Hedge Accounting Change Creates
Bonanza for Commodities
- With the advent of organized commodities markets, active trading created price volatility, and ultimately the desire to manage and mitigate commodity price risks.
- Historical hedging practices combined with an unfriendly US accounting framework resulted in decades of suboptimal commodities hedging practices and outcomes.
- A recent US accounting standards change provides numerous improvements, some of which are particularly favorable to commodities hedging.
- We expect these accounting changes will cause an increase in commodities hedging, and a shift in hedging practices that will improve outcomes.
Commodities marketplaces date to the middle of the 19th century in America, and evolved into organized exchanges such as NYMEX by late in that century. As these markets matured, commodity trading volumes increased, and so did volatility in commodities prices. It was only natural for market participants to desire to manage and mitigate the risks resulting from that price volatility. Commodities traders and users began to systematically employ future dated purchase contracts to manage risk, and the practice spawned a specific market for those contracts (ultimately called “futures”), beyond the physical commodities themselves.
Commodities markets are unique in their long history of hedging using purchase contracts and futures. Despite the advent of derivatives in the currencies, rates and credit markets by the late 1980’s, the advantages of customized OTC derivatives weren’t initially appreciated by many commodities firms. Matters were made worse by the introduction of onerous US accounting rules covering derivatives in 1998, which remained little changed for decades and caused many commodities firms to leave in place suboptimal hedging methods.
The commodities hedging landscape changed significantly in late 2017, following the introduction of US accounting rules that offer commodities firms the opportunity to employ hedging methods long used in the currencies and interest rates asset classes. We believe this change, along with a host of other favorable new accounting provisions, will motivate a shift in commodities hedging methods that will result in improved hedging outcomes.
COMMODITIES AND RISK
Many commodities start their life being extracted from the ground or being grown in or on it. To extract value typically requires large scale and capital intensive activities and enterprises. While commodities are often thought of as raw materials, many commodities actually involve multiple processes and inputs which are component parts of their total cost to produce. That leads to varying levels of vertical integration within the commodities industry generally, and sectors thereof. Most importantly, commodities are the building blocks of many intermediate products and finished goods, which span a broad spectrum of industries.
Due to the scale of commodities creation and processing, and their broad use in other products, many companies are either producers/sellers or buyers/users of commodities, and sometimes both. This exposes firms that create, process or use commodities to material price fluctuations, which can quickly make an otherwise profitable finished product less profitable or even money loosing. Whether it’s an oil company refining crude to jet fuel or a retail coffee company buying beans, commodity price fluctuations touch almost every sector of the economy.
Given this background, the economic rationale for commodities risk management and hedging is irrefutable. However, the accounting benefits are no less important: reducing the volatility of corporate operating results. The accounting motivation is strongest in public companies, where less volatile and more predictable operating results will directly increase the stock price and reduce borrowing costs, but this rationale also extends to private companies.
THE ACOUNTING LANDSCAPE
Over the last two decades, the US Financial Accounting Standards Board (FASB) has developed a framework to help understand and categorize various hedging activities, which specifies the way those activities must be presented on corporate financial statements. Following the publication of FAS 133 entitled “Accounting for Derivative Instruments and Hedging Activities” in 1998, FASB modified and supplemented FAS 133 extensively, and codified a major portion of it with ASC 815. While the FASB created GAAP standards are mandatory for all US public companies, they are optionally followed by many private ones.
The ASC 815 framework defines a derivative as an instrument or contract with (a) notional amount, payment terms or both, (b) no or low initial investment, which (c) can be net settled or physically delivered. The extraordinary breadth of this definition pulls many contracts and instruments under the umbrella of derivatives accounting that people might not immediately think of as derivatives. The impact is significant, since derivatives must be carried on the entity balance sheet at market value, and the gains and losses therefrom must be recognized on a current basis. Therefore, the use of derivatives may serve to reduce risk at the enterprise level, but may create artificial financial statement volatility, unless a scope exception is applicable or hedge accounting treatment is achieved.
Not surprisingly, numerous exceptions to the scope of derivatives accounting have arisen. The historical practice of commodities firms of using multiple purchase contracts of varying terms to mitigate a risk, even if they didn’t fully hedge the risk, resulted in the “normal purchase and normal sales” exception to derivatives accounting. To qualify, the contract must (a) be for a non-financial asset, (b) not net settle and likely be physically settled, (c) be in quantities consistent with normal business operations of the entity, and (d) have the election and rationale for qualification properly documented. If a contract qualifies for this exception, the good news is that you get out of derivatives accounting but the bad news is that the risk isn’t fully hedged. Further, the contract value still needs to be marked to market and reported on financial statements, so the fluctuating value of the contract creates artificial financial statement volatility.
