Are you looking to hedge a non-financial transaction? There are a few nuances for non-financial transactions (like delivery of a commodity like oil) as compared to financial transactions (like an interest rate). Chuck Melko shares three key areas he sees when addressing non-financial hedging transactions.
Hello, I’m Chuck Melko.
Many companies explore the use of derivative instruments in hedging to manage risk in their business. Sometimes these risks are financial in nature, like interest rates, but other times these risks relate to non-financial transactions, such as delivery of a commodity like oil.
Companies are frequently interested in applying hedge accounting to these transactions in an effort to align the financial reporting with the purposes of entering into them. Qualifying for hedge accounting when hedging non-financial risks can be challenging under the current hedge accounting model. In my conversations with clients as they evaluate the hedge accounting model for non-financial risks, there are three areas that commonly come up that I want to share with you.
The first is around hedge effectiveness. Hedging instruments available may not be designed in a way that fully mitigates the risk that is eligible to be hedged. As a result, there may be ineffectiveness between the hedged risk and the hedging instrument. Similarly, companies may look to aggregate individual non-financial transactions together and hedge them as a group. However, transactions can only be grouped together if it is demonstrated that the transactions share the same risk exposure. Prior to entering into these types of hedges, companies should thoroughly evaluate the drivers of the risk related to the transactions and derivatives, and whether the relationship will be highly effective.
Next, I wanted to mention another requirement of the standard on demonstrating the probability of forecasted transactions occurring that a company may want to hedge. Forecasted nonfinancial purchases and sales may be subject to customer demand or other operational constraints and events. If a forecasted purchase or sale is expected to be designated as a hedge, it must be demonstrated that the transaction is probable of occurring. When evaluating this assertion, companies should evaluate the history of operations and potential of future events occurring that may impact this assertion. Internal forecasts, executed contracts and macroeconomic considerations should be included in this assessment.
And lastly, I get a lot of questions around the impact on cash flow hedges when management’s assertion around the probability of a forecasted transaction occurring changes. To the extent a transaction is no longer probable of occurring, hedge accounting must cease. In addition, if a transaction becomes probable of not occurring, amounts in AOCI should be reclassified to current earnings. If a company has a pattern of missing forecasted transactions, their ability to forecast transactions may be called into question.
While these are a few of the more common considerations, there are many other unique aspects of how a non-financial transaction interacts with hedge accounting guidance.
For more information on this topic, refer to the Guide to Accounting for Derivative Instruments and Hedging Activities available on CFOdirect.com.
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