Should hedge accounting be outsourced?
By: John Trefethen, Director & Co-Founder
Hedge accounting is currently a leading cause of restatements of financial statements. The cost of a restatement, as well as the resulting headache, can be minimized if proper consideration is given to accounting when entering into a new derivative. Among the things to consider is whether to keep the hedge accounting function in house, or outsourced to a hedge accounting specialist. This article will explain what to consider when making this decision. For simplicity, the terms hedge accounting and derivative accounting, as well as derivative and hedge, will be used interchangeably.
According to statistics published by the International Swaps and Derivatives Association (ISDA), every day nearly $1 trillion of derivatives are traded. Much of this trading activity is by companies that use derivatives to hedge risks inherent to their business. Risks that are hedged can include a company’s exposure to volatility in interest rates, foreign currencies and raw material prices. After entering into a derivative, companies will often elect to apply hedge accounting (as permitted under ASC 815) in an effort to minimize earnings volatility from changes in value of the derivative. There are many things a company must consider when entering into a hedge. Considerations for the hedge include: the type (i.e. swaps, futures, options, etc.), the terms, the derivative provider, necessary documentation and governance, internal and board training, among other things.
One item that is often not fully considered until after the hedge is executed is the accounting implications of the derivative. Accounting should be part of the hedge planning process, prior to execution, for the following reasons:
To understand and demonstrate a derivative’s potential impact on earnings.
To analyze the effectiveness of the hedge from a hedge accounting perspective.
To provide input on the type and structure of hedge that will minimize or eliminate earnings volatility.
To prepare for the unique testing and reporting requirements which exist when applying hedge accounting.
When considering the accounting needs for a hedge, a company should consider the following items and determine how they will be addressed.
Hedge Accounting Capabilities
Without question, the most important consideration when reviewing hedge accounting options is capability of the company and/or capability of a third party provider. If a company has limited or no capabilities working with hedge accounting, then there is no need to consider an in house option. In this instance, it is clear that an outsourced provider should be used.
If the decision is made to use a third party hedge accounting provider, the company should consider the following when evaluating potential providers:
The provider’s experience with the risk being hedged.
The system used by the provider to perform the necessary calculations (hedge accounting software versus spreadsheets).
The provider’s source of market data used in the hedge accounting process.
If CPA’s with knowledge relevant to the hedge accounting rules are performing the work.
If the provider has robust internal controls that are vetted by an independent third party (i.e. a current SOC 1).
If a company does have the necessary internal capabilities to do hedge accounting on their own, they should validate their capabilities based on the criteria above. They should compare their capabilities to those of outsourced providers, to determine if the best option for the company is to keep the work in house, or have it outsourced.
Most companies have a short amount of time to close their books at the end of their fiscal quarter/year. Companies will need to determine their ability to consistently meet this recurring deadline. Where this gets challenging is in the fact that hedge accounting is generally a quarterly requirement. Those at the company responsible for hedge accounting have two challenges:
Being that they perform these tasks just four times per year (assuming quarterly reporting), they are often relearning aspects of hedge accounting each quarter because of hedge accounting’s uniqueness – and the fact that these are tasks they just simply don’t perform in their other functions. Having to relearn aspects of hedge accounting each quarter is clearly inefficient, and can lead to challenges in completing the tasks on time.
Those responsible for hedge accounting have other tasks they regularly perform throughout the year. Those tasks generally do not go away - and often intensify - when quarter end arrives. This can make completing hedge accounting, in a timely manner, challenging.
As stated at the beginning of this article, hedge accounting is a leading source of restating financial statements. This is embarrassing, costly, and potentially career damaging. The risk of a restatement increases if spreadsheets, or other internally developed processes, are used. The risk of a restatement also increases when the people completing the work are not sufficiently experienced. Putting this risk on a third party does not absolve the company. However, it can minimize some of the damage, including potentially putting the cost of a restatement on the third party provider. Finding a provider with an industry recognized hedge accounting system, as well as seasoned CPAs, is the best way to minimize this risk.
Assuming a company recognizes that generating hedge accounting reports on spreadsheets is not optimal, they will need to determine how to access a system developed specifically for hedge accounting. They can purchase their own system, or retain a third party that has a system. Without a significant number of derivatives that utilize hedge accounting, it will not be cost effective for a company to purchase hedge accounting specific software. Outsourced hedge accounting providers that have systems specific to hedge accounting are able to spread the system’s cost across many clients. This has the effect of lowering the “system cost” for each client of the hedge accounting provider.
Budget constraints must always be considered when choosing a hedge accounting solution. The hard dollar costs are relatively easy to evaluate – the internal cost of employee’s time combined with the cost of systems and data, compared to the cost of an outsourced provider. What also needs to be considered are soft dollar costs. For the companies those costs include:
The opportunity cost of having individuals working on hedge accounting once per quarter versus other tasks
The cost of the risk assumed by completing the work internally on systems that are not optimal, or by individuals that are not sufficiently well-versed in hedge accounting
From a third party cost perspective, as long as the third party is experienced, and using a system designed specifically for hedge accounting, there should be fixed costs only – no soft dollar costs.
Designing and running a hedging program is complex. The accounting related to derivatives adds to this complexity. A company should carefully consider all accounting options to be sure they use the option that introduces the least risk to the company, and overall is in their best interest.
Director / Co-Founder