Understanding Hedge Accounting & Financial Reporting: Avoiding the Pitfalls PRESENTED BY: BRYAN WRIGHT AND RANDY THROENER

Transcription

1 Understanding Hedge Accounting & Financial Reporting: Avoiding the Pitfalls PRESENTED BY: BRYAN WRIGHT AND RANDY THROENER

2 Hedge Accounting - U.S. GAAP 1. Is hedge accounting complicated? NO 2. Are the hedge accounting guidance, rules & interpretations complicated? Highly complicated 2

3 THE FUNDAMENTALS 3

4 Definition of a Derivative Instrument Financial instrument or other contract having each of the following 1. One or more underlyings & one or more notional amounts or payment provisions or both 2. No (or small) initial investment 3. Requires/permits net settlement 4

5 Underlying Variable that, along with either a notional amount or payment provision, determines settlement Common examples Commodity price or commodity price index (the price of corn in a forward contract) Interest rate or interest rate index (Libor in an interest rate swap) Exchange rate or exchange rate index (exchange rate of a foreign currency in a foreign currency option) 5

6 Notional Amount Quantity that determines the size of the change caused by the movement of the underlying Stated number/quantity of Barrels Bushels Stated notional (interest rate swap) Currency units 6

7 Notional Amount Example #1 Notional amount may require the consideration of volumes or formulas contained in attachments or appendices to the contract or other agreements Default provisions If the notional amount is not determinable, making the quantification of such an amount highly subjective & relatively unreliable, such contracts are considered not to contain a notional amount 7

8 Notional Amount A contract that specifies a minimum number of units always has a notional amount at least equal to the required minimum number of units Only that portion of the requirements contract with a determinable notional amount would be accounted for as a derivative instrument 8

9 No, or Small, Initial Investment Generally no exchange of cash, or relatively small, at the date the parties enter a derivative contract May require an initial investment as compensation for Time value (option premium) Terms more or less favorable than market 9

10 Net Settlement Contract terms Market mechanism Readily convertible to cash 10

11 Net Settlement Market mechanism One party is required to deliver an asset, but there is an established market mechanism that facilitates net settlement outside the contract e.g. Exchange-traded futures contract 11

12 Common Examples Contract Underlying Notional No, or Small, Initial Investment Futures contract Yes Price of commodity or financial instrument Yes specified quantity or face amount Yes Net Settlement Yes Market mechanism exists Derivative Yes Forward contract (purchase or sell commodity) Yes Price of commodity Yes A specified quantity of the commodity Yes Yes If it can be contractually net settled or commodity if RCC Yes May qualify for the normal purchase normal sale exception Interest rate swap Yes Benchmark interest rate Yes Specified amount Yes Yes Periodic payments Yes 12

13 Normal Purchase Normal Sale Certain scope exceptions under ASC 815 allow a contract that may otherwise qualify as a derivative to be accounted for as a nonderivative No Fair Value Accounting off balance sheet Effectively an election made at inception if criteria met, otherwise fair value accounting required If purchase or sale contracts are hedged, could result in an economic hedge with both hedged item & hedging instrument carried at fair value Normal purchases & normal sales (NPNS) contracts are one of the exceptions Probable of physical delivery Quantities are consistent with normal operational needs & are expected to be used or sold by the reporting entity in the normal course of business 13

14 Potential Challenges Company should define normal course of business Net settlement Ongoing monitoring Continues to be subject to lower of cost or net realizable value (onerous contract) 14

15 Hedge Accounting 1. Benefits & challenges of hedge accounting 2. Types of accounting hedges 3. Stringent criteria & documentation requirements 4. New hedge accounting guidance, ASU (August 2017) Targeted improvements to existing rules 15

16 Benefits of Hedge Accounting Reduced earning volatility Financial statement representation consistent with the company s risk management activities Challenges Strict criteria Hedge accounting is not a right, it s a privilege Reporting & disclosure requirements Ongoing monitoring cost (new guidance will help ease this) 16

