Hedge accounting has long been known for its complexity. Because of this complexity, hedging strategies haven’t been widely used. That could change with the new hedge accounting rules issued by the Financial Accounting Standards Board last summer, which aim to make hedging more “accessible” and “popular” among potential corporate adopters.
Under the new hedging rules, companies will have the ability to hedge contractually specified components of the price of forecasted purchases and sales of nonfinancial assets. The new guidance also adds to the previous allowable exclusions and changes the recognition of excluded components. Companies now have an option to use either a mark-to-market approach or an amortization approach to account for excluded components.
Bloomberg Tax spoke with Bill Fellows, a Deloitte partner, and Jon Howard, a senior consultation partner with Deloitte, to further understand how the new rules simplify hedge accounting and how they will impact companies’ financial statements.
More Companies Able to Apply on a Greater Scale
Hedge accounting has always been seen as very detailed and complex. Howard said that some companies haven’t used hedging strategies at all, and some had used, but later stopped because of the rules’ complexity. In the past, “if you missed one thing, then you didn’t get hedge accounting at all,” he added.
However, because the new rule, ASU 2017-12, simplifies the application of hedge accounting, Fellows said that incrementally, there will be more companies willing to attempt the application of hedge accounting strategies. “The benefits for companies to apply the [simplified] hedging standard are [potentially] significant,” he added.
In addition, “those that apply [hedging] today may be able to apply it on a greater scale,” Howard added. For example, companies now have the option to hedge a partial-term risk. He also expects to see more commodity hedging because the rule permits a hedge of a contractually-specified price component of a forecasted purchase or the sale of a non-financial item. “Banks may apply new risk management strategies, that is because they are able to implement those strategies that they couldn’t do before,” Howard said.
A ‘Different Look’ on the Income Statement
“The new hedge accounting reduces income statement volatility,” Howard said. Companies are permitted to exclude certain elements of a derivative instrument's change in fair value from the assessment of hedge effectiveness. Historically, companies were required to use a mark-to-market approach to recognize gains or losses of excluded components every period. This requirement could have been a source of income statement volatility because the gains and losses could be inconsistent from period-to-period. Howard said that companies have been putting notes in their income statements to explain the inconsistency of the gains and losses associated with the hedged items. But, the new standard allows companies to use an amortization approach, which gives them the ability to recognize the initial value of the excluded components and amortize them using a systematic and rational method over the life of the hedging instrument. Howard added, now companies that are doing economic hedging, especially in the commodity space, don’t have to explain to analysts and investors every period that the gains and losses of the derivatives went through the income statement. They no longer have to explain the volatility.
Celgene Corporation, who early adopted the new hedging guidance, also said in its 2017 third quarter 10-Q that the company believes “the revised guidance in ASU 2017-12 better portrays the economic results of our risk management activities and hedging relationships.” Therefore, Celgene has modified the recognition model for the excluded component from a mark-to-market approach to an amortization approach for all hedges existing as of the adoption date.
How to Prepare For Adoption
In the end, the Deloitte partners cautioned companies to pay attention when calculating the impact of the new hedge accounting rules and to pay attention to how things fall through the financial statements when adopting them. “There will be system change and process change,” Fellows said. For those companies that haven’t used hedge accounting at all, Fellows said that education is very important. But overall, Fellows believes that “the new rule is much easier. The standard is about making something really complicated less complicated.”
Rely on expert practitioners for practical guidance and real-world approaches to complex accounting issues with Bloomberg BNA’s Financial Accounting Resource Center.
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