March 2009 Newsletter

The hedge-accounting fallout of the economic crisis.

When companies report sharply reduced forecasts and declining profitability, their immediate focus may not be on their financial hedge programs. However, auditors are already scrutinizing the impact of financial strain on the “probability” of anticipated transactions in cash flow hedging relationships. For both accounting and economic reasons, it is best that treasury and accounting do the same, i.e., review all existing hedges of forecasted cash flows and test them against the guidance in FAS 133 to determine:

1. Do the exposures still meet the probability test in FAS 133? Or

2. If not, how should companies handle the accumulated gains or losses in OCI?

Tripping Points

Given the current business environment, there are several possible scenarios that corporate hedgers of forecasted cash flows may face:

• A significant drop in anticipated sales or purchases. Many companies hedged anticipated transactions out six or even 12 months, based on then-current forecasts. However, as economic conditions soured, the original forecast may become unrealistic, necessitating a review of designated hedge levels.
• A significant drop in profitability. Often, companies hedge a much smaller percent of anticipated transactions, in effect targeting profitability or net income. While the reduced hedge coverage ratio may prevent the hedges from tripping the “probability” of the gross revenue or gross costs, if business conditions change significantly – as they have and still may – outstanding net-income hedges may still overshoot, in effect increasing the company’s economic exposures.
• (On)Going concern. Finally, in this worse-case scenario, questions about the financial viability of a company may raise doubts about its ability to carry out the transactions in the first place, in particular in the case of future interest payments.

Running the FAS 133 Diagnostics

For help in figuring out the right thing to do, companies can look to several paragraphs in FAS 133, which provide guidance on which anticipated transactions qualify for hedge accounting, as well as what to do when the facts and circumstances surrounding the initial designation change.

Paragraph 29(b) sets up the probability requirement. “The occurrence of the forecasted transaction is probable.” But the more granular definition of what is considered probable is depicted by paragraphs 463 and 464, in the basis for conclusion.

Paragraph 463 outlines the circumstances that companies must consider in order to determine whether a transaction is, in fact, probable, e.g., the frequency of similar transactions, the financial and operational ability of the entity to carry out the transaction, the extent of loss or disruption that would occur were it to not take place, etc.

The next paragraph, 464, brings more clarity to the Board’s definition of probability, referring back to FAS 5, Accounting for Contingencies. In 464, the FASB outlined a spectrum of probabilities, from probable to occur to probable not to (i.e., remote) occur:

• Probable – The future event or events are likely to occur within the hedged period (or within the additional 60 day grace period);
• Reasonably possible – While no longer probable, the chance that a future event or events will occur is more than remote but less than likely; and
• Remote – The chance of the future event or events occurring is slight.

According to the guidance in FAS 133: “The term probable requires a significantly greater likelihood of occurrence than the phrase more likely than not.”

OCI Do’s and Don’ts

As soon as it becomes clear that a hedged forecasted transaction is no longer probable to occur within the original period plus two months, existing hedges MUST be de-designated. As companies “slide” down the probability scale, from probable, to reasonably possible to remote, the guidance in FAS 133 is strict.

As soon as a transaction is no longer probable, companies must:

• De-designate the hedge.
• Freeze the OCI balance. Any accumulated gains or losses are “frozen,” and not additional amounts can go into OCI. (See more about the OCI “rules” below.)
• Unwind or reassign. Upon de-designation, companies may choose to re-designated the hedge, by attaching the derivative to a new underlying, e.g., next quarter’s sales or a balance sheet hedge. In such cases, the effective portion of the new hedging relationship will accumulate prospectively in OCI, separate from the historical “frozen” balance related to the original hedge.

Concerned about the potential for earnings manipulation (capturing gains or losses by triggering a reclassification out of OCI), the FASB ensured that the language in FAS 133 and related DIG issue is clear. In DIG issue G3 says the following: OCI gain or loss must be immediately realized in earnings, only when “it is probable that a forecast transaction will not occur by the end of the originally specified time period or within an additional two month period thereafter.” In all other cases, according to G3: “The net derivative gain or loss related to the discontinued cash flow hedge should continue to be reported in accumulated OCI.”

