Minimize Earning's Volatility with Hedge Accounting
By: John Trefethen, Director & Co-Founder
Shareholders, owners and executives like their earnings smooth and go to great lengths to achieve steady earnings that grow quarter-over-quarter. However, one strategy for eliminating earnings volatility that is often underutilized is hedge accounting. If a company has an active hedging program and does not apply hedge accounting, the quarterly gains and losses of its hedges are reflected in earnings. When hedge accounting is used and an entity is able to prove that the hedge and hedged items are correlated, changes in value of the hedging instrument are then not isolated in earnings.
Benefits of Limited Earnings Volatility
Enterprise Value – Risk management theory argues that shareholders are better off with smooth earnings. Public companies are generally sensitive to earnings volatility because it is negatively valued by investors. The same theory holds for private companies, and perhaps even more impactful. A common technique used by investors to value a company is to discount projected future earnings. Companies that year-over-year have inconsistent earnings are generally valued at a lesser value than their peers. As an example, the CEO of Conoco justified his company’s pending merger with Phillips Petroleum in part by asserting that the deal would provide greater earnings stability throughout the commodity price cycle. He argued that this would enhance value for Conoco shareholders.
Executive Compensation – For senior leaders in a company, it is not unusual for 60-80% of their pay to be tied to company performance – often by quarterly earnings. Earnings that are impacted by events that are not related to normal operations, such as periodic gains and losses on hedging activity, can cause unintended results in compensation. Smoothing out earnings by removing non-operating activity such as hedging ensures that compensation is being driven by activities that are central to a company’s operations.
Credit Relationships – At the core of any credit relationship is the principal that lending institutions extend credit to companies based on the credit worthiness of the company. Credit worthiness is assessed through many factors including a company’s future earnings predictability and the likelihood that the company will be able to service the debt period-over-period for the life of the loan. Much like what was explained in the executive compensation section, earnings that are impacted by events that are not related to normal operations, such as periodic gains and losses from hedging activity, can lessen the predictability of future earnings from the lender’s perspective and influence their lending decisions.
Using derivatives to manage a company’s exposure to different risks (i.e. interest rate risk, foreign exchange risk, commodity risk, etc.) is a common risk management technique used by many companies. Using hedge accounting to account for the derivatives can remove from earnings the impact of changes in value on the derivative and help minimize earnings volatility. As long as measurable correlation between the hedging instrument and the hedged item exists, a company is able to take advantage of the benefits available with hedge accounting. The accounting standard that an entity follows determines the nuances of hedge accounting that must be met and followed. The most common standards are ASC 815 for FASB reporting entities and IAS 39 / IFRS 9 for entities that report under the international standards.
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