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A Look at Efforts to Simplify and Improve Hedge Accounting

Robert Herz | February 26, 2013

Hedge accounting is one of the more complex accounting subjects.

Over the years, it has caused headaches for corporate risk managers and company accountants alike, as they sought to properly reflect the results of their company's risk-management activities while also ensuring compliance with accounting rules.

The International Accounting Standards Board (IASB) plans to issue a new standard soon intended to improve and simplify its requirements relating to hedge accounting and to more closely align them with corporate risk-management activities. While the new IASB standard will only affect companies that report under IFRS, the Financial Accounting Standards Board has been monitoring IASB's work in this area and plans to consider whether modifications are needed to U.S. Generally Accepted Accounting Principles on accounting for hedging activities.

Specific rules on hedge accounting have been developed in order to enable companies to appropriately reflect in their financial statements the effects of transactions, usually those involving the use of derivatives designed to manage certain risks, including interest rate, prepayment, credit, foreign currency, and commodity price risks.

Accounting standards require derivatives to be carried at fair value with unrealized and realized gains and losses included currently in reported earnings unless they qualify for special hedge accounting rules. Special rules are needed in order to align the accounting for the effects of a hedging transaction with the accounting for the item being hedged.  For example, a company with variable-rate borrowing concerned with the potential negative cash flow effects of rising market interest rates could manage or “hedge” this risk by entering into an interest-rate swap under which it receives interest payments based on the variable rate on the borrowing and makes fixed-interest payments, effectively converting its interest cost to a fixed basis.

Without special accounting that enables the company to reflect the net effect on its periodic interest cost of the borrowing and the related interest rate swap, the company would report the variable-interest expense on the borrowing and the change in the fair value of the interest swap in its reported earnings each period.

As another example, an oil company may seek to lock in the net sales price from highly probable forecasted sales of crude oil over the next year by selling crude oil futures contracts covering the amount of the anticipated sales for each of the next twelve months. In this case, special hedge accounting rules enable it to “match” the results of the futures contracts in reporting its revenues from sales of crude oil over the next twelve months.

The above examples are simple ones. In practice, however, numerous instruments and techniques are used by companies to manage exposures to changing interest rates, foreign currencies, and commodity prices, and to counter-party credit risks. These can involve combinations of instruments; partial hedges; dynamic hedging techniques; hedges of portions of particular assets, liabilities, firm commitments, and forecasted transactions;  approaches intended to hedge portfolios and manage macro risk exposures; and the use of instruments whose changes in value and cash flows do not perfectly offset the corresponding changes in the hedged item.

Regulators, including the Securities and Exchange Commission, may have concerns over the robustness and enforceability of certain aspects of the IASB's new standard. So, it will certainly be interesting to see how FASB addresses these matters when it takes up the subject of hedge accounting.

Accordingly, a very lengthy, detailed, and in some cases complex set of rules has been developed in both U.S. GAAP and IFRS to try to ensure that the special hedge accounting treatment is available only for qualifying transactions and techniques that are sufficiently effective in achieving the intended risk-management results. Over the years, a number of companies have run afoul of these rules and had to restate their financial statements. Accordingly, some companies have decided not to apply hedge accounting for fear of unintentionally violating the rules, opting instead to try to explain the resulting “distortion” in their reported results to readers of their financial statements. Moreover, risk managers, financial executives, and CEOs have complained that overly strict and narrow hedge accounting requirements sometimes preclude their companies from properly reflecting the effects of bona fide risk-management activities in their financial statements.

The working draft of the forthcoming IFRS standard on hedge accounting, attempts to address these concerns head on by stating that: “The objective of hedge accounting is to represent, in the financial statements, the effect of an entity's risk-management activities that use financial instruments to manage exposures arising from particular risks that could affect profit and loss (or other comprehensive income)” However, because hedge accounting will, as it is under current U.S. GAAP and IFRS, continue to be optional under the new IASB standard and because the new standard will continue to contain certain qualifying conditions for being able to elect to apply hedge accounting to particular transactions, it is not clear that the stated objective will always be achieved.

Also, because the new standard does not address or change the accounting for risk exposures that are not managed and which, under other accounting standards, are not reflected in the financial statements, the new hedge accounting standard should not be viewed as providing a broader portrayal of a company's risk exposures in its financial statements. Nonetheless, because the new standard expands the range of transactions and techniques that can qualify for hedge accounting, it is intended to enable companies to more closely align the accounting of their risk-management activities with the effects of those activities on their performance.

Where the Differences Are

So what are some of the key provisions in the new IASB hedge accounting approach and how do they differ from the current requirements under U.S. GAAP? One major change relates to the elimination of the requirement that a hedging transaction must be “highly effective.” To qualify for hedge accounting under existing guidance, changes in the fair value of the hedging instrument must offset changes in the fair value of the hedged item within a band of 80 to 125 percent, with any ineffectiveness within that range charged to earnings.

Under IASB's new approach, hedge accounting will be permitted where there is an “economic relationship” between the hedging instrument and the hedged item such that the values of the two items generally move in opposite directions. This would seem to have the potential to significantly widen the range of transactions and instruments that could qualify for hedge accounting.

The new IASB standard will also allow companies to designate a specified portion of an item as the hedged risk as long as that risk is separately identifiable and measureable. Thus, for example, an airline could designate changes in the price of crude oil as a specified risk relating to its highly probable forecasted purchases of jet fuel over the next year. It could hedge that specified risk by buying crude oil futures covering the anticipated timing and amounts of the forecasted jet fuel purchases and treat the hedge as 100 percent effective.

This treatment would seem allowable even though the gain or loss from the hedging instruments (the “long” crude oil contracts) might only partially offset the corresponding increase or decrease in the cost of the jet fuel purchases or might even at times result in there being both a loss on the oil futures contracts and an increase in the cost of jet fuel. Under current U.S. GAAP this transaction would only qualify for hedge accounting if the crude oil futures are highly effective in hedging the cost of jet fuel, and then only to the extent that changes in the value of the crude oil futures offset changes in the cost of jet fuel.  Again, the new IASB approach would seem to potentially significantly broaden the availability of hedge accounting, particularly for companies that manage commodity price risks, and to enable them to do so without having to record any hedge ineffectiveness in earnings.

The new IASB standard will cover a number of other areas, including hedging net exposures and hedging transactions involving combinations of instruments and exposures. It will also allow the use of certain non-derivative financial instruments as hedging devices and will enable companies to separately account for the time value of purchased options used as hedges. It will also change the manner in which the results of certain hedging transactions are portrayed in the financial statements and the disclosures provided in the footnotes. The new standard is expected to be effective for companies that use IFRS in 2015, with earlier application permitted. IASB also plans to try to develop a standard on accounting for “macro hedges” of portfolios of items.

Overall, the new IASB standard will contain many differences from the current U.S. rules on hedge accounting. My guess is that U.S. companies will generally welcome many of the types of changes in the IASB standard, but that some professional investors and other users of financial statements may be concerned that the new standard may provide too much flexibility to companies in this area that could reduce the quality, consistency, and comparability of reported financial information.  Regulators, including the Securities and Exchange Commission, may have concerns over the robustness and enforceability of certain aspects of the IASB's new standard. So, it will certainly be interesting to see how FASB addresses these matters when it takes up the subject of hedge accounting.