While this sounds very clear, in effect there are plenty of gray areas in the guidance. For example, a lot will depend on the language of the original designation documentation. The more generic the designation the less likely a company will be able to (or forced to) recognize the accumulated gain or loss in OCI in current income.

For instance, even if a company’s forecast for sales in Europe is sharply reduced, as long as the company continues to do business in euro, it will be impossible to argue that there is no chance that the transaction (or at least some of it) will occur.

For example, a company may have originally forecast GBP25M in sales and is now forecasting sales of only GBP5M. The company needs to determine where to draw the line between reasonably possible and remote (i.e., between GBP 25M and 5M). Clearly the 5,000,001st sale is possible, and it is just as likely that the 25 millionth is remote. The distinction is important, however: Historic OCI balances associated with transactions that are reasonably possible stay in OCI, whereas any OCI balance related to transactions that are now remote must be re-classed into earnings. (In both cases, no additional amounts can go to OCI.)

Things are a lot simpler when the hedge designation is very specific, for example the purchase of a machine. In such cases, the company could assert that it will not be purchasing the machine during the hedge period, close out the hedged and flush out the OCI balance.

The Economics

Regardless of the accounting treatment and probability litmus test, companies must also consider their economic exposures. Corporates often attempt to hedge net income, by hedging a smaller percent of their anticipated cash flows. The low hedge-cover ratio may keep the auditors from forcing the companies to de-designate (as the hedges remain within the bounds of reduced forecasts).

However, as profitability takes a huge hit, the net income hedge becomes ineffective from an economic standpoint, i.e., the company will be over hedged. Thus, even if some positions can remain open from the auditors’ standpoint, it may be a good economic move to close out open positions and reduce the overall level of protection. As mentioned above, this will not create a pre-mature P&L impact.

There is one more accounting and economic scenario to consider, as economic activity slows: To qualify for hedge accounting treatment, not only do companies have to demonstrate that the transaction is likely to occur, they must also assert the “financial and operational ability of the entity to carry out the transaction.”

If the company’s financial future is clouded, and its borrowing spreads widen significantly, and there is a risk that the hedged debt cannot be refinanced, the chance that the hedged debt transactions (or any transactions for that matter) will occur moves from probable, to possible, to probable NOT to occur (remote means probable not to occur). Auditors are increasingly pushing clients under serious financial strain, companies that face bankruptcy or companies that are in serious violation of the debt covenants to discontinue cash flow hedge accounting.

When it’s time to select the right model and discount rate for performing FAS 157 credit adjustments, treasury organizations face several tough choices.

FAS 157 brought a new level of complexity to corporate hedge accounting, by introducing the “own credit” component to determining the fair value of a financial instrument. Under FAS 157, companies must not only take into account the non-performance risk of their counterparts, but also apply a discount rate that is based on their own credit worthiness.

This is clearly the case when the company is in a liability position, although some auditors argue that regardless of whether the derivative is an asset or a liability, both parties must apply both rates when measuring the fair value of the instruments.

For corporate treasury and accounting groups, one of the biggest hurdles to the implementation of FAS 157 has been identifying the correct rate input, for both their own credit and that of their counterparts. It is hard enough to collect data inputs for calculating the non-performance risk of their derivative counterparties. The data is available, but to get it, companies must have a way to access it, be it on Bloomberg or via another data subscription service. It is even more difficult for treasury to identify which discount rate to use calculating the fair value of a derivative.

Step 1 – Choose a Model

The first step toward FAS 157 compliance is to select a model or approach for adjusting an instrument’s fair value to a company’s own or its counterparty’s credit. There are a couple of ways companies can perform the credit adjustment.

• Point in time measurement. The most straightforward, common, and practical approach so far is to apply a relevant (more on this below) discount rate and apply it at the point of measuring the instrument’s fair value.
• Probability models. A much more sophisticated approach involves using probability models, e.g., Lattice models or Value at Risk (VaR) to determine the likelihood of loss at different confidence intervals. Such models may incorporate inputs such as probability of default and recovery rates for particular instruments or entities; however, inputs aside, the actual modeling requirements are far beyond the capability of most corporate treasury organizations. (Perhaps ominously, a recent PwC write up hinted at the idea that these probability-based rate assumptions would and should become more prevalent.)

