In June, the Financial Accounting Standards Board (FASB) voted to proceed with finalizing the Accounting Standards Updates (ASU) for hedging activity. The final rules are expected to be announced in the next few months. Recognizing that our customers are impacted by these changes, Cargilll Risk Management’s Andrew Brodbeck asked Tim Potter at HedgeStar, a global firm based in Minneapolis, a few questions.
Andrew Brodbeck: What do the proposed changes mean for anyone with commodities or raw materials exposure?
Tim Potter: The accounting changes provide greater hedging opportunity and flexibility. The ASU better aligns an entity’s hedging activities with its risk management objectives. Before these changes, commodity exposures might have been off-the-table for hedge accounting due to refinement, conversion and transportation costs, or even basis differences between the hedging contract and commodity purchase pricing. The ASU effectively minimizes the “noise” and allows entities to identify a specific hedged risk or the commodity itself, which will help streamline tests for hedge effectiveness and reduce earnings impacts.
Andrew Brodbeck: Could you provide your perspective on some of the key benefits of the anticipated rules?
Tim Potter: There are many benefits from the accounting changes, but there are two that are significant for entities with commodities exposure. The first relates to an entity’s ability to designate as a hedged item, any contractually specified component of a commodity purchase agreement. An entity can define the primary driver of the purchase price and avoid extraneous costs that may disrupt a tight correlation between the hedging derivative and hedged item. For example, a jet fuel purchase agreement might delineate pricing between the raw crude oil commodity, a refining margin and logistical charge for delivery. Under the new ASU, a hedger may identify only the crude oil component as the hedged item and exclude the other charges when testing effectiveness of the relationship. As a result, that hedger can manage its risk using futures or swaps to mitigate cash flow variability tied to market price changes in crude oil, without worrying about undesirable accounting consequences. Through this process, the hedger now has a hedge correlation at or near 1.00.
The other key benefit relates to the measurement of hedge ineffectiveness. Under the old accounting regime, an entity would test for hedge effectiveness and conclude the hedge is highly effective. For bookkeeping purposes, that same entity could experience earnings impact if the cumulative change in value on the hedging derivative exceeded that of the hedged item. Under the ASU, this result will not occur. If that same entity can pass the effectiveness tests, all cumulative change in value on the hedging derivative would flow through equity instead of earnings. This is an exciting concept for those entities that experience mild to significant earnings leakage despite effective hedge relationships.
Andrew Brodbeck: Are there certain markets you expect to see utilize the change more than others?
Tim Potter: I think any entity with a desire and appetite to hedge commodity risk exposure will stand to benefit from this ASU. Getting more specific, the steel industry could be a standout, simply due to the interplay between cold roll coil purchases and the more liquid hot roll coil futures market. Really any entity from any market will benefit from these rule changes, especially those that struggle to navigate a hedge of aggregate cash flows from commodity purchases relative to some loosely-correlated commodities index or market benchmark.
Andrew Brodbeck: When are the final rules expected be published, and when will they be effective?
Tim Potter: The final rules are slated to be published by the end of August 2017 and will be effective for fiscal years beginning after December 15, 2018 for public companies, and December 15, 2019 for private companies. Having said that, early adoption of accounting rule changes is typically received favorably by auditors and regulatory bodies alike. We anticipate many of our clients will adopt the final rules as early as possible barring approval from those governing organizations.
Andrew Brodbeck: What does that mean for corporate reporting? Every hedge from that day forward can be counted as such or can they look backwards for hedges currently on the books?
Tim Potter: The transition will require adoption of all new amendments at one date, and will involve the typical disclosures around accounting changes (reason for the change, cumulative effect of the change, and disclosures). Entities will need to disclose and record the cumulative effect of the accounting rule application as an offsetting adjustment through the opening balance of retained earnings. Tabular disclosures will also be required for comparative periods presented in the current fiscal year financial statements.
Application of the new ASU will certainly vary by entity depending on its resources and capabilities to adopt the amendments all at once. I also believe that the rule changes related to contractually specified components and to ineffectiveness measurements will be the primary drivers for current hedgers to early adopt.
My sense is that many entities will also revisit old hedges under the new ASU that failed effectiveness tests in the past, and/or re-evaluate new hedges that had been initially dismissed. Personally, I am excited to work with entities exploring new ways to mitigate commodity risk and to discover hedging opportunities that may have seemed insurmountable under the old accounting regime – hedging opportunities that are now accessible and achievable under the new ASU.
Andrew Brodbeck: Typically, new rules require careful coordination between tax, accounting and treasury. What is the sentiment you hear from your clients about adopting this in terms of ease of implementation?
Tim Potter: “Ease” is a relative concept. For some entities, achieving hedge accounting has been a far cry from reality. Now that the game has changed and the probability of effective hedges has increased, the accounting rule changes may warrant moderate changes to risk management and hedge accounting processes that simply haven’t existed in the past. Historically, the sentiment has been that “accounting does not follow economics”; these amendments now remove several burdensome requirements and concepts from the equation. As such, the conversation between key stakeholders can focus more on process and control, and not as much on the onerous technical requirements of the previous rules.
For other entities, already familiar with and taking advantage of hedge accounting, these rule changes should only relieve the operational burden for accounting/finance groups. No more earnings leakage. Fewer broken hedge accounting relationships. Overall, this ASU is a massive step toward aligning the economics and accounting for hedges. Since we began spreading the word of the new ASU, clients across all industries have been clamoring for pre-implementation and “ASU readiness” as we wait patiently for early adoption of these impactful changes.