Know Your Options: Amended derivative accounting affords benefits for forward and option hedgers

 

Publication: AFP Exchange Fall 2018

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Whenever new or amended accounting guidance comes along, the new rules may justify rethinking business strategies. A case in point arises in response to the amended guidance for derivatives and hedging transactions, ASU 2017-12. Though released in August of last year with implementation not mandated until after 2018, early adoption of the guidance is permitted and easy to institute; and early adoption may create some attractive consequences for companies that use derivatives (or contemplate using them) in connection with managing interest rate risk, currency exchange rate risk, or risks associated with commodity purchases or sales.

 

The new opportunities that this article addresses derive from the revised treatment relating forward points and option time values. These rules have wide applicability to virtually any hedging entity that uses forwards, futures or options in their hedging programs.

 

 

Background

 

When hedgers use futures or forward contracts, the typical economic objective would be to lock in a price or rate relating to a future transaction, where, otherwise, the price would be uncertain. The accounting requirements for hedge accounting, however, reflect somewhat of a different orientation:  Rather than considering effectiveness on the basis of satisfying this economic objective, the prerequisites for hedge accounting require that derivative gains or losses must closely offset the earnings impacts of the risks being hedged. In fact, these two objectives are different. Locking in a price isn’t necessarily the same thing as offsetting a given exposure.

 

The following example illustrates the issue: Suppose a company needs to buy widgets in the future.  Assume today’s spot price for widgets is $100 and the forward price (appropriate for the intended purchase date) is $110. If the purchase occurs as expected, buying the forward contract would lock in an effective price of $110, irrespective of where the spot price for widgets happens to go.  Two caveats: (1) the forward contract terminates at its maturity when the then-prevailing forward price will necessarily converge to the spot price, and (2) the risk being hedged bears no basis risk (i.e., the deliverable asset underlying the forward contract is identical to the source of the exposure.)

 

Scenario 1 – Widget prices rise to $125: In this case, the widget buyer pays the market price, $125, to buy the physical widgets from the supplier, but the forward contract price rises from $110 to $125 for an offsetting gain of $15. Combining these effects yields an effective price of $110 (= $125 - $15) for the widgets.

Scenario 2 – Widget prices fall to $75:  Again, the widget buyer pays the market price—this time $75—but this time, the forward price falls from $110 to $75 for a loss of $35. Combining the purchase price of $75 with the loss of $35 again yields the same effective price of S110 (= $75+ $35).

It should be clear that the same effective price will be realized under any price scenario, subject, again, to the two previously stated caveats.

 

The problem for financial reporters is that the “offsets” that FASB seems to be requiring aren’t satisfied. The change in the spot rates (i.e., the risk being hedged) is $25 in both scenarios shown, but the hedge results are $15 and $35, respectively. Both ratios ($15/$25 and $35/$25) fall considerably outside the traditional 80 percent to 125 percent boundary conditions required to authorize hedge accounting.

 

FASB squares this circle with a band-aid that permits forward points to be excluded from the assessment of hedge effectiveness. Excluding the starting forward points (valued at $10) from the forward contract allows us to view the derivative’s gain or loss as being $25 in both scenarios—precisely equal to the spot price change. With this perspective, we can now assert that the hedge offset is “perfect.” It’s perfect, however, only because of a semantic election that allows us to assert that the derivative is offsetting a particular risk exposure, even when it really isn’t.

 

An analogous pair of examples could be constructed for an option hedge. In these cases, though, the unequal offsets derive from option time values rather than forward points. Thus, if the option and the exposure share the same underlying spot prices, the allowance to exclude option time values again allows us to conclude that such hedges could be perfect in an accounting sense.

 

One critical difference between a forward hedge and a purchased option hedge is that with forward hedges, the forward points could be either beneficial or adverse, depending on whether the entity is buying the forward or selling it and whether the forward price is at a discount to the spot price or at a premium.

  • Buying a forward at a premium is adverse in that the hedge serves to raise ex post purchase prices.

  • Buying a forward at a discount is beneficial in that the hedge serves to lower ex post purchase prices.

  • Selling a forward at a premium is beneficial in that the hedge serves to raise the effective sales prices.

  • Selling a forward at a discount is adverse in that the hedge serves to lower the ex post sales prices.

The notion that it’s expensive to hedge with forward contracts is patently wrong in half of the possible applications! In those cases, the market effectively pays the hedging entity to lock in a price. It’s different for purchased option hedges. With a purchased option hedge, the hedger realizes (or should) that the decay of the option’s time value will always foster explicit costs independent from any value changes relating to the risks being hedged. 

