Corporate Case Study: Strategy & Accounting

June 20, 2014 Parke Shissler

Corporate Case Study: Strategy & Accounting

Our Client:

A global packaging and manufacturing company with over $7 billion in revenues and a complex capital structure.

Situation:

The company had recently issued fixed rate financing and was considering converting it to variable via a pay-variable, receive-fixed interest rate swap. Management’s objective was to achieve a certain fixed-floating mix, but was sensitive to the earnings impact that could be generated from the changes in fair value of a pay variable interest rate swap.

Summary:

The company sought our advice regarding the potential application of fair value hedge accounting on the proposed structure. Our analysis not only highlighted crucial issues that hindered the application of the shortcut method (such as the presence of equity-linked options in the hedged bond), but also showed the earnings impact over the life of the hedging strategy, under a “long-haul” effectiveness testing methodology.

Using a range of market scenarios, the analysis identified the impact of the hedging strategy on earnings and unveiled that expected P&L ineffectiveness would range from $4 to $10 million per quarter. The analysis highlighted the sensitivity of the combined position (i.e. the derivative and the hedged fixed rate debt) to both interest rates and credit risk, including assessing the credit risk of multiple bank counterparties associated with the derivative transactions. Importantly, we showed the benefits of diversifying across multiple bank counterparties, and that selecting a less creditworthy financial institution as counterparty may lead to $1 – $3 million in additional ineffectiveness and income statement volatility each quarter.

Outcome:

The analysis and results were a key consideration in management’s decision-making process with regard to both the economic hedging decision, as well as the ensuing hedge accounting treatment. Chatham’s expertise and consulting involvement was instrumental in the company avoiding a potential earnings restatement event; and with the careful selection and execution of its hedging strategy.

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