17 Types of Accounting Hedges Fair value hedge Hedges the exposure to changes in fair value of a recognized asset or liability, or an unrecognized firm commitment, that are attributable to a particular risk Cash flow hedge Hedges the exposure to variability in the cash flows of a recognized asset or liability, or forecasted transaction, that is attributable to a particular risk 17

18 Types of Accounting Hedges Hedging Instrument Mark to Fair Value (Asset/Liability & OCI) Cash Flow Hedge Hedged Item (Floating Price Transaction/ Contract) No Accounting Hedging Instrument Mark to Fair Value (Asset/Liability & P&L) Fair Value Hedge Hedged Item (Fixed Price Transaction/ Contract) Change in Fair Value (Asset/Liability & P&L) 18

19 What Is OCI? 1. Other comprehensive income reported within equity on the balance sheet 2. Examples of items reported in OCI Unrealized gains/loss on marketable securities Translations from foreign currency Pension accounting Cash flow hedges (Mark to Market) 19

20 Types of Accounting Hedges Hedge ineffectiveness is always reported currently in earnings Modified by new guidance issued in 2017 for cash flow hedges Cash flow hedge changes in fair value deferred in OCI until hedged transaction affects earnings If forecasted transaction no longer probable, immediately recognize in earnings 20

21 Accounting Example - Cash Flow Hedge Assume the following 1. Copper has been purchased at a fixed price Inventory 2. Forecasted sale of copper has been identified for February & designated as the hedged item in a cash flow hedge 3. March copper futures (short) contract used to hedge sale - deemed highly effective (assume 100%) 4. Subsequent to hedge, prices increase in both spot & futures market Futures now valued at $(100,000) Loss 5. What does the cash flow hedge accounting look like? 21

22 Cash Flow Hedge Example Balance Sheet Before Hedge Accounting After Assets Inventory $ 1,000,000 $ 1,000,000 Equipment $ 5,000,000 $ 5,000,000 Total Assets $ 6,000,000 $ 6,000,000 Liabilities & Equity Accounts Payable $ (1,000,000) $ (1,000,000) Futures Contract Liability $ (100,000) $ (100,000) Equity/OCI $ (5,000,000) $ 100,000* $ (4,900,000) Total Liabilities & Equity $ (6,000,000) $ (6,000,000) *Loss on future reclassified to earnings once the forecasted sale is recorded. 22

23 Accounting Example - Fair Value Hedge Assume the following 1. Copper has been purchased at a fixed price Inventory 2. Copper inventory is designated as the hedged item with the risk being overall changes in fair value 3. March copper futures (short) contract used to hedge inventory deemed highly effective 4. Subsequent to hedge, prices increase in both spot & futures market Futures now valued at $(100,000) Loss Change in fair value of the copper inventory is $98,000 Gain 5. What does the fair value hedge accounting look like? 23

24 Fair Value Hedge Example Balance Sheet Before Hedge Accounting After Assets Inventory $1,000,000 $98,000 $1,098,000 Equipment 5,000,000 ** 5,000,000 Total Assets $6,000,000 $6,098,000 Liabilities & Equity Accounts Payable $ (1,000,000) $ (1,000,000) Futures Contract Liability $ (100,000) (100,000) Equity/OCI (5,000,000) $2,000 (4,998,000) Net P&L impact of hedge accounting Total Liabilities & Equity $ (6,000,000) $ (6,098,000) **Hedged item is adjusted for changes in fair value. 24

25 Fair Value Hedge Example Income Statement Hedge Before Accounting After Sales $ XXX,XXX $ XXX,XXX COGS Futures Gain (Loss) $ (100,000) $ (100,000) Change in FV of Hedged Item $ 98,000 $ 98,000 Net Impact of Hedge Accounting $ (2,000) 25

