We live in an uncertain world. Indeed, lately it has felt like the only certainty in the currency and commodity markets is volatility, and, with the US economy in particular showing signs of recovery, we may also soon be facing renewed interest rate volatility as well.
Consequently, risk management is near the top of every treasurer’s to-do list. Managing risk, particularly where derivatives are used, requires treasurers to understand a broad range of impacts, and while economic and strategic considerations will rightly be foremost in the treasurer’s mind, regulatory and accounting issues are of increasing importance.
In the past, derivative (and hedge) accounting has often been seen as the preserve of large or sophisticated companies and not as an area that every treasurer needs to understand. Following recent changes to UK accounting rules, however, all unrealised fair value gains and losses on derivatives will be recognised in profit and loss (P&L), unless hedge accounting is applied. So every UK treasurer who is involved in risk management will benefit from understanding the answers to the questions below.
UK companies that are not preparing IFRS financial statements, or applying the little-used FRS 26, Financial Instruments: Recognition and Measurement standard, have not in the past had to account for derivatives at fair value and, consequently, have not faced any of the challenges or considerations laid out below.
That is all changing for accounting periods starting on or after 1 January 2015, however, with the ushering in of an entirely new accounting framework in the UK (the so-called ‘New UK GAAP’).
Hedging with derivatives can result in the need for third-party valuations to provide independent, auditable numbers that are fully compliant with the relevant accounting framework
For many UK companies, this will involve adopting FRS 102, The Financial Reporting Standard applicable in the UK and Republic of Ireland unless EU-endorsed IFRS is being applied. Going forward, all UK companies will have to mark derivatives to market via P&L, unless hedge accounting is applied. And companies that have never considered accounting to be part of their risk management equation will have to think again.
The changes will even affect subsidiary companies where there is not normally a focus on financial reporting, or at least not at the level of that individual subsidiary, since derivative volatility could impact the timing of tax payments by that company or even the ability of that company to pass dividends up the chain to other group companies.
With derivatives now being recognised in the financial statements of many companies for the first time, UK companies should expect heightened scrutiny from their auditors with respect to how the fair value of derivatives is determined.
UK companies may try to obtain fair values from their derivative counterparties, but such values do not normally provide information about the inputs and assumptions used in the valuation model, and therefore may not be readily auditable under the new UK GAAP framework. Therefore, hedging with derivatives can result in the need for third-party derivative valuations to provide independent, auditable numbers that are fully compliant with the relevant accounting framework.
Ultimately, any interest rate, foreign currency or commodity risk-management programme needs to be reported back to investors in financial statements.
The main purpose of hedge accounting is to modify the normal accounting rules to align the financial statement numbers more closely with the intended risk-management result. In the absence of hedge accounting, the default accounting rules for derivatives will result in potentially significant P&L volatility from ‘unrealised’ gains or loss on derivative hedging instruments.
Many companies find that failing to apply hedge accounting has real cash impacts for their business
Therefore, for companies whose financial statements are subject to significant investor scrutiny, or for whom reported profits are important for other reasons, the ability to qualify for hedge accounting becomes an important part of the risk-management discussion.
We frequently speak to corporates that consider the application of hedge accounting to be de facto mandatory, given the potential sensitivity of key numbers, such as earnings per share and EBITDA to derivative volatility. And, in these volatile times, there are plenty of real-world examples of companies for whom applying hedge accounting or not has been the difference between a profit and a loss.
The qualifying conditions for hedge accounting can be complex and vary, depending on the specific accounting standard being applied. And, in some cases, perfectly sound economic hedge strategies may either fail to qualify for hedge accounting completely or result in hedge ineffectiveness being recognised in profit and loss, particularly where an unsophisticated or reactive approach to hedge accounting is being taken.
Therefore, it is vital that a proactive hedge accounting approach is adopted with accounting questions being considered prior to trading the derivatives, since tweaks to the structure that might have facilitated hedge accounting will rarely be possible once instruments have traded, at least not without introducing additional cost and accounting inefficiencies.
The recent changes to UK accounting standards mean that accounting for derivatives is no longer only an issue for larger or more sophisticated companies
A proactive, well-considered approach will also allow for the application of more sophisticated hedge accounting techniques, such as regression testing, proxy hedging or carefully defined exposure ‘buckets’. Such techniques, where appropriate, can be used to minimise the ineffectiveness arising from hedge relationships or even, in some cases, allow hedges to qualify for hedge accounting when they would have failed to meet the qualifying criteria had a more simplistic approach been adopted.
The additional administrative burden and complexity mean that many companies find it is not cost-efficient to run a hedge-accounting programme in-house, and outsourcing the work to a specialist hedge accounting provider or hiring additional specialist staff may be the preferred option.
Private companies may feel that hedge accounting is not for them. Having a smaller investor base, private companies have more scope to explain any P&L volatility to their stakeholders, and the administrative burden of running a hedge accounting programme may seem unattractive.
P&L volatility arising from derivative accounting is not purely a financial reporting issue, though. Where hedge accounting is not applied, derivative volatility may restrict the ability of a company to pay dividends and thereby return cash to investors, result in volatile tax payments that are not aligned to underlying profits, and, in some cases, result in companies breaching their loan covenants.
Consequently, many companies, both private and public, find that failing to apply hedge accounting has real cash impacts for their business. A recent example of this outcome occurred when a company with long-dated interest rate swaps was unable to pay dividends to its investors, despite the presence of underlying cash profits, purely because of unrealised losses associated with those swaps.
Conversely, if the company had chosen to apply hedge accounting from the inception of the hedge, dividends consistent with the historic dividend yield could have been paid.
Today’s treasurer does not necessarily have to be fluent in hedge accounting or fully appreciate all the deep technicalities, but a broad understanding of when it would be beneficial to apply hedge accounting and how hedge accounting considerations can impact the holistic risk-management discussion are increasingly required.
The recent changes to UK accounting standards mean that accounting for derivatives is no longer only an issue for larger or more sophisticated companies. Now every UK treasurer who uses derivatives to manage risk needs to be aware of the accounting ramifications.
Kern Roberts and Zwi Sacho are directors of hedge accounting at Chatham Financial
