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Tracey Ferguson Knight Director, Solution Consulting May 29, 2014 Hedge Accounting for Effective Risk Management
Tracey Ferguson Knight
Director, Solution Consulting
May 29, 2014
Hedge Accounting for Effective Risk Management
Agenda
o Introduction to Hedge Accounting
o Benefits of Hedge Accounting
o Framework for Implementing a Program
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What is Hedge Accounting?
o “Special accounting treatment that alters the normal accounting
for one or more components of a hedge so that counterbalancing
changes in the fair values of hedged items and hedging
instruments, from the date the hedge is established, are not
included in earnings in different periods.” (formerly SFAS
133, par 320)
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Basic Treatment
o “An entity shall recognize all of its derivative instruments in its
statement of financial position as either assets or liabilities
depending on the rights or obligations under the contracts. All
derivative instruments shall be measured at fair value.” (formerly
SFAS 133, par 17)
Hedge Accounting
Introduction
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CF
Hedge
Derivative? Yes
MtM
No
Accrual
FV
Hedge
Definition of a Derivative: Characteristics of a derivative ASC 815-10-15
(formerly SFAS 133, par 6)
83(a) Underlying
83(a) Notional amount
83(b) No (or minimal) initial net investment
83(c) Net settlement
Basic Accounting Treatment: Derivatives are recorded at FMV, with changes in FMV recognized currently in earnings
Hedge Types: • Cash flow hedges are recorded at FMV with
effective changes in FMV deferred in OCI
• Fair value hedges are recorded at FMV with offsetting gains and losses on the hedged item recognized currently in earnings
Major Provisions of Hedge Accounting
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o Documentation – Risk Management Strategy and Objective
– Nature of the Hedged Risk
– Hedging Instrument Identified
– Hedged Item Defined
– Effectiveness Assessments and Ineffectiveness Measurement
o Effectiveness Assessments – Regression, Dollar Offset, Critical Terms, Shortcut
o Ineffectiveness Measurement – Lesser of the cumulative change
o Disclosures
Agenda
o Introduction to Hedge Accounting
o Benefits of Hedge Accounting
o Framework for Implementing a Program
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Benefits of Hedge Accounting
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Cash Flow Hedge
Trade Date Settlement
Hedge
Hedged Item
Fair Value Hedge
Trade Date Settlement
Hedge
Hedged Item
Recognize in Earnings
Recognize in Earnings
Changes in derivative value are deferred to OCI until the hedged item impacts the income statement.
Changes in the hedged item value are booked to earnings at the same time as when the derivative changes.
Benefit 1: Alignment of Derivative and Hedged Item Impacts on Income Statement
Benefits of Hedge Accounting
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Benefit 2: P&L Volatility Reduction
Forecast Sales
Loss
/Gai
n
FX rate at fcst date
FX Rate
FX Forward Net Acctg Impact
No Hedge Accounting
Loss
/Gai
n
FX Fwd Rate
FX Rate
Loss
/Gai
n
FX Fwd Rate
FX Rate
Loss
/Gai
n
FX rate at fcst date
FX Rate
With Hedge Accounting Lo
ss/G
ain
FX Fwd Rate
FX Rate
Loss
/Gai
n
FX Fwd Rate
FX Rate
Cash Flow Hedge
Benefits of Hedge Accounting
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Benefit 3: Improved Economic Hedging Performance
Transaction Timeline:
Txn Event
t0 t1
Quote Order
t2
Sale/ Revenue Recognized
t3
Cash Received
Rates Planning Acctg1 Acctg2
Hedge Type Cash Flow Fair Value Balance Sheet
Objective: Minimize the difference between the hedge rate and planning rate
Potential P&L Impact
Economic Risk Accounting + Economic Risk
Benefits of Hedge Accounting
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Other benefits of implementing a hedge accounting program
o Improved insight into underlying business exposures
– Companies are forced to analyze, measure and monitor
business transactions on an ongoing basis
o Process controllership
– Companies are required to have proper processes and controls
Agenda
o Introduction to Hedge Accounting
o Benefits of Hedge Accounting
o Framework for Implementing a Program
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Risk Management Framework
Hedge Accounting Lifecycle
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Risk
Identification
Risk Appetite
Business Goals and Objectives
Assessment
and Strategy
Definition
Execution Reporting
Roles and Responsibilities
Policies and Procedures
Technology
Hedge Accounting Lifecycle
High Level Derivative Lifecycle
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Reporting
Designation Maintenance Termination
• Policy definition
• Exposure tracking
• Trade execution
• Hedge documentation
• Prospective and retrospective effectiveness testing
• Valuations
• Measurement
• Documentation of hedge termination
• OCI management
Implementation Framework
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o Policy definition:
– Types of exposures, policy for hedging, operational controls
– Embed key HA language into policy and refer trade to this
o Exposure tracking:
– Need repository to store exposure information (date, amount,
revision history, actuals etc.)
