All other things being equal, shareholders, owners and executives like earnings to be predictable and smooth. They go to great lengths to achieve steady earnings that grow quarter-over-quarter. One strategy for eliminating earnings volatility that is too often underutilized is hedge accounting. Hedge accounting is a specific form of accounting for derivatives that a company can elect to apply if they qualify. If a company uses derivatives to manage risk associated with commodity prices, interest rates or foreign currency exchange and does not apply hedge accounting, then the quarterly gains and losses of the derivatives are recorded in earnings. When hedge accounting is used and an entity is able to prove that the derivative and hedged items are correlated, changes in value of the derivative are then not isolated in earnings.
Benefits of Limited Earnings Volatility
Enterprise Value – Risk management theory argues that shareholders are better off with predictable and 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 is 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 with steady earnings. 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 various financial risks (i.e. interest rate risk, foreign exchange risk, commodity price risk, etc.) is a common risk management technique used by many companies. Using hedge accounting to account for the derivatives can remove the impact of changes in the value of the derivative from earnings, and help minimize earnings volatility. As long as measurable correlation between the derivative and the hedged item exists, a company is able to take advantage of the earnings benefits available from 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 IFRS 9 for entities that report under international standards.
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