dan Gentzel, head of Chatham’s global accounting advisory team, the drivers of a trucking company may use a corporate credit card to buy fuel at the pump, but those prices vary significantly from state to state and the purchases likely are not contractually specified.

“So there’s a situation where they will have to hedge the overall changes in the purchase price rather than just the contractually specified commodity-price component itself,” Mr. Gentzel said. “It’s a situation where they probably will not be able to benefit as much from the new guidance.”

Under the new guidance, critical terms match and the short cut method continue to be valid approaches for assessing the effectiveness of a hedging relationship. In addition, FASB has introduced a new approach to assessing effectiveness that involves performing a quantitative assessment at inception with qualitative assessments thereafter.

This means that if the critical terms of a hedging relationship match, the company is required to perform a quantitative assessment, like statistical regression, at inception of the hedging relationship but is then permitted to perform qualitative assessments each quarter to ensure the facts and circumstances that existed at inception have not changed. If the facts and circumstances have changed in such a way that it can no longer qualitatively assess that the original quantitative assessment is still valid, it must update its quantitative assessment in hopes of demonstrating the hedging relationship is still highly effective.

That sounds nice in theory, Mr. Gentzel said, but in practice it can be challenging. The new guidance does allow for a mismatch in terms within a certain range, but depending on how markets perform the mismatches can grow. Determining when facts and circumstances change will be easy in some cases and challenging in others. As a result, in situations where mismatches exist, Chatham believes most companies will just continue performing ongoing quantitative testing like regression analysis.

“The reality is that a lot of hedging relationships have mismatches in them, some small and others big,” Mr. Gentzel said. “So if a hedging relationship does have a mismatch or it develops one or potentially could develop one, we think you will need to do ongoing quantitative testing in those cases in order to demonstrate the hedging relationship is highly effective.

Mr. Gentzel laid out several examples where applying hedge accounting could be as challenging under the new guidance as it is under the current guidance. One is commodity or FX hedging programs, where a company uses a single derivative maturing on a specific date to hedge the purchases or sales that occur over a period of time. By definition that’s a mismatch, and so FASB added language to the guidance allowing the mismatch to be up to the maximum of 31 days or a fiscal month, so if all the hedged transactions occur in that period, the company can still apply the critical terms match method.

“That’s favorable,” Mr. Gentzel said, “But you have companies that are trying to hedge revenues or expenses over a three-month period, so most likely they will have to do the quantitative test on an ongoing basis.”

To retain hedge accounting, the company would somehow have to reach a valid supportable and auditable conclusion that the difference in timing will not cause the hedging relationship to fail to qualify. “The reality is you can’t do that without doing a quantitative test of some sort that can be audited,” Mr. Gentzel said.

Besides timing, mismatches can take several forms. Off-market hedging relationships, for example, can be a major source ineffectiveness. A typical example where this occurs is when a company acquires another company that has derivatives on its balance sheet. In that case, the derivatives must be re-designated upon acquisition into brand new hedging relationships that are “off market,” meaning they have fair values other than zero.

“When a non-option product that has a fair value other than zero is designated, it will not get perfect accounting,” Mr. Gentzel said, adding that regular quantitative assessments will be necessary to retain hedge accounting.

Corporates may find off-market hedge relationships arising in other ways. For example, a perfectly hedged exposure may incur a mismatch when a company refinances or restructures debt, because the debt’s terms change and it no longer qualifies under the existing hedging relationship. In that case, the company must re-designate the derivative into a new off-market hedging relationship that likely will be sufficiently mismatched to require ongoing quantitative assessments.

On the interest-rate side, floors typically are embedded in variable-rate credit agreements and tend to be in the 0.5% to 1% range, and more recently they’ve been at 0% because rates are so low. However companies have been unwilling to embed floors in the swaps hedging their debt because those floors have been expensive and the market saw little chance of rates falling.

“Almost every piece of corporate debt that gets negotiated today has a floor in it, and a lot of them are at 0%,” Mr. Gentzel said. “However, companies often enter into swaps with no floor to hedge debt that does have a floor, and that creates a mismatch. That’s ineffectiveness.” However, most companies don’t want to buy 0% floors in their swaps because it won’t provide them with any real protection in today’s rising rate environment.

Also on the interest-rate side are forward-starting swaps that corporate issuers put in place to lock the rate of a future bond issuance. The company has to pick an issuance date and will enter into a swap that becomes effective on that date. That swap is perfectly effective at that time, but no corporate treasurer can predict precisely when the offering will occur, because it depends on market dynamics as the date approaches, and the actual offering may take place within a few days or even a few months of that chosen date.

“The swap date doesn’t change, so now the company finds itself in a situation where the swap becomes effective on a certain date, and the debt comes about on a different date, and that’s a mismatch in the hedging relationship,” Mr. Gentzel said. “Anytime a company is going to issue debt and hedge that issuance, they’re going to have to do a quantitative test.”

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