March 2011 Newsletter View in pdf
A Second Chance to Make a Difference in the Future of Hedge Accounting
From Helen’s Desk:
In May of last year the FASB issued an exposure draft that substantially changed accounting for financial instruments in general and significantly modified the hedge accounting requirements originally laid out in FAS133. The response to their invitation to comment was overwhelming: 2200+ comment letters were received. However, very few addressed the substantive changes to hedge accounting or more specifically the substantive changes around effectiveness testing requirements. The FASB has re-issued their invitation to comment, inviting you to compare and contrast the IASB’s November Exposure Draft with its general overhaul of derivative accounting to the FASB’s more sedate proposal. Your comments are requested by April 25, 2011. I recommend submitting them earlier given quarter end schedules and the fact that the boards are already considering the proposals. The FASB has been invited to participate in the IASB discussions on hedge accounting and both Boards have an objective of “convergence”. Interestingly, current international and domestic guidance on hedge accounting is much closer than the two proposals.
There are some fundamental differences that warrant your investigation and perhaps your comments. The few topics summarized below represent the items that we believe will be of interest to the greatest number of you. For those of you that want the full story:
IASB’s Exposure Draft – link
FASB’s Request for Comments that includes the IASB Exposure Draft – link
Amending Hedge Documentation
The FASB introduced the concept of amending hedge documentation requirements when there were changes to hedged notionals, in lieu of current dedesignation/redesignation requirements. The IASB has advanced the idea substantially by recommending that most elements of the relationship documentation can be updated prospectively without triggering a dedesignation/redesignation.
Ineffectiveness Testing
Both boards are throwing out the 80-125% litmus tests that have arisen in hedge relationship testing and accepting reasonably effective hedge relationships. The FASB is proposing requiring effectiveness tests only at inception, and only when the hedge relationship is not an obvious economic relationship (i.e. interest rate swaps hedging tire inventory). They are also eliminating the concept of perfect offset in a hedge relationship (a move toward convergence) thereby increasing the focus on measuring ineffectiveness. The IASB is proposing the elimination of “retrospective” testing, but preserving a prospective testing concept. This would tie into their prohibition on a bias in the hedge relationship ratio, and requirements to update that relationship ratio. For example, if historically an underlying responds 110% to changes in rates, then the ratio of hedgednotional to derivative notional in the hedge relationship would be 110/100.
Cash Flow Ineffectiveness
FASB is proposing recording ineffectiveness for both over and underperformance of the hedge. This rule is probably designed to offset the abuse of hedge relationship ratios, because there is no existing or proposed prohibition on a bias in a hedge relationship. Under the current rules where ineffectiveness reflects over-performance of the derivative without the bias restraint proposed by the IASB, I believe the FASB’s intent was to contain the abuse of the hedge relationship ratio by recording ineffectiveness from both over and underperformance.
Bifurcation of Risk
The IASB is proposing that any component risk may be designated as a hedged item to the degree that the component is “separately identifiable and reliably measured”. This would substantially increase commodity hedging opportunities for many companies. The hedged item would be the commodity price component or adder. Other irrelevant moving parts would not need to be considered within the hedge relationship. On the financial instrument side entities with Prime exposure would be able to hedge the interest rate component like a benchmark hedge. This flexibility was proposed in most letters to the FASB even though the FASB had not commented on bifurcation of risk.
No Voluntary Dedesignation
Once a hedge relationship between a derivative and an exposure is created both Boards are proposing that relationship is to be constant until either the exposure or derivative were terminated. FASB is even requiring the “designation” of a compensating contract. The IASB also offered termination of the relationship as a result of a change in “hedge objective”
Option Premiums
Both boards are offering new solutions for option premiums. IASB has indicated the time value will remain outside of the hedge relationship, but will be either amortized to income (when hedging existing assets or liabilities) or reclassified to income with the hedged item (when hedging anticipated transactions).
The proposals from both boards are clearly designed to stop all the “failing effectiveness” and restatement pain. They seem to be focused on simplifying hedge accounting and improving compliance. We hope they can achieve these objectives and we encourage you to participate in the process by commenting on the proposals. We would be happy to serve as a sounding board or review comments you are proposing at no charge.
Foreign Currency Impact on the Cash Flow Statement
Recently a few clients have contacted us to assist in responding to auditor requests related to the impact of foreign currency and exchange rates on the Statement of Cash Flows. Per ASC 830 (formerly FAS 52) this is a separately reported line on the reconciliation of beginning and ending balances of cash and cash equivalents in the statement of cash flows and represents the effect of exchange rate changes on cash held in foreign currencies. For companies with multiple entities and numerous currencies transacted, this can be a complex number to analyze at the consolidated level. Therefore, we recommend preparing separate cash flow statements for each reporting entity, in that entity’s functional currency, and then translating each functional currency cash flow statement to the reporting currency. At that point each entity’s cash flow statement in reporting currency can be consolidated to form a total company cash flow statement.
