Accounting Considerations When Hedging
By: John Trefethen, Director & Co-Founder
Companies commonly choose to enhance certainty in future commodity prices, interest rates and currency exchange rates through hedging. Hedging is often accomplished with financial products such as swaps, options and futures, commonly referred to as derivatives. When a company chooses to hedge, it must also decide how to account for the derivatives. Two accounting options exist for hedgers:
Standard Derivative Accounting
Hedge Accounting
Standard Derivative Accounting
Under standard derivative accounting, an entity is required to measure derivative instruments at fair value, with changes in fair value recognized through the income statement. Fair value is the price that would be received to sell a derivative that is an asset, or paid to transfer a derivative that is a liability, in an orderly transaction between market participants - on the measurement date. Non-performance risk or the risk that an obligation will not be fulfilled, also known as counterparty credit risk, is required to be considered when determining the fair value. While the definitions may differ slightly, the concept is largely the same under U.S. and international accounting standards.
Fair value is driven heavily by 1) systematic risk, or market variability, and 2) the specific risk(s) of the entities involved in the transaction. Thus, fair value is subject to meaningful changes between measurement dates. These swings in value represent period-over-period changes in gain/loss on the derivative.
Accounting for derivatives in this manner creates a common issue for organizations. By recording the derivative at fair value each reporting period, the entity often introduces volatility to its financial statements, particularly to its earnings. This issue can often be minimized or eliminated when applying hedge accounting.
Hedge Accounting
The concept of hedge accounting addresses the accounting treatment of the change in gain/loss resulting from the remeasurement of a derivative’s fair value. At a high level, hedge accounting allows an entity to record the gain/loss on the hedge(s) as an offset to the hedged item(s) in the same accounting period(s). Hedges that qualify for hedge accounting fall into one of three categories:
Fair Value Hedge
Cash Flow Hedge
Net Investment Hedge
Fair Value Hedge
A fair value hedge is used when an organization seeks to reduce or eliminate exposure that comes from changes in the fair value of an asset or liability due to changes in an underlying risk. In this type of hedge relationship, the hedged item is permitted to be measured at fair value. Any resulting adjustment to the fair value of the hedged item [related to the hedged risk] is reported in the income statement and will be largely or entirely offset by adjustments in the fair value of the derivative, effectively minimizing or eliminating volatility in the income statement that would have resulted from the derivative.
Cash Flow Hedge
A cash flow hedge is used when an organization seeks to reduce exposure that comes from changes in cash flows of an asset or liability due to changes in an underlying risk. Variability in the hedged cash flows can arise from changes in underlying commodity prices, interest rates or currency amounts. As long as the hedge relationship is deemed to be highly effective (described below), gains/losses from the change in fair value of the derivative are deferred into other comprehensive income (OCI) and presented within equity.
Net Investment Hedge
A net investment hedge is a specific type of hedge of foreign currency cash flows that are used to minimize or eliminate an entity’s exposure to foreign currency resulting from an entity’s net investment in a foreign operation (NIFO). A NIFO may represent an entity’s interest in a foreign subsidiary, branch, department or equity method investment. Each period when the NIFO is consolidated into the parent organization’s financial statement, a foreign currency gain or loss is recognized in shareholder’s equity. A net investment hedge can be used to minimize or eliminate volatility in shareholder’s equity. When a hedging instrument is used in this manner, the change in fair value of the hedging instrument is recorded in equity.
Qualifying for Hedge Accounting
To qualify for hedge accounting an entity must complete the following items:
Hedge Documentation
Hedge Effectiveness Testing
Hedge Documentation
Formal documentation of the hedge relationship needs to exist that details, at a minimum, the following:
the risk management objective and strategy for entering into the hedge;
the nature of the risk being hedged;
a clear description of the hedge instrument and hedged item; and
the methods used to test the effectiveness of the hedge relationship.
Hedge Effectiveness Testing
Hedge effectiveness testing proves that changes in fair value or cash flows from the hedge instrument will be highly effective at offsetting changes in fair value or cash flows from the hedged item. This is often performed with statistical analysis such as a regression test. If the analysis shows significant correlation, the relationship can be considered highly effective and would qualify for hedge accounting.
Hedge Accounting Standard Update
In August 2017, FASB issued an accounting standards update (ASU) that simplified hedge accounting and expanded the hedging strategies that qualify for hedge accounting. Included in the ASU was an elimination of the concept of measuring ineffectiveness. Historically, an entity would record the ineffective portion, or “earnings bleed,” from a hedge relationship. Ineffectiveness was determined by recording in equity the lesser of the value of the derivative or the hedged item; if the hedged item’s value was the lesser of the two, the difference between the derivative and hedged item values was recorded immediately in earnings. An entity no longer needs to distinguish and report on effective and ineffective portions of a hedge relationship.
Another meaningful change is the expansion of strategies that will qualify for hedge accounting under the ASU. They include:
Hedging contractually specified price components of a commodity purchase or sale.
Hedges of the benchmark rate component of contractual coupon cash flows of fixed-rate assets or liabilities.
Hedges of the portion of a closed portfolio of prepayable assets not expected to be prepaid.
Partial term hedges of fixed-rate assets or liabilities.
Summary
Using derivatives to hedge price, interest rate and foreign currency exchange risk can be a prudent and cost-effective way for entities to mitigate their risk exposures. However, under current accounting standards, using derivatives can introduce volatility in an entity’s income statement. If an entity is going to use derivatives for hedging purposes, they should consider applying hedge accounting to manage that volatility.
John Trefethen
952-746-6040