26 Which Accounting Looks More Appealing? Cash flow hedge Simpler Generally avoid impacting earnings until hedged transaction complete (Refer to ASU for changes) Fair value hedge More complex as hedged item requires fair value measurement (changes) Ineffectiveness in hedge accounting impacts earnings each period Not designated as a hedge Derivative contract marked to market with offset to earnings Very common & much less complicated accounting/disclosures Adjusted for in management reporting May be eligible for either cash flow or fair value depending on the transaction & circumstances documented at inception!!! 26

27 Hedging Criteria & Requirements To qualify for hedge accounting, the company must Contemporaneously document at inception specific qualifying criteria Establish effectiveness of hedging relationship as HIGHLY EFFECTIVE (80% to 125%) Eligibility of hedged item & hedging instrument Prove & monitor probability of forecasted transaction (cash flow hedge) No documentation = no hedge accounting Uncertainty &/or non-occurring forecasted transaction = discontinue hedge accounting (cash flow hedge) 27

28 New Hedge Accounting Guidance ASU Issued August 2017 Key changes include 1. Provides for hedging contractually specified components as hedged risk (cash flow hedge) 2. Entire changes in fair value of cash flow hedge reported in OCI no longer measure & report ineffectiveness 3. Allows for qualitative hedge effectiveness assessment after initial assessment of quantitative effectiveness is determined 4. Initial quantitative effectiveness testing can be completed after hedge designation until first quarterly measurement (public entities) or date before the financial statements are available for issuance (private entities) 28

29 New Hedge Accounting Guidance ASU Effective date Years beginning after December 15, 2018 (Public) December 15, 2019 (Private) Early adoption permitted as of beginning of fiscal year of adoption 29

30 Cash Flow Hedges Hedging the exposure to variability in the cash flow of a recognized asset of liability, or of a forecasted transaction, that are attributable to particular risk 30

31 Accounting Treatment for Cash Flow Hedges The effective portion of the gain or loss on a derivative instrument designated as a cash flow hedge is reported in other comprehensive income, while the ineffective portion is reported in earnings (changed under new guidance) If the hedged transaction results in the acquisition of an asset or the incurrence of a liability, the gains & losses in accumulated other comprehensive income shall be reclassified into earnings in the same period or periods during which the asset acquired or liability incurred affects earnings Amounts in accumulated other comprehensive income shall be reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings 31

32 Criteria Required for Qualification as a Cash Flow Hedge Formal designation & documentation at hedge inception A. Hedge relationship B. Entity s risk management objective & strategy for undertaking the hedge 1. Hedge instrument 2. Hedged item or transaction 3. Nature of risk being hedged (the hedged item or transaction presents an exposure that could affect reported earnings) 4. Method that will be used to assess hedge effectiveness 32

33 Criteria Required for Qualification as a Cash Flow Hedge C. For a cash flow hedge of a forecasted transaction, documentation shall include 1. Date on or period within which the forecasted transaction is expected to occur 2. Specific nature of asset or liability involved, if any 3. The quantity of the forecasted transaction (purchase units, debt amounts, etc.) 4. The current price of the forecasted transaction 5. Escribed with sufficient specificity so that when the transaction occurs, it is clear the transaction is or is not hedged 33

34 Examples of Sufficient Details - Requirement Escribed with sufficient specificity so that when the transaction occurs it is clear the transaction is or is not hedged Example 1. Goal to hedge the sale of 1,000,000 units of product 2. Designated units a) Any 1,000,000 units sold No hedge accounting b) Last 1,000,000 units sold No hedge accounting c) First 1,000,000 units sold Qualifies 34

35 Criteria Required for Qualification as a Cash Flow Hedge Eligibility of hedged items & transactions A. An existing recognized asset or liability Such as all or certain future interest payments on variablerate debt or inventory B. A forecasted transaction Such as a forecasted purchase or sale 35

36 A forecasted transaction is eligible for designation as a hedged transaction in a cash flow hedge if all of the following additional criteria are met A. The forecasted transaction is specifically identified as either of the following 1. A single transaction 2. A group of individual transactions that share the same risk exposure for which they are designated as being hedged A forecasted purchase & a forecasted sale shall not both be included in the same group of individual transactions that constitute the hedged transaction B. The occurrence of the forecasted transaction is probable 36

