Risk management and derivative accounting
Financial derivatives are a complex subject made even more challenging when you introduce the complexity of accounting for them. Although hedge accounting is not a requirement for hedging, many organizations, especially public companies, choose to apply hedge accounting to align the economics and the accounting for financial derivatives.
According to the hedge accounting standards, there are three broad types of hedges that qualify for hedge accounting:
- Fair Value Hedge: Gain/loss on the derivative is offset by the gain/loss on the hedged item for changes in the hedged risk (both marked through earnings)
- Net Investment Hedge: Hedge of FX risk associated with a subsidiary with a different functional currency than that of the parent company; gains and losses are reported consistent with cumulative translation adjustments in other comprehensive income as a separate component of stockholder’s equity; effective portion of hedge also gets deferred in OCI
- Cash Flow Hedge: Gain/loss on the derivative is recognized in OCI and reclassified into earnings in the periods during which the hedged transactions will affect earnings. This is the most common type of hedging employed by corporations.
Common hedging products
To understand the application, consider some common financial risk management products corporations use to lock in prices.
Interest rate swaps synthetically convert floating rate debt to a fixed rate. The borrower pays a fixed swap rate to the swap provider who then pays the borrower a floating rate (i.e. 1-month LIBOR). The floating rate received from the swap provider cancels out the floating rate paid on loan, so the borrower is left paying just the fixed swap rate—an agreed-upon rate based on expectations of LIBOR plus the loan spread (swap provider’s credit charge/profit).
FX Forward contracts allow two parties to exchange foreign currencies on a pre-defined future date at a pre-defined exchange rate.
Commodity futures are like forward contracts, except they are traded on an exchange, rather than over the counter, and marked to market daily, causing cash collateral to change hands during the lifetime of the contract.
Why elect hedge accounting?
Companies do not necessarily have to apply hedge accounting to account for their derivatives. In fact, hedge accounting is known as a “special election” and you must jump through some hoops to achieve it. So why bother adhering to these stringent guidelines? Generally, it comes down to aligning the organization’s economic and financial reporting objectives.
In the below example, a company needs to hedge its projected foreign profit for the next 12 months. The company would execute a series of twelve FX forwards, one for each month’s profit. As time passes, these forward contracts will change in their mark-to-market (MTM) values, as any derivative would. By default, the changes in MTM would flow through the income statement as gains or losses. This is no different from how one would account for other financial instruments on a company’s books whose values are fluctuating. Without hedge accounting, all fluctuations in derivatives’ values will flow straight into the income statement.
These swings impact the income statement, showing volatility that does not reflect the economic benefit of the hedge. This happens because the changes in MTM for all twelve forwards will affect the income statement at the same time. However, the January forward should only impact January earnings, the February forward should only impact February earnings, and so on. This timing alignment can only be achieved with hedge accounting. Without hedge accounting, all fluctuations in derivatives’ values will flow straight into the income statement.
With the election of hedge accounting, the changes in MTM of a cash flow hedge are stored on the balance sheet (within the equity section), specifically in Other Comprehensive Income (OCI), until needed.
When the hedged item comes into play (i.e. the June revenue is finally recognized in June), then the stored up MTM changes for that June hedge will be released from OCI and into the income statement. Hedge accounting enables OCI to effectively store MTM changes until the timing of the hedge and hedged item finally align.
There are two main reason companies apply hedge accounting. The first is that companies want to reduce their P&L volatility. This may be more important to some companies than others. For example, public companies may care more about reducing earnings volatility than private companies. The second main reason is to achieve matching between the earnings impact of the hedging derivative and the earnings impact of the risk being hedged.
How do you elect and apply hedge accounting?
Hedge accounting is a special election and entails significant requirements (both at the onset of a hedging program, and in the ongoing maintenance mode).
Your organization must meet each of the below criteria at the onset of a hedging relationship:
Because hedge accounting is a special election, you can’t just verbally say you are applying it or imply that you have elected it just by having commercial risk. You must formally document this election at the onset of the hedging relationship. This is accomplished via a hedge designation memo (HDM).
If you are hedging a forecasted cash flow, such as floating interest payments, foreign revenue, or expenses, the forecasted transaction must be highly probable.
