Some companies take advantage of hedge accounting changes early
The Financial Accounting Standards Board’s new hedge accounting standard is prompting some companies to adopt the standard ahead of the Jan. 1, 2019 effective date, though many companies are still not using hedge accounting at all.
A poll during a May webcast by Deloitte found that 20.6 percent of company executives report their organization has already implemented or plans to implement the new, optional hedge accounting standard ahead of the effective date. However, more than one-third (32.6 percent) of the companies polled admitted they hardly use hedge accounting.
“The use of derivatives, to begin with, is already a voluntary process,” said Jon Howard, a senior consultation partner at Deloitte. “Not everyone enters into derivatives to manage their risk, so that would be a portion of the population who don’t even use derivatives. But then also I’d say there’s a decent portion of the population that uses derivatives to manage their risk, but have not been applying hedge accounting.”
There are a few reasons for that. “In the area of commodities, at least prior to the recent targeted improvements, it was difficult to get hedge accounting because a lot of times you might have location differences or grade of commodity differences that you couldn’t really match up with your derivative,” said Howard. “Before these changes, you had to hedge for total changes in purchase price or total changes in sales price. You couldn’t just hedge a component. They weren’t able to get highly effective hedges, so they’ve been doing what I call economic hedges, not applying hedge accounting. The derivatives would just get recorded on their balance sheet at fair value every period, and any changes in fair value would go through income.”
Those companies have been communicating that to their investors and analysts, basically telling them about their derivative gains and losses, without formally using hedge accounting. Howard expects many of them to start applying hedge accounting under the new rules now that they can do component hedges.
On the other hand, some companies were eager to start using the new accounting standard and decided to adopt it early. “We have seen a group of people early adopt and we know some people still are going to early adopt, even if it’s just a quarter early, and may adopt in the fourth quarter,” said Howard. “The changes in the rules have put new strategies on the table that I think are going to be popular in the financial services industry, with partial-term hedging and last-of-layer hedges. Those are all for fixed-rate assets or liabilities that they have, hedging strategies that they couldn’t do before that now they will enter into, and then the commodities hedgers may start to move over.”
Bill Fellows, a partner in Deloitte Risk and Financial Advisory, sees companies early adopting the standard even now. “I have been working with companies since that poll was taken that have continued to adopt, so the way the adoption works, if they adopt now or my client adopted in the third quarter or if they adopt in the fourth quarter, it will still get pushed back until the beginning of the year,” he said. “I still see interest in companies that are selectively pursuing this. There’s the net investment strategy that I think continues to be palatable to our clients, and they are still making that shift based upon potentially the interaction that they’ve had with their bankers and the like. I think that there is still a fair degree of movement as it relates to early adoption of the standard.”
Some of the early adoption has been occurring because of foreign currency hedging.
“One thing we saw that a fair number of early adopters — and this is something I don’t think I was expecting necessarily, or anybody was necessarily expecting — was in foreign currency hedging,” said Howard. “For a lot of global companies that have subsidiaries in Europe — including ones that are British pounds, and also in Japan — the change in the rules has allowed companies to have what we call the spot method for foreign currency, hedges of net investments in subs they have over there. So if you have a subsidiary over in Europe or a subsidiary in Japan, as soon as this standard came out, because of the pricing of the derivatives right now and how the spot method basically allows you to take what we’ll call the forward points — the difference between the forward rate and today’s exchange rate — instead of having to recognize the change in fair value of that spread, now we can kind of lock it in on day one and recognize it and amortize it over the life of the hedge. Because of the pricing, those are all positive amounts, so that’s actually income. If I enter into a forward exchange to sell euros and buy dollars, I’ll actually get more dollars the farther out that forward goes than if I just went and used today’s exchange rate, just because of the pricing and how those things work in Europe and Japan compared to here in the U.S.”
He describes the situation as “almost a perfect storm” with the change in accounting and the economic advantages of forward and cross-currency interest rate swaps of U.S. dollars for euros, British pounds and Japanese yen. The top benefit of using hedge accounting reported by 18.4 percent of the executives polled by Deloitte was unlocking new business opportunities.
“We had a lot of investment banks going to our global clients that have operations all over the world, and they looked at the accounting change and the pricing was right,” said Howard. “We’ve seen a lot of companies early adopt just to do hedges of their subsidiaries in Europe and Japan. It was really across all industries. That was probably the most common thing that I was consulted on as a consultation partner in the national office. I would say that nine out of 10 of our new hedge accounting questions were related to these net investment hedges.”
One of the biggest obstacles to implementing the new hedge accounting standard was education (according to 20.7 percent of the survey respondents) because it will be the first time that many companies use hedging strategies. Accountants can help educate clients about the advantages of the new standard.
“For those that have already been applying hedge accounting, there’s one level of education on the new rules and how to change your tracking and your reporting,” said Howard. “We’ve gotten rid of the whole notion of measuring effectiveness for cash flow hedges. We’ve kind of refined how you can calculate changes in the fair value of the hedged item for fair value hedges, so it is teaching them about the changes. Obviously that means changing their systems and changing how they calculate some of these things. That flows through into the financial reporting process. Then because of the net investment hedges, there’s also been a set of clients that haven’t been applying hedge accounting at all, where now it’s not even about what’s changed. It’s about here’s how you do hedge accounting. With that second group, there’s probably more education but less pain in adopting the standard because once you learn it, it’s not like you have do a bunch of system changes and figure out how to change things for all of your existing hedges. It’s something where it’s a brand new hedging strategy for them and it’s just putting things in place, but not making changes to something you already have.”