For public companies with a Dec. 31, 2018, fiscal year-end, new hedge accounting rules will become effective Jan. 1, 2019. The FASB issued the new hedge accounting guidance Aug. 28, 2017, through Accounting Standards Update (ASU) No. 2017-12. The ASU provided the election to early adopt the new guidance and some companies made the early election to take advantage of favorable provisions. The following is a discussion of lessons learned by commodity hedgers that early adopted the new guidance.
It has been interesting to note that relatively few companies early adopted the new hedge accounting guidance. Entities maintaining derivatives can be divided into two groups: those applying hedge accounting and those that do not apply hedge accounting. For companies that do not apply hedge accounting, the new guidance has not prompted companies to start electing hedge accounting. Those companies have become comfortable addressing the earnings volatility associated with derivative instruments utilizing non-GAAP measures. For companies applying hedge accounting, early adopters mostly included companies that were starting new hedging programs or companies that desired to remove ineffectiveness from their financial statements. While companies viewed the new hedge accounting rules favorably, many companies shied away from early adoption. This was largely because accounting resources have been strained adopting other new accounting standards for revenue recognition and leases.
For commodity hedgers, the largest changes to the hedge accounting rules under the new guidance include the following three items:
• Ability to perform qualitative effectiveness assessment testing following designation inception
• Ability to designate a contractually specified component
• Elimination of the requirement to separately measure and report hedge ineffectiveness
One of the greatest struggles for commodity hedgers to achieve hedge accounting under the existing guidance was the effort associated with ongoing effectiveness assessment tests. Under the current accounting guidance, a commodity hedger typically performed effectiveness assessment testing by performing regression analysis. The challenge was largely the lack of available market data representing the hedged item required to perform the on-going regression analysis. This analysis was required at inception and at least quarterly thereafter. Under the new hedge accounting guidance, a company may perform an inception quantitative effectiveness assessment test utilizing regression and then perform ongoing effectiveness testing qualitatively. When an entity performs qualitative assessments of hedge effectiveness, it must verify and document that the facts and circumstances related to the hedging relationship have not changed such that it can assert qualitatively that the hedging relationship was and continues to be highly effective. Early adopters hedging commodity price risk have noted limited benefits with qualitative testing as they execute hedges on a continuous basis requiring inception regression testing on an ongoing basis. In addition, even though the accounting standard provides for qualitative updates, many auditors are continuing to request ongoing quantitative support unless the hedging relationship is highly correlated, such as instances where the hedging instrument mirrors a designated contractually-specified component.
Under the current hedge accounting guidance, a commodity hedger is required to hedge the cashflow risk associated with the entire contractual cash flow. This was counter to how many companies utilized derivative instruments to manage their price risk. The new guidance gives companies the ability to designate a contractually-specified component, which is a significant benefit to many commodity hedgers. However, there have been some challenges for some companies to meet the criteria of a contractually-specified component.
Early adopters have noted three areas of concern when electing to designate a contractually-specified component:
• Finding documents to support the contractually-specified component;
• Ability to designate spot purchases; and
• The interplay with the normal purchases and normal sales scope exemption.
Finding documents to support the existence of a contractually-specified component can be challenging for companies in some industries. Some industries have industry standards that incorporate contractually-specified pricing component language into the boilerplate purchase and sale agreements. Agricultural, livestock and many metals are purchased and sold under market mechanisms that already include the contractually-specified language required to meet the contractually-specified component designation.
Common Commodity Industry Groups
• Oil, Natural Gas, NGLs
• Refined Products (Diesel, Gasoline, Chemicals, etc.)
• Precious Metals
• Industrial Metals
• Agricultural (Dairy, Grains, Fiber, etc.) and Livestock
Companies that operate in power, crude oil, natural gas, NGLs and refined products have mixed results when seeking to designate a contractually-specified component. The ability to designate a contractually-specified component is relatively limited for manufacturing or refining companies where the input into a finished good can have a contractually-specified component; however, once processed or combined with other items, the ultimate product sold does not contain a contractually-specified component. For example, crude oil might be a significant input for jet fuel, but a sales contract for the ultimate sale of jet fuel often will not reference a crude oil index.
Many companies purchase and sell product in a spot market. This can be particularly true for larger oil and natural gas producers that market their own production and for trading organizations. These companies have found significant limitations in designating a contractually-specified component under the new hedge accounting guidance. When a company knows that they will be buying or selling product at a future date, they often execute a derivative to hedge future price variability. However, a contract does not exist specifying the pricing at delivery of the physical product. The company will buy or sell the product at a negotiated price a few weeks prior to delivery or at delivery. The market convention to negotiate the ultimate spot price will reference industry benchmarks, but nothing will be included in the contract noting the pricing components. For example, a trucking company operating in New York and Pennsylvania knows that they will be purchasing diesel in 12 months and executes New York Harbor ultralow sulfur diesel (ULSD) futures contracts to hedge the purchases. The fleet will be purchasing the diesel at the pump under spot pricing, but this spot price will not meet the contractually-specified component requirements.
In order for a company to qualify for a contractually-specified component designation, the new accounting guidance requires the company to designate the hedged item under the normal purchase and normal sale exemption. This election often does not create issues for most companies. However, for companies that are engaged in trading activities where physical fixed price positions are recorded at fair value to offset financial positions, this can be problematic. A company may enter into a physical agreement that has an index price and the fixed price will be determined at a later date. The normal purchase and normal sale exemption is an irrevocable election, so once the election is made for the physical agreement before the fixed price is determined, the company cannot record the fixed price agreement at fair value later.
In addition, the normal purchase and normal sale exemption contains a prohibition against net settlement. This can be problematic for companies that have physical purchase and sales with the same counterparty. Rather than physically deliver all the purchases and separately deliver all the sales, they will only deliver the net position, which is not allowed under the normal purchase and normal sales exemption. Companies engaged in these activities are limited in their ability to receive the benefits of a contractually-specified component designation.
While there have been challenges encountered by early adopters, the Financial Accounting Standards Board’s (FASB) changes to the hedge accounting rules have been favorably received by users for the most part. Companies should carefully consider the changes under the new hedge accounting guidance and take steps to properly implement any changes.
About the author: As a Managing Director at Opportune, Shane assists companies and financial institutions throughout North America, South America, Europe and Asia-Pacific in their understanding of what is possible as they deal with the challenges of implementing risk management programs and highly technical accounting pronouncements. Shane oversees the risk management, derivatives, stock-based compensation and complex securities service offerings of Opportune. He assists clients with the entire risk management lifecycle, including strategy, execution, compliance, valuation and hedge accounting. He has undergraduate and graduate degrees in accounting from Oklahoma State University. He is also a member of the American Institute of Certified Public Accountants.