Derivatives and hedging
The volume, variety, and inherent complexity of derivative contracts have increased over time as the nature of hedging activities continues to grow and evolve. In practice, hedge accounting can be difficult to apply and misapplication of the accounting guidance for hedging activities has resulted in a significant number of restatements in the marketplace. For this reason, the use of derivative instruments and the application of hedge accounting still attracts heightened scrutiny from regulators and other interested parties.
That being said, many corporations continue to use hedge accounting despite the risk associated with misapplication, as derivative instruments allow companies to disaggregate risks and manage them separately—an ability that translates into greater efficiency and cost effectiveness.
Some key challenges include:
- Identifying resources with the appropriate expertise and experience;
- Preparing hedge documentation that is complete and compliant with the accounting rules;
- Coordinating between departments (e.g., accounting, treasury and risk management);
- Implementing hedge accounting including assessing hedge effectiveness/measuring ineffectiveness;
- Identifying embedded derivatives and obtaining the appropriate fair value measurements as needed;
- Understanding appropriateness of the "shortcut method“.
In response to the challenges and perceived “inflexibility” of accounting standards, the FASB and IASB have expressed their commitment to improving the workability of the accounting guidance. They are currently engaged in a joint project intended to address the accounting for all financial instruments, including hedge accounting. While simplification is welcomed, companies will need to stay focused on the forthcoming changes and align practices accordingly.
We recognize that some may view the accounting for derivatives and hedge accounting predominately as a compliance exercise and often a hurdle to executing a structured trade. Our goal is to help clarify a complex area of accounting by providing relevant guidance, analysis and perspective in a commercial context.
Chad Kokenge, Partner
Impacts to companies:
- Without the application of hedge accounting, derivatives can generate significant volatility in earnings.
- Applying hedge accounting exposes companies to potential misapplication of the accounting rules and restatements.
- Correctly setting up hedging documentation can reduce the risk of de-designating the hedging relationship.
- Companies may face challenges once the FASB's proposals are finalized.
What companies should do:
- Ensure application of hedge accounting is well vetted during the pre-trade execution period.
- Consider nuances inherent in exchange-traded and OTC derivative markets when applying the accounting guidance.
- Employ staff well-versed in the topic or seek assistance from third parties to ensure accuracy in application.
- Take advantage of systems and controls to support and ease the burden of applying the accounting rules.
- Stay up to speed on the FASB and IASB's proposed changes in contemplating and negotiating future derivative transactions.