Impacts of The New Hedge Accounting Standard: A Q&A With Deloitte’s Jon Howard

Companies that buy a lot of commodities in different locations will be impacted the most.

The Financial Accounting Standards Board (FASB) issued a new standard this week that improves hedge accounting. Deloitte’s recently published Heads Up, which summarizes the ASU’s key provisions. FEI Daily spoke with Jon Howard, senior consultation partner in Deloitte’s National Office Accounting Services, about which industries will be most impacted by the new guidance and the affect the standard will have on companies not previously applying hedge accounting.

FEI Daily: What is hedge accounting and what does the new guidance accomplish?

Jon Howard: Even for most of the accounting community, hedge accounting has been one of the more complicated areas of accounting. The reason for this update was to try to simplify the criteria to even achieve hedge accounting, to simplify operationally what companies have to do every period, and then also to reduce some of the volatility in the financial statements.

Generally speaking, entities do a lot of things to manage their risks. For example, if an entity has to buy commodities to make products or maybe you’re selling finished products that are commodities. Think about a power plant that uses oil to produce energy. If you’re worried about price changes in the underlying commodity, or about the price of oil going up, one thing they can do is enter into derivatives to kind of fix the price of the oil they will be buying. They may do that and just enter into a contract with someone to supply the oil. Alternatively, they may go to the Chicago Mercantile Exchange or other exchanges, enter into futures contracts that would be financially settled such that if the price of oil went up, they would receive cash. They made money on that contract to offset the fact that now they have to buy oil for more money because their cost of buying the oil would go up.

Hedge accounting lets us match those things together. Generally speaking, when you enter into a derivative you have to mark that to market on your balance sheet and that will go through your P&L. But hedge accounting allows you to say if this is a forecasted purchase of oil that I’m going to use for my production of electricity, while the tenet of accounting for derivatives is mark-to-market, if I can achieve hedge accounting, I can at least put the changes in fair value in equity (in other comprehensive income) and release it from that when the oil actually impacts my earnings, so I want to actually use it as a cost of sales when I use it to turn it into electricity.

I can then pull the gains or losses of that derivative out so that it effectively fixes my cost of producing the power and instead of me having to recognize the mark-to-market on the derivative while it’s unsettled and then separately have a higher cost of goods sold later, I can match those things.

This standard has made some changes to the old rules by letting you designate risks that you weren’t allowed to do before and how to test if you have a highly effective hedge. It was highly regimented and you had to run the math every quarter. There were some exceptions for what we call perfect hedges, but in the real world sometimes you can’t match things up perfectly and you had to run the math every three months. In addition, you had to document everything before you could even start hedge accounting and do the math. So they’re basically giving people some relief on when you have to even run the math initially and how often do you even have to run the math. You may be able to do it qualitatively, if it’s really good on Day One and you have no reason to believe that it would become a bad hedge. If it was 95 percent effective when you first got into it, why would I have to run the math if the goal posts are really 80 to 125. There’s no reason for me to believe this isn’t still working. What used to be an operational burden in that you had to do it the first minute and you had to do it every three months, now they’re saying you can wait until the end of the first quarter as you enter into the hedge to prove with your math that it was effective enough. Then you may just be able to qualitatively do it until your derivative is done.

FEI Daily: What industries are most affected by this new change to hedge accounting?

Howard: Frankly speaking, in any industry, if you issue debt and you put swaps on your debt, it could impact you. But I would say the ones that are impacted the most are entities that buy a lot of commodities in different locations. The energy industry or anybody that has to acquire goods for production that has multiple locations, this is going to help a lot. That is because, prior to  these changes, if I had to buy the same commodity in 10 different locations the prices aren’t going to be the same in those 10 locations. They may be based off of some price at a central hub but the cost to get it from one place to another varies from time to time in those 10 different locations. So, I would actually have to hedge for the total change in the price of what I’m buying before.

I may have a contract with a supplier who says it starts with the Henry Hub price for this oil, but at this fixed spread, if it’s going to location A, add 10 cents and if it’s going to location B, add 20 cents, and so on. And I used to have to maybe enter into a hedge for each of the different locations because the prices could vary enough that I wouldn’t be able to, with one derivative, get at 80 to 125 percent. Now, with all those fixed price differentials, as long as I’m just worried about the change in the Henry Hub price, that’s all that matters. And so now, all of a sudden I go from having a hedge that might not have been highly effective to one where if I can just say it’s that component I am hedging, it’s actually a perfect hedge.  I can hedge my purchases at all the different locations, as long as I have a general idea of how much I’m going to buy in total as opposed to drilling it down to individual hedges at each individual location. So, you can use one derivative to hedge an entire group of transactions.

