Accounting Standards Update for Hedge Accounting – A Cargill and HedgeStar Q&A
In June, the Financial Accounting Standards Board (FASB) voted to proceed with finalizing the Accounting Standards Updates (ASU) for hedging activity. The final rules are expected to be announced in the next few months. Recognizing that our customers are impacted by these changes, Cargilll Risk Management’s Andrew Brodbeck asked Tim Potter at HedgeStar, a global firm based in Minneapolis, a few questions.
Andrew Brodbeck: What do the proposed changes mean for anyone with commodities or raw materials exposure?
Tim Potter: The accounting changes provide greater hedging opportunity and flexibility. The ASU better aligns an entity’s hedging activities with its risk management objectives. Before these changes, commodity exposures might have been off-the-table for hedge accounting due to refinement, conversion and transportation costs, or even basis differences between the hedging contract and commodity purchase pricing. The ASU effectively minimizes the “noise” and allows entities to identify a specific hedged risk or the commodity itself, which will help streamline tests for hedge effectiveness and reduce earnings impacts.
Andrew Brodbeck: Could you provide your perspective on some of the key benefits of the anticipated rules?
Tim Potter: There are many benefits from the accounting changes, but there are two that are significant for entities with commodities exposure. The first relates to an entity’s ability to designate as a hedged item, any contractually specified component of a commodity purchase agreement. An entity can define the primary driver of the purchase price and avoid extraneous costs that may disrupt a tight correlation between the hedging derivative and hedged item. For example, a jet fuel purchase agreement might delineate pricing between the raw crude oil commodity, a refining margin and logistical charge for delivery. Under the new ASU, a hedger may identify only the crude oil component as the hedged item and exclude the other charges when testing effectiveness of the relationship. As a result, that hedger can manage its risk using futures or swaps to mitigate cash flow variability tied to market price changes in crude oil, without worrying about undesirable accounting consequences. Through this process, the hedger now has a hedge correlation at or near 1.00.
The other key benefit relates to the measurement of hedge ineffectiveness. Under the old accounting regime, an entity would test for hedge effectiveness and conclude the hedge is highly effective. For bookkeeping purposes, that same entity could experience earnings impact if the cumulative change in value on the hedging derivative exceeded that of the hedged item. Under the ASU, this result will not occur. If that same entity can pass the effectiveness tests, all cumulative change in value on the hedging derivative would flow through equity instead of earnings. This is an exciting concept for those entities that experience mild to significant earnings leakage despite effective hedge relationships.
Click here for the full interview on the accounting standards update for hedge accounting.
Read Tim Potter’s summary of the accounting standards update as it relates to hedge accounting, and what it specifically means for commodity hedge accounting.
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Connect with our hedge accounting manager, Tim Potter, CPA