For example, suppose you are in the business of selling snowblowers. If you hedge €100mm of foreign revenue you are forecasting for the next winter, and the revenue doesn’t actually materialize (maybe demand for snowblowers isn’t as high as you expected), then you essentially missed your forecast.
You never want to be caught in a situation where you are over-hedging because of missed forecasts. If you have any inkling that some portion of the €100mm of forecasted revenue isn’t likely to occur, you should dial down the size of your hedge to only hedge the portion that is highly probable to occur. For this reason, many companies choose to layer on hedges over time. This enables them to hedge a bit more strategically and allows them to adjust as the forecast changes.
Hedge must be highly effective. Of course, treasury teams want hedges that effectively mitigate the underlying risks. However, as much as we try to design hedges that closely match the underlying risks, some slippages or imperfections will occur. That’s why the FASB wanted to make sure whoever applies hedge accounting conscientiously designs a hedge that is as effective as possible. They set a high bar so that organizations don’t apply hedge accounting to poor hedging strategies.
For a hedging relationship to be completely effective, the MTM changes of the hedged item should perfectly offset the MTM changes of the hedge. In other words, there is a 1-to-1 ratio between the hedge and the hedged item. Since hedging relationships are never perfect, the regulators have decided that highly effective is sufficient and defined this threshold as 80% to 125% effective.
Prospective and retrospective assessment
Hedge accounting standards require you to establish the “highly effective” nature on a prospective and retrospective basis.
Prospective: Forward looking. Is the hedging relationship expected to be highly effective in the future?
Retrospective: Backward looking. Has the hedging relationship been highly effective in the past?
It is easy to see how you can assess effectiveness retrospectively. You just take actual ΔMTMs and calculate the ratio. It is less obvious how you might do this prospectively. Under the critical terms match method, you can “prove” effectiveness if the derivative is structured “exactly” like the hedged item (notional, settlement dates, index, etc.).
You could also make up hypothetical ΔMTM by valuing the hedge and the hedged item under different market environments (say the last 36 month ends) and see if the relationship would have been highly effective had you hedged a long time ago.
Frequency of assessment
Effectiveness must be assessed at inception of the hedging relationship and at least quarterly or every time the company issues financial statements.
The accounting standards do not dictate what method you use to prove effectiveness prospectively and retrospectively. The choice of method depends on the nature of risk and type of hedge you have structured. However, the method must be formally documented at inception of hedge relationship and applied consistently to all similar hedges, unless another method is justified.
Assessment vs. measurement
As any parent could attest, there is an art to asking the “right” question of your child. Binary questions generally produce poorer results than gradient questions. For example: “Did you pass or fail your final exam?” is probably less useful than asking, “How high was you grade on the final exam?”. Or to use a sport analogy, assessment is “are you in the game”, measurement is “what’s the score?”
Similarly, simply assessing effectiveness will only produce a binary answer, “It is highly effective or not."
Impact to reported earnings
This requirement seems obvious. After all, if the hedge item doesn’t impact earnings, why bother hedging it? But as you peel away the layers of the hedge accounting onion, you realize this rule is an important guidepost.
For example, suppose you are a USD biotech firm with significant operations and intellectual property in Europe. The USD parent company receives dividends from the profits in the European subsidiary in EUR each quarter. This exposes the company to the cash impact of changes in the EUR/USD exchange rate. However, dividends do not impact earnings. The intercompany dividends are an equity transaction for the subsidiary (the subsidiary’s equity value is decreased) and an asset transaction for the parent (the parent’s cash is increased).
Consider another example where hedge accounting cannot be applied. Suppose the USD parent pays EUR to the subsidiary for the rights to license the intellectual property for distribution in U.S. markets. This is entirely an intercompany transaction that does not involve a third party and is, thus, fully eliminated on consolidation.
How can Chatham help?
Chatham's team of accounting consultants, regulatory experts, and hedging advisors can help you navigate the accounting implications of COVID-19 and their impacts to your hedging programs. Please reach out to your Chatham accounting contact or relationship manager if you have any questions or would like to discuss impacts to any of your programs.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal/notices/.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 20-0190