37 A forecasted transaction is eligible for designation as a hedged transaction in a cash flow hedge if all of the following additional criteria are met C. The forecasted transaction meets both of the following conditions 1. It is a transaction with a party external to the reporting entity 2. It presents an exposure to variations in cash flows for the hedged risk that could affect reported earnings D. The forecasted transaction is not the acquisition of an asset or incurrence of a liability that will subsequently be remeasured with changes in fair value attributable to the hedged risk reported currently in earnings E. If the forecasted transaction relates to a recognized asset or liability, the asset or liability is not remeasured with changes in fair value attributable to the hedged risk reported currently in earnings 37

38 A forecasted transaction is eligible for designation as a hedged transaction in a cash flow hedge if all of the following additional criteria are met F. If the variable cash flows of the forecasted transaction related to a debt security this is classified as held to maturity under Topic 320 G. The forecasted transaction does not involve a business combination subject to the provisions of Topic 805 H. The forecasted transaction is not a transaction (such as a forecasted purchase, sale or dividend) involving either a parent entity s interests in consolidated subsidiaries or an entity s own equity instruments 38 I. If the hedged transaction is the forecasted purchase or sale of a nonfinancial asset, the designated risk being hedged is either the risk of changes in the functional-currency-equivalent cash flows attributable to changes in the related foreign currency exchange rates or the risk of changes in the cash flows related to all changes in the purchase price or sales price of the asset reflecting its actual location if a physical asset, not the risk of changes in the cash flows related to the purchase or sale of a similar asset in a different location or of a major ingredient

39 A forecasted transaction is eligible for designation as a hedged transaction in a cash flow hedge if all of the following additional criteria are met J. If the hedged transaction is the forecasted purchase or sale of a financial asset or liability or the interest payments on that financial asset or liability or the variable cash inflow or outflow of an existing financial asset or liability, the designated risk being hedged is any of the following 1. The risk of overall changes in the hedged cash flows related to the asset or liability, such as those relating to all changes in the purchase price or sale price**** Changed by new ASU with the addition of component hedging 2. The risk of changes in its cash flows attributable to changes in the designated benchmark interest rate 3. The risk of changes in the functional-currency-equivalent cash flows attributable to changes in the related foreign currency exchange rates 39

40 Component Hedging - Cash Flow Hedge ASU Provides for hedging contractually specified components as hedged risk (cash flow hedge) Variability in cash flows attributable to changes in specified component designated as the hedged risk Example Tasty Treats, Inc. purchases bourbon whiskey from a local distiller as a key ingredient Contract with supplier calls for variable pricing per unit based on a distiller charge plus beginning of month spot corn prices (CBOT) x QTY required Tasty s February bourbon order requires 20,000 bushels of corn & will be priced February 1 (CBOT) Tasty s enters into a forward purchase contract for corn (CBOT) maturing February 1 to purchase 20,000 bushels - settlement based on contract price & February 1 spot price 40

41 Component Hedge Example What is the risk being hedged? Variability in the purchase price of bourbon attributable to the changes in the corn price index contractually specified What is the hedging instrument? Forward contact What is the hedged item? Forecasted purchase of bourbon What type of hedge? (fair value or cash flow) 41

42 42 Component Hedging (ASU )

43 Component Hedging (ASU ) (Interest Rate SWAPs) Cash Flow Hedges of Interest Rate Risk. The Update permits the variability in cash flows attributable to the contractually specified interest rate as the hedged interest rate risk, effectively eliminating the benchmark interest rate concept requirement for variable-rate instruments. The ability to hedge the variability of the contractually specified rate, such as Prime rate, permits more hedging strategies to be eligible for the shortcut method when all other requirements have been met. 43

44 44 Component Hedging (ASU ) (Interest Rate Hedges)