THE HOLY GRAIL
Within derivatives accounting, the FASB framework distinguishes between derivatives generally and those that achieve so-called hedge accounting treatment. The former are discussed above but the latter are truly the holy grail of commodities hedging. Prior to FASB’s release of ASU 2017-12 (discussed below) hedge accounting treatment was difficult to achieve, requiring companies to document the hedging strategy, the hedged item and the instrument used, and then demonstrate that the hedge is highly effective (offset the vast majority of the associated risk) both before and after it is entered into. This so called “effectiveness testing” was particularly difficult post-ante, requiring periodic regression analysis. Also before ASU 2017-12, the risks associated with nonfinancial contracts or assets (such as commodities) were not allowed to be broken down into component parts, so that each part could be hedged separately.
For situations where hedge accounting treatment was achieved and maintained through the life of the derivative, no intermediate term volatility in the value of the derivative was required to flow through to the company’s financial statement, and the earnings recognition from the derivative was delayed to coincide with the earnings effect from the hedged exposure. In that case both the economic and accounting objectives for hedging are achieved: (a) the risk is properly and fully hedged and (b) financial statement volatility is reduced. In less ideal cases where hedge accounting treatment was achieved at the outset, but the hedge became ineffective during its life, only the ineffective portion was flowed through to financial statements. This is still a better outcome than futures or purchase contracts, since the risk is fully hedged and the amount of financial statement volatility is reduced although not eliminated.
Historically, accounting treatment and presentation has shaped many of the activities and practices in commodities hedging. The challenges noted above have historically resulted in commodities hedges achieving hedge accounting treatment only about 35% of the time, while foreign exchange and interest rates hedges achieved hedge accounting treatment over 80% of the time. With hedge accounting treatment a distant dream for many commodities firms, they settled for risk mitigation using purchase contracts or hedging using futures, both of which don’t properly or completely hedge the risk and result in unnecessary financial statement volatility.
THE DAWN OF A NEW ERA
The culmination of a 10 year project, FASB issued important changes to the existing accounting framework in ASU 2017-12 entitled “Targeted Improvements to Accounting for Hedging Activities” during August 2017 (“New Standard”). FASB’s objectives were to (a) better align accounting rules with risk management activities, (b) better reflect hedging results in financial statements, and (c) simplify hedge accounting. The New Standard is unquestionably targeted and beneficial, and for commodities hedging a game changer. While not mandatory for US public companies until December 2018, it may be elected immediately.
The single most important change for commodities hedging is the extension of component hedging for financial risks (typically currencies and rates) to now include non-financial risks (such as commodities). This allows specific components of a financial statement item to be designated and hedged as opposed to the total cash flows, and for the first time puts commodities hedging on equal footing with financial hedging. Given that commodities themselves often include various component costs, as do intermediate and finished goods, this should simplify and thus boost commodities hedging activities.
In addition to the component hedging prohibition noted above, the documentation and effectiveness testing requirements under the prior framework kept many commodities firms from seeking hedge accounting treatment. The New Standard takes specific aim at these problems by (a) providing more time for entities to put documentation in place and (b) eliminating the separate measurement and reporting of hedge ineffectiveness. Under the old framework, before entering into the hedge companies had to prove the proposed hedge was highly effective, and after entering into the hedge periodically measure the effectiveness and flow the ineffective portion to their financial statements. Under the New Standards, the initial effectiveness assessment must be quantitative, but the subsequent assessments can be qualitative. Not only does this greatly reduce the administrative burden of hedge accounting, it also eliminates financial statement “noise” caused by reporting the ineffective portion of a hedge. These changes, combined with new presentation rules requiring the hedging transaction to be reported on the same line as the hedged item, make hedge accounting treatment more accessible, transparent and desirable.
Risk management activities and hedging strategies have long been effected by accounting rules. The advent of the New Standard is expected to increase the use of targeted risk management strategies using customized derivatives for commodities hedging, and cause a move away from using purchase contracts or futures. By using customized derivatives, commodities firms can accurately match the instrument with the risk (and hedge specific components thereof) to decrease or eliminate basis risk (the so called “perfect hedge”). Doing so will maximize the economic benefit of the hedge, and enable qualification for hedge accounting treatment to maximize the accounting value of the hedge, creating the most optimal hedging outcome.
By: Chip Horton, January 22, 2018
About This Insight
Direct Swap is an electronic marketplace for customized OTC derivatives. We securely connect members with traditional and unique sources of liquidity, and provide exclusive access to bespoke solutions for precision hedging and counterparty management. We are the only online derivatives solution providing key features which help firms realize the full potential of these new hedge accounting standards. To form the opinions expressed here, we’ve collected both publicly available information and input from our proprietary sources. However, all opinions expressed here are the views of the author, and should not be attributed to any other person or organization.