o Trade execution:
– Consider hedge accounting structure when executing trades
(e.g. are internal derivatives needed)
Designation Maintenance Termination
Implementation Framework
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Designation Maintenance Termination
FX Hedges Eligible for HA? Type
Unrecognized firm commitment with an unrelated party Yes Fair Value
Foreign currency denominated asset or liability Yes Fair Value
Non-financial asset (e.g.,inventory or a fixed asset) Yes Fair Value
Firm commitment to purchase a nonfinancial asset Yes Fair Value
forecasted purchase or sale of a foreign currency-denominated financial asset with a third party
Yes Cash Flow
Forecasted intercompany purchase or sale of a foreign currency denominated financial asset
Yes Cash Flow
Receipt or payment of interest on a foreign currency denominated debt instrument
Yes Cash Flow
Forecasted intercompany dividend No
Hedge of a forecast/firm commitment to purchase a foreign equity method Investment or business combination
No
Implementation Framework
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Designation Maintenance Termination
Documentation Requirement
Details
Hedge Type Cash Flow, Fair Value or Net Investment Hedge
Objective and strategy
Need to define what the risk of the hedged item is along with the mitigation strategy
Risk Changes in FX, interest flows attributable to the benchmark rate, price
Assessment of Effectiveness
Company expects that both at inception and on an ongoing basis the relationship will be highly effective… Methods: 1) critical terms/shortcut, 2) dollar offset, 3) regression
Hedged Item Need to be specific as to what the exposure is
Hedge Instrument Need to refer to the specific derivative
Timing Designation must be made contemporaneously
Implementation Framework
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o Prospective/Retrospective Effectiveness Testing – Must be performed at least quarterly
– Optimal method is regression
– Specific guidance for options, forward contracts
– Impact of basis on commodities
o Valuations – Source of market data
– Confidence in pricing models
o Measurement – Book to ledger after adjusting for excluded components,
ineffectiveness, lesser of the cumulative change
– Result is set of GL bookings
Designation Maintenance Termination
Implementation Framework
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o Cash Flow Hedges: – Regular Termination (e.g. at expiry of hedge contract)
• Amounts in OCI are reclassified from OCI to income statement in same period as which the hedged item impacts the income statement
– Irregular Termination (e.g. failed effectiveness) • Cumulative gain/loss on the derivative is discharged immediately from OCI to
P&L
– Management Decision (e.g. de-designation prior to maturity) • Amounts in OCI are reclassified from OCI to income statement in same period as
which the hedged item impacts the income statement
o Fair Value Hedges: – Cease adjusting the carrying value of the asset/liability/firm commitment
– An adjustment to the carrying value of hedged item is accounted for in the same manner as the hedged item itself (e.g. adjustment to inventory is held until the inventory is sold)
Designation Maintenance Termination
Implementation Framework
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Other Considerations
o Advanced FAS topics
– DIG Issues
– Treasury Center/Netting
– Intercompany Transactions
– Commodities
– Cross Currency Swaps
o FAS 157
– De-minimus testing
– Credit adjusted values (at contract or on a net basis)
Designation Maintenance Termination
The Reval® Solution – How We Help
o Reval helps optimize our
clients global treasury
operations across: – Cash Management
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– Financial Risk Management
– Hedge Accounting &
Compliance
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support
o Over 500 global clients
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Q&A
Tracey Ferguson Knight
Director, Solution Consulting
Reval
972-668-0419
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