Step 2: Choose a Rate

Assuming most corporate hedgers opt for the first and more practical approach (see above), they still have to decide which rate to use, when making the FAS 157 credit adjustment to their derivatives’ fair value. While banks’ CDS spreads may be accessed through data subscription services, most middle- and many large-size companies do even have a corresponding CDS rate. So what are the alternatives? There are few, and none is perfect:

1. The spread over LIBOR the company pays for its bank revolver. This rate is clearly observable (a.k.a Level 2 input under the FAS 157 hierarchy). However, for many companies, the revolver rate had been negotiated some time ago, and may no longer be an economically-accurate reflection the company’s creditworthiness. Then again, the negotiated rate is likely to be lower, which means it would reduce liabilities by a lesser amount. To “refresh” the revolver spread, many companies are asking their lenders what their spread over LIBOR borrowing rate “would be” were they to refinance in the current market. However, if this “what if” spread becomes a significant factor in the valuation, it could move the derivative valuations to Level 3 since the input is not observable.

2. The spread on debt in the secondary market. While good in theory, many companies do not have debt that is trading in the secondary market. But even if they do, the spread over Treasuries, for example, captures more than just the issuer’s underlying credit; in fact, it is difficult to figure out what part of the spread is attributable to the specific company’s credit, vs. supply and demand issues or general industry concerns.

3. Relative credit rating. Companies can also look to the credit spread associated with their credit rating category; however, this, too, is a very “messy” indicator. Rating categories are very wide, encompassing a large variety of corporations with very different balance sheets, debt levels etc. On March 10, 2009, for example, the CDS rates for BBB-rated industrials ranged from 82 to 583 basis points. So figuring out which spread is correct is less than obvious, even if it is observable (still Level-2).

4. Mark to model. It is often easier and better to choose an observable rate even if it is imprecise than it is to try to come up with a theoretical rate that would be closer to “reality.” When the observable rates are lower than the would-be rates (see above), it is a no-brainer because using the lower rate will produce a better “result.” In other cases however, when the markets dry up or supply and demand are out of sync, the observable input may be very detrimental, i.e., implying a much wider spread. The FASB and the SEC have made it clear that when there are such “off-market” bids, they cannot just be ignored.

Potential Complications: The Asset/Liability Flip Flop

Last but not least, applying one’s own credit “discount rate” in calculating the fair value of derivatives may produce counter-intuitive results, particularly for companies with wider credit spreads – which in these days is a very common issue, even for banks.  Here is how it works: Typically long-term swaps (pay fixed/receive variable) begin their life-cycle at zero fair value (the fixed rate paid is equal to the market expectation of the variable rate received). In an upward sloping yield curve environment, the initial anticipated cash outflows on the swap are offset by future anticipated inflows. This suggests that when applying a discount rate to the entire instrument, both near-term and long-term cash flows, the value of the longer-term cash flows (positive) can turn an instrument with zero fair value into a liability. In future periods, market-valued assets could be discounted into liabilities. Discounting might actually increase an assets value.

This outcome is problematic. Until recently , the pricing of the swap this way would be “off market” since historically the market did not discount all future cash flows at a discount rate plus the discount rate based on the company’s credit standing. However, more recently, companies attempting to monetize their gains (perhaps to reduce counterparty exposure) have been quoted “credit-discounted” values. Interestingly, banks attempting to reduce their credit exposures to corporations have offered to settle the derivatives at a discount.

Disclosure, Disclosure, Disclosure

Regardless of how management decides to handle the issue of selecting a model and choosing a rate that captures the company’s “own credit” risk, there is one critical step all companies must take: they should disclose what model and what rate they are using in calculating the fair value of derivatives and explain why they chose it.  Providing a full and detailed description of the company’s choice is the best antidote to challenges from audit firms or others.