Companies take a new look at net investment hedging after FASB standard
The new hedge accounting standard is encouraging more companies to re-evaluate how they are using net investment hedging for risk management, according to a new report from Deloitte.
Net investment hedging helps corporate treasurers minimize foreign exchange risk in their overseas investments. The value of an investment in a foreign operation can vary according to fluctuations in the exchange rate between the company’s local currency and the investor’s reporting currency. A net investment hedge is supposed to mitigate that risk.
“ASU 2017-12 was issued in 2017 as an amendment to the hedge accounting guidance,” said Andrew Hubacker, a partner in Deloitte’s audit practice involved in the firm’s accounting and reporting advisory services, who co-authored the report. “The intent of the standard was to simplify and make less complex some of the hedge accounting guidance. One of the areas that was impacted is net investment hedging.”
Deloitte has received many questions from clients about this aspect of the new standard, especially about whether to use cross-currency swaps or the spot method.
“This particular hedging strategy is not new by any means, but the amendment significantly impacted how companies apply it,” said William Fellows, a partner in Deloitte’s analytics practice and also a co-author of the report. “That was one of the major drivers for early adoption of ASU 2017-11. Now we’re past early adoption for public companies, which had to already adopt it. The private companies are still evaluating early adoption. It continues to be an area where I think there’s been a lot of interest. Many companies that adopt this strategy use the spot method. It’s actually accretive to earnings in addition to serving as a risk management tool. It’s pretty popular across the board in the corporate space.”
Even though the hedging standard already took effect for public companies, the Financial Accounting Standards Board voted last year to give private companies an extra year to adopt it, although they had the option to adopt it early (see our story). Early adoption was popular among public companies, but private companies were more hesitant. “We saw an initial wave after the issuance of the standard,” said Fellows. “For those that haven’t early adopted, that are still holdouts, I would say that for many of them the incremental benefits of early adoption aren’t clear.”
However, he sees benefits from the new standard for both public and private companies, especially when it comes to net investment hedging. “It very much relaxes some of the stringent requirements that were in ASC 815 [the earlier hedge accounting standard], so many of them may rethink as to whether or not they want to early adopt,” said Fellows.
Pick a method
There are two methods of assessing the effectiveness of a net investment hedging relationship: the forward method, which is based on changes in forward exchange rates, and the spot method, which is based on changes in spot exchange rates. The new standard may now make the spot method more appealing to companies.
“Companies have always used these types of derivatives to mitigate and hedge, but using the spot method was not as attractive previously as it is now,” said Hubacker. “That’s what we’ve been seeing quite a bit. Companies are reassessing the method of assessing effectiveness, going from the forward method to the spot method, because of the relative benefits of that from a financial reporting perspective.”
Before the new standard was issued, many companies were reluctant to use the spot method because the old hedging standard required them to recognize changes in the fair value of the excluded component currently in earnings, which had the potential for unpredictable income statement volatility. Companies were required under that method to recognize periodic hedge ineffectiveness in their earnings, which could mean even more income statement volatility. The new hedge accounting standard reduces those concerns because of the approach it takes to amortization.
Net investment hedging strategies aren’t affected much by the tariffs and trade wars of recent years. “What a company is really hedging there is a subsidiary that has a functional currency that is denominated in a currency other than the parent’s currency," said Fellows. “It’s kind of a quirk of the accounting rules that the way that comes over, it causes some volatility in what’s called CTA [cumulative translation adjustment], or a component of other comprehensive income. That’s going to exist without regard to whatever individual trade between two countries might be. Long term, tariffs could have an impact on whether or not companies decide to invest overseas and have overseas subsidiaries, but in the short term I don’t think we’ve seen a lot of impact.”
FASB has been continuing to tweak the hedge accounting standard, most recently to help companies in the transition from LIBOR to SOFR, the Secured Overnight Financing Rate, as the benchmark reference rate used by banks.
“The FASB along with the [International Accounting Standards Board] are taking action to respond to and anticipate impacts related to LIBOR transition, but that’s a broader issue than just net investment hedging,” said Fellows.