The current rules on hedge accounting are among the most detailed and complex aspects of U.S. Generally Accepted Accounting Principles. The application of these rules has caused headaches for corporate risk managers and company accountants seeking to properly reflect the results of their company’s risk management activities while also ensuring compliance with accounting requirements. The Financial Accounting Standards Board plans to soon issue an exposure draft of a proposed standard intended to improve and simplify the requirements relating to hedge accounting and to more closely align them with companies’ risk management activities.
Specific rules on hedge accounting have been developed in order to enable companies to reflect in their financial statements the effects of transactions—usually involving the use of derivatives—designed to manage certain risks, such as 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. The 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 a variable rate borrowing that is 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. This effectively converts 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, a gold producer may seek to lock in the proceeds from highly probable forecasted sales of gold over the next year by selling gold futures contracts covering the amount of the anticipated sales for each of the next twelve months. In this case the hedge accounting rules enable it to “match” the results of the futures contracts in reporting its revenues from sales of gold over the twelve months.
The above examples are simple ones. In practice, however, a wide range of instruments and techniques are used by companies to manage exposures to changing interest rates, foreign currencies, commodity prices, and counterparty credit risks. These can involve combinations of instruments; partial hedges; use of instruments whose changes in value and cash flows do not perfectly offset the corresponding changes in the hedged item; dynamic hedging techniques; hedges of portions and proportions of particular assets; liabilities; firm commitments and forecasted transactions; and approaches intended to hedge portfolios and manage macro risk exposures. Accordingly, a very lengthy, detailed and, in many cases, complex set of rules has been developed to try to ensure that the special hedge accounting treatment is available only for qualifying transactions and techniques that are designated as, and are sufficiently effective in, achieving the intended risk management results and that hedge accounting is applied only to the extent hedges are actually effective.
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 even some 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.
As part of its broader effort to improve the accounting for financial instruments, FASB will be proposing a number of targeted changes intended to improve the hedge accounting model and reducing the operational burdens and potential pitfalls that companies have encountered in applying the current rules.
Accordingly, as part of its broader effort to improve the accounting for financial instruments, FASB will be proposing a number of targeted changes intended to improve the hedge accounting model and reducing the operational burdens and potential pitfalls that companies have encountered in applying the current rules. As a result, hedge accounting would be permitted for a broader range of financial and non-financial risk management techniques than under the current rules. In turn, that could increase the use of hedge accounting—both in terms of the range of transactions to which it is applied, and by companies that that do not currently apply hedge accounting—to their risk management activities either for fear of running afoul of the current rules or because their particular risk management transactions do not currently qualify for hedge accounting.
So what are some of the key changes FASB is proposing? One of most significant relates to how the results of a qualifying “cash flow hedge” are recorded. Under the current rules, only the effective portion of the change in the fair value of the hedging instrument receives hedge accounting treatment, with the ineffective portion having to be immediately recorded in earnings. Under the proposed change, the entire change in the fair value of the hedging instrument receives hedge accounting treatment. So, for example, an oil company wishing to hedge the proceeds it receives from a forecasted sale of its crude oil a year from now could accomplish this by entering into a 12-month West Texas Intermediate (WTI) oil futures contract. Ineffectiveness in the hedge will arise to the extent that changes in the value of the WTI oil futures contract is not perfectly correlated with changes in the fair value of the company’s crude oil. Under the current rules, the effective portion receives hedge accounting by initially recording that amount outside earnings in other accumulated comprehensive income and reclassifying it to earnings when the company sells its crude oil. Any ineffectiveness in the hedging relationship must be recorded immediately in earnings. Under the proposed requirements, the entire change in the value of the futures contract would receive the hedge accounting treatment and be recorded in the same line item as the earnings effect of the hedged item.
The proposed changes would also allow companies to designate a contractually specified component of an item as the hedged risk and apply hedge accounting only with respect to that specified risk. Thus, for example, an airline could enter into a contract to purchase jet fuel that specifies that part of the jet fuel price is linked to changes in the price of a specified grade of crude oil during the contract period. The airline could then hedge the variability in the price of the crude oil price component of the jet fuel purchase with the appropriate oil futures contracts. This treatment would be allowable even though the gain/loss from the hedging instruments (the “long” crude oil contracts ) might only partially offset the increase/decrease in the cost of the jet fuel purchases or might even, for example, at times result in there being both a loss on the oil futures contracts and an increase in the purchase cost of the 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, as discussed above, only to the extent that changes in the value of the crude oil futures offset changes in the cost of jet fuel.
The forthcoming FASB exposure draft will also propose a number of other changes to the hedge accounting requirements. These include changes relating to interest rate hedges, partial-term hedges of debt instruments, and hedging of callable debt. Although FASB decided to retain the current “highly effective” threshold for qualifying for hedge accounting, the proposal will include some changes intended to reduce the operational burden of assessing, monitoring, and documenting the effectiveness of hedging relationships.
In November 2013, the International Accounting Standards Board amended the IFRS hedge accounting requirements. While there are some similarities between the changes FASB is proposing and those made by the IASB, there are also some significant differences. For example, IFRS rules no longer require that a hedging relationship be highly effective to qualify for hedge accounting, only that there be an “economic relationship” between the hedging instrument and the hedged item and that the relationship not be dominated by credit risk. Thus, under IFRS, more risk management techniques may qualify for hedge accounting than under the forthcoming FASB proposal. However, under IFRS, only the effective portion of a hedge receives hedge accounting treatment. The IFRS rules permit greater flexibility on hedging specified risks than what FASB is proposing. Under IFRS, a company may designate a specified portion of an item as the hedged risk as long as that risk is separately identifiable and measureable, i.e., it does not have to be contractually specified.
Companies that engage in hedging and risk management transactions will need to carefully read the forthcoming FASB proposal, consider its potential effects on their financial reporting and on their operations, and submit comments to the board.