 

What’s new?

 

Two things relevant to forward hedges and purchased option hedges have changed in the amended guidance. 

 

First is the allowance to define “component hedges” in connection with commodity exposures. Critically, in order to hedge a component of a commodity price risk, that component must be explicitly identified in the purchase or sale order. Thus, if you are able to structure purchase or sales contracts tied to the same underlying price referenced by the hedging derivative, the new guidance allows us to consider this hedge to be “perfect.” Without this liberalization, many entities that have tried to hedge the full price risk of commodity exposures—which is the legacy requirement for commodity hedges—have found the variability of the basis implicit in those commodity prices to be so excessive as to rule out hedge accounting altogether. Those proscriptions could be substantially curtailed; but, as mentioned above, qualifying for this new treatment requires contractually setting these commodity prices in a manner that specifically ties them, formulaically, to the underlying price variable specified in the hedging derivative.

 

The second issue has to do with the accounting treatment for items that have been excluded from the assessment of hedge effectiveness – i.e., forward points and option time values. Under the prior guidance, if those items were explicitly identified as being excluded from the assessment of hedge effectiveness—which often was the only way to assure that hedge accounting wouldn’t be prematurely terminated—changes in market values of those excluded elements would be reported in current earnings. This treatment necessarily fosters some degree of unintended and undesirable earnings volatility. For forward hedges, this effect would generally be slight, as forward point amounts are typically inconsequential. For option hedges, on the other hand, the size of the excluded items’ earnings effects could be much more substantial.

 

The big accounting rule change in this area is that rather than realizing these effects on a market basis throughout the holding period of the derivative, reporting entities are now free to report these effects in earnings during the horizon of the hedge, on any “rational” basis. That means that companies will now be able to allocate these effects linearly, smoothing out some measure of income volatility. 

 

Hedging anticipated debt issuances

 

As attractive as this new ratable method may be, in certain cases, it might be preferable to avoid this treatment and apply an alternative method for some cash flow hedges with options. Specifically, in certain cases, FASB allows hedgers to defer earnings recognition of time value effects if the terminal value method is used for assessing hedge effectiveness. If the entity qualifies for and applies this treatment, the full gain or loss of the derivative would be posted to other comprehensive income, with reclassification of those effects, in certain cases,  over a period well beyond the date the hedge terminates.

 

One of the most attractive situations for this treatment applies to hedges for anticipated issuance of debt. Consider, for example, the case of a company that intended to issue five-year fixed-rate, say, in the next four months. Here, the company would be exposed to the risk of rising interest rates between now and the issue date. While the most popular hedge for this exposure would likely be a forward starting swap, a swaption might be a particularly interesting alternative.

 

In this context, a swaption is simply an option to enter into a pay-fixed/receive-variable swap contract. It would serve to assure that the effective funding costs be limited to some worst-case (maximum) fixed interest rate, dictated by the swaption’s strike price. Although the entity may elect to exclude the swaption’s time value and realize this cost during the period preceding the funding, a more appropriate choice would be to apply the terminal value method for assessing hedge effectiveness, in which case the full gain or loss of the swaption would initially be recorded in OCI, but the reclassification process would occur over the entire funding horizon. Spreading these costs over the longer period (via the terminal value method), as opposed to the shorter period (via the time value exclusion method) would likely make this strategy much more palatable.

 

Conclusion

 

As a rule, economic considerations should drive the decision to hedge—or how much to hedge—but accounting considerations inevitably come into play because of the way the hedging activity is reflected on financial statements. The most recent changes allow many hedging situations to show lower income volatility than the presentation dictated by the pre-amendment rules. These changes would likely be seen as resulting in an earnings presentation that more closely reflected the intended economics of the hedging activity than that which arose under the pre-amended guidance. The changes should also motivate many who may have shied away from hedging with derivatives (or hedging with particular types of derivatives) to give those situations a second look.

 

Key Takeaways

 

Early adoption of the amended guidance for derivatives and hedging transactions may create some attractive consequences for companies that use derivatives.

 

The amended guidance allows for "component hedging" in connection with commodity exposures.

 

Rather than realizing "excluded items" in earning on a market basis, entities are now free to report these effects in earnings uring the horizon of the hedge, on any rational basis.

 

 

 

 

 

Ira Kawaller

Managing Director

ikawaller@hedgestar.com

718-938-7812

 

 

 

 

 

 

 

 

 

 

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