Beginner's guide to hedge accounting

Risk management and derivative accounting

Financial derivatives are a complex subject made even more challenging when you introduce the complexity of accounting for them. Although hedge accounting is not required for hedging, many organizations, especially public companies, choose to apply hedge accounting to align the economics and the financial reporting objectives for financial derivatives.

According to the hedge accounting standards, three broad types of hedges qualify for hedge accounting:

• Fair Value Hedge: Gain/loss on the derivative is offset by the gain/loss on the hedged item for changes in the hedged risk (both marked through earnings)
• Net Investment Hedge: Hedge of FX risk associated with a subsidiary with a different functional currency than that of the parent company; gains and losses are reported consistent with cumulative translation adjustments in other comprehensive income as a separate component of stockholder’s equity.

• Cash Flow Hedge: Gain/loss on the derivative is recognized in OCI and reclassified into earnings in the periods during which the hedged transactions impact earnings. This is the most common type of hedging employed by corporations.

Common hedging products

To understand the application, consider some common financial risk management products corporations use to lock in prices.

Interest rate swaps synthetically convert floating rate debt to a fixed rate. The borrower pays a fixed swap rate to the swap provider in exchange for a floating rate (i.e. 1-month LIBOR). The floating rate received from the swap provider cancels out the floating rate paid on loan, so the borrower is left paying just the fixed swap rate — an agreed-upon rate based on expectations of LIBOR.

FX Forward contracts allow two parties to exchange foreign currencies on a pre-defined future date at a pre-defined exchange rate.

Commodity futures are like forward contracts, except they are traded on an exchange rather than over the counter and marked to market daily, causing cash collateral to change hands during the lifetime of the contract.

Why elect hedge accounting?

Companies are not required to apply hedge accounting to account for their derivatives. In fact, hedge accounting is known as a “special election” and you must jump through some hoops to achieve it. So why bother adhering to these stringent guidelines? Generally, it comes down to aligning the organization’s economic and financial reporting objectives.

In the below example, a company needs to hedge its projected foreign revenue for the next 12 months. The company would execute a series of twelve FX forwards, one for each month’s revenue. As time passes, these forward contracts will change in their mark-to-market (MTM) values, as any derivative would. By default, the changes in MTM would flow through the income statement as gains or losses. This is no different from how one would account for other financial instruments on a company’s books whose values are fluctuating. Without hedge accounting, all fluctuations in derivatives’ values will flow straight into the income statement.

These swings impact the income statement, showing volatility that does not reflect the economic benefit of the hedge. This happens because the changes in MTM for all twelve forwards will affect the income statement at the same time. However, to align financial reporting with the economic objectives, the January forward should only impact January earnings, the February forward should only impact February earnings, and so on. This timing alignment can only be achieved with hedge accounting. Without hedge accounting, all fluctuations in derivatives’ values will flow straight into the income statement. With the election of hedge accounting, the changes in MTM of a cash flow hedge are stored on the balance sheet (within the equity section), specifically in Other Comprehensive Income (OCI), until the hedged transaction impacts earnings.

When the hedged item comes into play (i.e. the June revenue is finally recognized in June), then the stored up MTM changes for that June hedge will be released from OCI and into the income statement. Hedge accounting enables OCI to effectively store MTM changes until the timing of the hedge and hedged item finally align.

How do you elect and apply hedge accounting?

Hedge accounting is a special election and entails significant requirements, both at the onset of a hedging program and in the ongoing maintenance mode.

Your organization must meet each of the below criteria at the onset of a hedging relationship.

Formal documentation

Because hedge accounting is a special election, you can’t just verbally say you are applying it or imply that you have elected it just by having commercial risk. You must formally document this election at the onset of the hedging relationship. This is accomplished via a hedge designation memo (HDM).

Forecasted transactions

If you are hedging a forecasted cash flow, such as floating interest payments, foreign revenue, or expenses, the forecasted transaction must be highly probable.

For example, suppose you are in the business of selling snowblowers. If you hedge €100 million of foreign revenue you are forecasting for the next winter, and the revenue doesn’t actually materialize (maybe demand for snowblowers isn’t as high as you expected), then you essentially missed your forecast.

You never want to be caught in a situation where you are over-hedging because of missed forecasts. If you have any inkling that some portion of the €100 million of forecasted revenue isn’t likely to occur, you should only hedge the portion that is highly probable to occur. For this reason, many companies choose to layer on hedges over time. This enables them to hedge a bit more strategically and allows them to adjust as the forecast changes.

Effectiveness assessments

To qualify for hedge accounting, the hedge must also be highly effective. Of course, treasury teams want hedges that effectively mitigate the underlying risks. However, as much as we try to design hedges that closely match the underlying risks, some slippages or imperfections may occur. That’s why the FASB wanted to make sure whoever applies hedge accounting conscientiously designs a hedge that is as effective as possible. They set a high bar so that organizations don’t apply hedge accounting to poor hedging strategies. For a hedging relationship to be highly effective, the changes in value attributed to the hedged risk should offset the changes in value of the hedge within stated limits. Practice has dictated that highly effective is defined as 80% to 125% effective.

Frequency of assessment

Effectiveness must be assessed at inception of the hedging relationship and at least quarterly or every time the company issues financial statements. The accounting standards do not dictate what method you use to prove effectiveness prospectively and retrospectively. The choice of method depends on the nature of risk and type of hedge you have structured. However, the method must be formally documented at inception of the hedge relationship and applied consistently to all similar hedges, unless another method is justified.

Impact to reported earnings

This requirement seems obvious for cash flow hedges. However, as you peel away the layers of the hedge accounting onion, you realize this rule is an important guidepost.

For example, suppose you are a USD biotech firm with significant operations and intellectual property in Europe. The USD parent company receives dividends from the profits in the European subsidiary in EUR each quarter. This exposes the company to the cash impact of changes in the EUR/USD exchange rate. However, dividends do not impact earnings and, therefore, cash flow hedge accounting cannot be applied to this transaction.

Consider another example where hedge accounting cannot be applied. Suppose the USD parent pays EUR to the subsidiary for the rights to license the intellectual property for distribution in U.S. markets. This is entirely an intercompany transaction that does not involve a third party and is, thus, fully eliminated on consolidation.