Commodity Hedge Accounting
The new hedge accounting guidance recently issued by FASB in ASU 2017-12 (the “Update”) will better align the accounting for commodity hedges with how companies manage their commodity risk. Similar to today’s accounting for interest rate and foreign exchange hedges, Companies will be allowed to point to a specific commodity risk component, as long as that component is contractually specified. This is a big change from current guidance that requires consideration of the overall changes in fair value or the variability in total cash flows.
The new accounting guidance will make it easier for hedges of commodity risk to qualify for hedge accounting treatment and will improve the accounting results of the hedges as reported in the financial statements. For example, a company that uses copper as a significant component to manufacture its widgets will be allowed to designate its copper hedges against changes in cash flows related solely to the contractually specified copper component (e.g., the COMEX copper index) in its purchase contracts. This will be applicable for the effectiveness assessments as well, which may enable qualitative testing and more scenarios where critical terms will match.
Other changes in the Update are also advantageous for commodity hedging. The Update changes the timing and presentation of ineffectiveness, effectiveness assessment guidance, and the accounting alternatives available to account for excluded components (e.g., time value of options or the spot-forward differential). The combination of these changes allows hedgers to simplify effectiveness testing using spot rates even if the commodity exposure is not contractually specified and results in the full change in the value of the derivative going to OCI in a cash flow hedge until the hedge transactions impact earnings with the excluded non-spot changes being amortized to earnings. As a result, even when the commodity exposure is not contractually specified, hedging relationships can be structured to achieve similar results. Quantitative effectiveness assessments likely will be necessary when the commodity exposure is not contractually specified, but the ability to exclude either time value or forward points can be helpful in simplifying the work to be done.
Current accounting guidance requires companies seeking to apply hedge accounting to commodity exposures to consider variability in total cash flows in the hedging relationship when assessing effectiveness and measuring ineffectiveness. Even if the commodity index exposure is noted as a separate component of the price, a company must incorporate all factors (e.g., including freight or manufacturing costs, differences in taxes between geographies, and other basis differentials) in order to qualify for hedge accounting. This requirement makes hedge accounting more challenging for hedges of commodity risk, and also creates more earnings volatility through increased ineffectiveness or marking the entire trade to market through earnings when hedge accounting is not achievable. This is largely eliminated through the Update.
The Update will be very beneficial to companies with contractually specified commodity exposures. Even when commodity exposures are not contractually specified, companies can still achieve favorable results by leveraging other provisions of the Update related to effectiveness assessments, the changes to ineffectiveness measurement, and excluded components. This will not always be the case so companies may want to consider amending contracts to include a contractually specified component, thereby allowing them to take full advantage of this preferential update to hedge accounting.
Take advantage of these positive changes today by implementing the new hedge accounting guidance. Prepare for the new hedge accounting standard by learning about Chatham’s 8-Step Transition and Implementation Process.
Contact us today to learn more. CorpAcctgTeam@chathamfinancial.com