45 A forecasted transaction is eligible for designation as a hedged transaction in a cash flow hedge if all of the following additional criteria are met: 4. The risk of changes in its cash flows attributable to all of the following (referred to as credit risk) Default Changes in the obligor s credit-worthiness Changes in the spread over the benchmark interest rate with respect to the related financial asset s or liability s credit sector at inception of the hedge If the risk designated as being hedged is not the risk in paragraph (j)(1), two or more of the other risks (interest rate risk, foreign exchange risk & credit risk) simultaneously may be designated as being hedged K. The item is not otherwise specifically ineligible for designation 45

46 Hedging Effectiveness To qualify for hedge accounting, the cash flow hedging relationship, both at inception of the hedge & on an ongoing basis, shall be expected to be highly effective in achieving the following (80% to 125%) Offsetting cash flows attributable to the hedged risk during the term of the hedge except as indicated in paragraph If the cash flow hedging instrument, such as an at-the-money option contract, provides only one-sided offset of the hedged risk, the following condition shall be met The cash inflows (outflows) from the hedging instrument are expected to be highly effective in offsetting the corresponding change in the cash outflows or inflows of the hedged transaction 46

47 Fair Value Hedges Hedges the exposure to changes in fair value of a recognized asset or liability, or an unrecognized firm commitment, that are attributable to a particular risk 47

48 Asset or liability is eligible for designation as a hedged item in a fair value hedge if the additional criteria are met (key items) A. Hedged items are specifically identified as all or a specific portion (%) of a recognized asset, liability or unrecognized firm commitment B. If the hedged items are a nonfinancial asset or liability, the designated risk being hedged is the risk of changes in the fair value of the entire hedged asset or liability (reflecting actual physical location) 1. Major ingredient within an asset can t be hedged 2. e.g. Hedging changes in fair value of gasoline inventory can t designate the risk of changes in the price of crude as the risk being hedged 48

49 Economic Hedge Natural Hedge What is an economic hedge? Derivatives used for risk management, but not designated as hedges under ASC 815 either because of failure to qualify or management decision Function in a very similar manner to fair value hedges with the asset or liability being hedged and the derivative instrument recorded at market value in the balance sheet though an income statement/earnings entry 49

50 Economic Hedge Most commonly see in agribusiness with inventories reflected at market value Recording the derivative at market value through the income statement creates a natural fair value hedge when the item hedged is also recorded at market value through the income statement. Ineffectiveness is also automatically reflected in the income statement 50

51 Economic Hedge Also commonly seen in converting fixed rate forward contracts to variable through futures contracts Assume the following fact pattern: 1. In September the Company enters into a forward sales contract to sell 100,000 bushels of soybeans in December at a fixed price of $9.00/bushel (the Company did not elect normal purchases and sales treatment) 2. In September the Company also purchases a long futures contract for 100,000 bushels that expires in December for $9.25 per bushel 3. In November the cash price of soybeans is $9.50 per bushel and the December long contract $9.70 per bushel 51

52 Economic Hedge Balance Sheet Before Economic Hedge After Accounting Assets Inventory $1,500,000 $1,500,000 Futures Contract - Asset $ 45,000 45,000 ** Total Assets $1,500,000 $1,545,000 Liabilities & Equity Accounts Payable $ (1,000,000) $ (1,000,000) Forward Contract Liability $ (50,000) (50,000) ** Equity (500,000) $ 5,000 (495,000) Net P&L impact of hedge accounting Total Liabilities & Equity $ (1,500,000) $ (1,545,000) **Hedged item is adjusted for changes in fair value. 52

53 Economic Hedge Financial Statement Presentation The gain or loss on an economic derivative should be record in the same income statement line item as the risk being hedged (in the example either sales or possibly cost of sales) Economic hedges require financial statement disclosure consistent with qualifying hedging activities 53

54 Pitfalls Why Companies Fail to Qualify Lack of documentation at inception Risk being hedged does not qualify Failure of hedge effectiveness testing Poor transaction records reflecting hedging result & risk management lack of detail 54

55 55 Questions?

56 Thank You! Bryan J. Wright, CPA // Partner Randy Throener, CPA // Partner