5 common misconceptions about hedge accounting
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For corporations using derivatives to manage financial risk, the question of whether to apply hedge accounting has been highly debated. While there is no “one-size-fits-all” answer, overcoming these five common misconceptions can facilitate the decision to initiate, expand, or overhaul a hedge accounting program.
- You can lower the barrier to entry by taking an incremental approach to hedge accounting.
- After getting a handle on your most material exposures, you can stop there or leverage the infrastructure you’ve built to expand to additional programs over time.
- Many of the prevalent approaches for managing missed forecasts and FX volatility require a transition from the CTM method to a Long-Haul method.
- The mindset that the work is complete after preparing journal entries and financial statement disclosures ignores the complexity and critical nature of designing a hedge accounting program and misses out on its strategic value to the organization.
For most public companies (and those aspiring to go public), clearly communicating financial results to investors is a critical priority. That’s why many organizations using derivatives to manage financial risk seek to apply hedge accounting to ensure their financial statements accurately reflect the program’s economic objectives. Hedge accounting grows even more valuable in times of increased volatility and forecast uncertainty, since it allows companies to shield the income statement and align hedged gains and losses with the timing impact from the hedged transactions. However, it is something you need to get right at the outset since inappropriately applying hedge accounting invites auditor scrutiny and puts your organization at risk. This tension between delivering high value financial results and meeting rigorous requirements can complicate the decision about whether, when, and how to apply hedge accounting.
Misconception #1: Hedge accounting is very difficult to achieve and maintain
While companies new to hedge accounting can quickly get overwhelmed when deciding where to begin, you can lower the barrier to entry by taking an incremental approach:
- Start small and focus on understanding exposures causing the most risk to your organization.
- Determine an appropriate hedge accounting strategy and method for assessing hedge effectiveness.
- Put in place hedge documentation outlining the strategy and assessment details.
- Obtain approval for implementing your program, making sure you have sufficient technical expertise in place to address questions from auditors and senior executives.
If your accounting team is small or doesn’t maintain specialized hedge accounting knowledge in-house, you can partner with a hedge accounting advisor to ensure adequate oversight and expertise. A competent partner can determine whether your organization can achieve hedge accounting and assist with setting up and maintaining your program, including:
- Finding sufficient hedge accounting capacity to protect overall economic risk.
- Designing a flexible, operationally scalable strategy.
- Drafting contemporaneous hedge documentation prior to designating the trades.
- Proving the program will qualify through inception and ongoing assessments.
You can also minimize the work hours required for hedge accounting by leveraging a technology platform to streamline workflows, provide predefined treatments, and automate period-end processes.
Misconception #2: Hedge accounting is an "all-or-nothing" endeavor
Hedge accounting doesn’t have to be “all-or-nothing” across your entire portfolio. If you focus on your immediate challenge by getting a handle on your most material exposures, you can stop there or leverage the infrastructure you’ve built to expand to additional programs over time. While companies often start small and focus on a single hedge accounting program for well-known exposures, it is common to expand the application of hedge accounting to additional programs as the business grows. With today’s technology, you can easily scale your hedge accounting program, alleviating the manual burden and allowing your accounting and treasury resources to focus on other high-value activities.
It’s important, though, that your team and its risk management partners are prepared to meet the evolving needs and challenges of your business (and the market) over time. Too often, corporates implement programs and select hedging, hedge accounting, and technology partners unable to grow and nimbly adapt to the company’s changing priorities. Ultimately, this results in significant switching costs as your organization outgrows the capabilities and core competencies of these providers. Selecting partners with an eye towards your future growth trajectory can help you avoid these pitfalls and position your company for success.
Misconception #3: Critical Terms Match (CTM) makes every hedge accounting strategy easy
While simplified hedge accounting approaches, such as Critical Term Match (CTM) or Shortcut, can help ease the administrative burden of operationalizing a hedge accounting program, many of the prevalent approaches for managing missed forecasts and FX volatility, such as utilizing the spot method or rolling exposure windows, require a transition from the CTM method to a Long-Haul, regression method.
Even with simplified approaches, hedge accounting is complex and can expose your organization to risk when done incorrectly. Auditors and regulators continue to scrutinize hedging programs from their onset and look to ensure appropriate controls are in place to monitor programs. Without the proper resources and controls, you risk making errors, such as:
- Lacking a full understanding of your forecasts.
- Applying a qualitative approach when it should be quantitative.
- Adopting an overly aggressive approach.
- Missing the key importance of timely documentation.
Fortunately, automating the process can add rigor and lighten the burden on your hedge accounting team. For example, automating inception testing and designation workflows enables you to enter all the proper attributes only once so your organization knows it will qualify for hedge accounting before trade execution. Today’s technology can streamline the entire hedging process across front, middle, and back offices.
Misconception #4: Treasury and hedge accounting can be run independently
It’s important for treasury and accounting teams to communicate early and often on the hedging program. When practitioners operate in silos between the front, middle, and back office, it can limit an organization’s strategic alternatives and cause unnecessary problems when accounting for trades. For example, one strategy seen in practice that allows for increased hedge volumes is intentional over-hedging. However, under this strategy, the derivative notional is more than the amount of the underlying hedged transactions, making this strategy inappropriate for the use of CTM. While treasury may determine this strategy is beneficial from an economic standpoint, your accounting team may still need to put the proper documentation in place and gain auditor sign-off to support it. To ensure success from the onset, corporate accounting teams should always collaborate with treasury in the development and implementation of any hedging program, the controls put in place, and the selection of technology to adequately support the program as it evolves over time.
Misconception #5: All hedge accounting programs are basically the same.
One of the most common misconceptions about hedge accounting is that all programs are basically the same, and that the work is complete following preparation of journal entries and financial statement disclosures. This mindset both ignores the complexity and critical nature of designing a hedge accounting program and misses out on the strategic value it can bring to an organization.
When evaluating new hedging strategies and whether to apply hedge accounting, there isn’t a one-size-fits all approach. Company size, type, structure, and industry all influence whether hedge accounting is appropriate for your organization. If your company is public with a broad investor base, you may prioritize hedge accounting to protect earnings from the volatility of your hedging instruments. Similarly, if you’re a private company looking to go public in the future, you may want to apply hedge accounting in advance of an IPO.
Your hedge accounting team or consulting partner can play a critical role in any hedging program, including:
- Working closely with senior management and auditors to ensure the hedging strategies under consideration have been appropriately reviewed and approved.
- Partnering with treasury to implement and operationalize the hedging program correctly at the outset, avoiding common pitfalls and designing the program to run smoothly.
- Utilizing data-driven approaches for evaluating overall program effectiveness.
- Leveraging complex, nuanced hedging strategies available due to FASB guidance.
The bottom line
With the right tools and expertise, hedge accounting can not only be attainable, but also an essential component of a successful risk management program. As the trusted hedge accounting advisory and technology partner for 700 accounting clients across the globe, Chatham is well-equipped to help companies of all sizes and industries grow their hedge accounting programs to protect financial results and stay competitive in an increasingly complex and challenging business environment. Chatham’s corporate hedge accounting team can empower your organization to better understand, implement, and operationalize your hedge accounting programs across interest rates, foreign currency, and commodities. Our clients face a vast array of complex, unique hedge accounting challenges, and rely on our deep subject matter expertise and unique blend of advisory, operational, and technology capabilities to solve their problems and drive success.
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Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.21-0330
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