By preparing a cash flow statement for each entity the company will be able to understand which currencies are most heavily impacting cash and cash equivalents and why. A write up at quarter end can then be produced to explain the primary drivers of this number. An example of a consolidating statement of cash flows with foreign subsidiaries can be found ASC 830-230-55 (Implementation Guidance and Illustrations).
Considerations for Interest Rate Hedgers (Cash Flow)
A common interest rate hedging strategy is converting LIBOR-indexed variable rate debt to fixed rate debt using an interest rate swap, or protecting interest expense through entering into a costless collar or purchasing an interest rate cap. If cash flow hedge accounting of benchmark interest rate risk (LIBOR) is elected, consideration should be given to the index driving the variable rate debt vs. the contractual variable index in the hedging derivative. Ideally, the tenor of the variable rate index in the debt (e.g. 3M LIBOR) matches that of the derivative, as well as the dates on which the variable rate index change (e.g. both debt and derivative reset at calendar quarter ends). Reset date differences on the debt and the hedging derivative will typically cause only minor hedge ineffectiveness, if the LIBOR tenors of hedged debt and derivative are the same. Tenor differences on the debt’s and derivative’s variable rate indices will typically cause more hedge ineffectiveness (e.g. if 1M LIBOR or 6M LIBOR debt is hedged with a 3M LIBOR swap).
In addition, interest rate hedgers should consider whether their variable-rate borrowing arrangements allow for flexibility in the choice of the LIBOR tenor (1, 3, 6 month), and whether or not they would like to utilize those options and change the tenor of the index once the debt has been hedged. Typically, preserving that flexibility on the hedged debt involves increased administration in terms of hedge effectiveness assessment and documentation. In addition, whenever possible, hedging relationships should be designated as of the trade date of the derivative, as designations subsequent to that date may produce additional hedge ineffectiveness, due to the derivative’s value being off-market at the point of designation.
Corporate’s Increased Interest in Commodity Hedging – Opportunities and Difficulties
In today’s volatile and changing global economy, corporate interest in commodity price risk management is increasing. Almost every commodity has seen price increases, and many corporations want to protect themselves from these volatile price movements. However, the decision to hedge can be dependent upon factors beyond the economics of the transaction. The difficulties lie in the qualification for hedge accounting treatment of the derivative. Many factors need to be considered, but the fact that commodity hedgers can only hedge the overall price risk (of the physical purchase or sale to the delivered location) is by far the largest hurdle. An often consideration in the testing is the “likeness” of the pool of transactions hedged, if delivered to/from varying locations. The corporation must have access to historical data in order to establish the effectiveness of the hedging relationship.
For those who are thinking of getting started: Kick things off by talking to procurement, understand how many suppliers are used and how the prices are determined under suchsupplier agreements. The next hurdle is finding the derivative instrument that will best match the exposure you need to hedge.
Is your price determined based on spot, average or prior month average index pricing? You may need to look beyond what is obvious and ensure that your derivativeinstrument is the best match, possibly considering a combination of derivatives to get thebest price match (for instance, a combination of an indexed future contract with a location basis swap). While getting started might seem daunting, there are opportunities to qualify for special hedge accounting when hedging commodity price risk.
A little extra effort and data capture may be required, but you can protect the economics and achieve the accounting presentation that matches the transaction timing.
Acappella Users Corner
Rolling contracts is a common practice – either due to changes in forecast or as part of a structured rolling program. This can create accounting complexities for designated hedges. First, new documentation must be prepared for the rolled-to contract, even though it is essentially a continuation of the previous hedge relationship. Also, when the contract is rolled forward, any OCI related to the original contract must be tracked and released to earnings when the hedged item occurs, along with any OCI related to the new contract. This can be especially complex when a contract is rolled multiple times, partially rolled or is rolled into multiple contracts. Hedge Trackers’ hedge accounting software, AcappellaFX, is a simple solution for tracking rolled trades. When you roll a trade in AcappellaFX, the system tracks the OCI balance associated with prior trades associated with prior trades until the last rolled trade is completely triggered and released. The system also creates all required hedge inception documentation, continuing the original hedge relationship, for the new contract.
Tip/Trick:
- For a partial roll, you can split the trade in the exposure window prior to rolling it or simply change the “Roll Amount” directly in the roll screen.
- Also, you can change the “Roll to Date” in the “Select Exposures To Be Rolled” pop-up box. If you have exposures/trades with more than one “Roll to Date” the system will bifurcate the original trade into two separate trades and roll each with its own forward trade and compensating trade.
Hedge Trackers Announces Strategic Partnership with SunGard
SunGard AvantGard and Hedge Trackers are excited to announce that they have entered into a referral partnership in order to strengthen the hedge accounting offerings provided by SunGard. This strategic partnership will help organizations that are clients of SunGard AvantGard leverage Hedge Trackers proven services for derivative accounting software and outsourced derivative accounting.
SunGard AvantGard is the market leader in supplying Treasury, Receivables and Payment solutions to the Corporate Marketplace.
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