Another industry that is going to be significantly impacted by the changes is the financial services industry, primarily banks and insurance companies.  There are a lot of new interest rate hedging strategies that can now achieve hedge accounting.  The new standard allows entities to hedge pools of fixed-rate pre-payable financial assets under a new “last of layer” method.  Under this approach, entities can hedge a portion of closed pools of pre-payable financial assets (like mortgages) without having to consider prepayment risk or credit risk when measuring the changes in fair value of those assets due to changes in interest rates.  Without this approach, it is either impossible or impractical to hedge pools of fixed-rate mortgages.

FEI Daily: Do you expect those who were not previously applying hedge accounting to start as a result of the new guidance?

Howard: Yes, I do. When the standard first came out, it was FAS 133 back then, in about the 2000 timeframe when people were adopting it.  Early on it was very prescriptive on how you had to document things. If you got one thing wrong the penalty was you’ve got an error on your hands and, frankly, you shouldn’t have applied hedge accounting. If you didn’t cross one T or dot one I correctly, there was a possibility that you shouldn’t have applied hedge accounting at all — and that could be a material error.

There were entities that were kind of afraid to even enter the game because it was too difficult and it was very prescriptive. And there’s something that is meant to be easy called the shortcut method where if I have debt and I just put a swap on fixed rate debt and I change it to float and everything matches up, it’s a perfect hedge and it’s supposed to be very operationally easy. However, if you missed one of the criteria, it was a full on restatement error to remove hedge accounting.

The FASB has now said, even if you want to do that shortcut method, you can have a backup that says even if I miss one criterion and it shouldn’t have been a shortcut, as long as it was highly effective and you said how were going to figure that out under that backup method. Then the error is really not the difference between perfect hedge accounting and no hedge accounting, it is the difference between perfect hedge accounting and hedge accounting under these new rules, in which in many cases it’s going to be very little of an error and probably not a restatement. Having that as a backup, I think people are going to be less afraid and people that aren’t even applying hedge accounting will go ahead and do the shortcut method.

The commodities hedgers, because of all the basis risks between what they were buying or selling and what is a standard derivative, were just entering into these derivatives and not getting hedge accounting. They’ve just been reporting to their financial statement users and their analysts, giving non-GAAP information like, “Here are the GAAP numbers, but here’s the impact of our economic hedges. We’re just not getting hedge accounting because we can’t.” They probably will now think about going to hedge accounting.

If you’re a public company, the SEC has been coming down and at least making a lot of statements about non-GAAP disclosures for a while and if there’s a GAAP alternative on the table where you could get hedge accounting and you’re just choosing not to, will they question your choice to still provide non-GAAP measures to your users? That might be a reason for people to move to hedge accounting because, for one, it’s easier and it’s actually achievable and, two, if they don’t maybe they won’t be able to provide the non-GAAP measures without getting a lot of pushback from the SEC.

I think there will be people applying more hedge accounting that have been sitting on the sidelines. The standard does allow immediate adoption, although it’s technically not effective until 2019 if you’re a public company or 2020 if you’re a non-public. Early adoption is allowed and we do expect that people are going to want to early adopt this.

FEI Daily: How difficult will this new standard be to implement?

Howard: It is going to be easier and less operationally burdensome making the transition  because there are so many things that are beneficial about the standard that will make things easier, and make even your income statement volatility less now that you can define what your hedged risks are.

The actual adoption itself, depending on how much you already have that you’re getting hedge accounting for but that you’d like to revise, it’s going to take some time to go through that inventory.

If you want to early adopt, you can’t just start applying the new rules to new hedges and then make changes to your old hedges as you see fit. You get one shot. Whenever you adopt, there are several things that you can do with things that are already on your books that you can only do when you adopt.

While we think people are going to want to early adopt, we do think it will take some effort if you have a lot of things that you’d like to realize the full benefits. Early on, we heard a lot people wanting to adopt immediately. And the FASB’s original decision stated that it had to be the beginning of a fiscal year and a lot of people said to let us adopt it as soon as it comes out. So, frankly, if someone wants to adopt it tomorrow they could. But, since you only get one shot to take advantage of everything, what we’re hearing is people are most likely going to wait until the beginning of the next year.

FEI Daily: How favorably is this standard being received by the accounting community?

Howard: To be honest, I don’t remember the last time an accounting standard has come out with so few complaints and so many people anxiously waiting for it to come out. I’m not going to say it’s not at all complicated, derivatives and hedging is still a complicated matter, but they’ve really simplified it and they put several new concepts on the table.

This was something where the FASB staff did a really good job of outreach, of educating the board every step of the way. It was the fastest board meeting to approve the issuance of a standard or even an issuance of the exposure draft. They’ve really been good at outreach with financial statement users, prepares, auditors. Is everyone going to be 100 percent happy? No. But generally speaking this is something that’s a net positive for probably everybody.