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Designation strategies using simplified documentation could make hedge accounting more complicated

Summary

Companies must understand the facts and circumstances in which documenting and applying a simplified hedge accounting approach is appropriate or risk invalidating the hedging relationship.

Key takeaways

  • The hedge designation memo serves as the foundational document by which any future program changes are assessed. Therefore, companies should implement robust and well-researched documentation.
  • The FASB provides simplified hedge accounting approaches, such as Critical Term Match (“CTM”) or Shortcut, to help ease the administrative burden of operationalizing a hedge accounting program.
  • When differences in critical terms between a derivative and its underlying exposure exist at the inception of a hedge accounting relationship, they make a simplified approach inappropriate to apply.
  • Long-haul designation approaches may allow for hedge accounting to be applied even if mismatches are present at inception or arise during the life of a hedge accounting relationship.

Provided by the FASB, simplified hedge accounting approaches, such as Critical Term Match (“CTM”) or Shortcut, can help ease the administrative burden of operationalizing a hedge accounting program. In certain situations, these designation approaches are beneficial and appropriate. However, it is critical that your organization understands the facts and circumstances that allow a hedge accounting relationship to qualify for these simplified approaches.

Risks of employing the simplified approach

When differences in critical terms (e.g. LIBOR tenor, floor rate, timing, notional etc.) between a derivative and its underlying exposure exist at the inception of a hedge accounting relationship, they render a simplified approach inappropriate to apply. If mismatches are introduced after designation, FASB guidance requires fallback to a quantitative method of effectiveness assessment.

Regardless of when they occur, mismatches are not always apparent. Identifying the economic terms applicable is not necessarily intuitive, and updates to exposures happen frequently without being communicated to the teams managing the accounting process. It is also important to remember that mismatches in a hedging relationship are quite common. Of all the active trades in our system designated for hedge accounting, roughly 70% include some form of mismatch incorporated into the hypothetical derivatives used.

Chatham frequently receives consulting requests after documentation has been completed by companies who inappropriately applied a simplified approach, potentially rendering the hedge accounting relationship invalid from inception. This often requires quantification of an error caused by deferring gains/losses into other comprehensive income rather than recording them directly to earnings, which could lead to a misstatement.

Considering a long-haul approach

Long-haul designation approaches may allow for hedge accounting to be applied even if mismatches are present at inception or arise during the life of a hedge accounting relationship. We have seen companies rely on long-haul quantitative effectiveness testing more heavily this year as the impacts from COVID-19 drastically changed the landscape from which historical forecasts and hedging decisions were based.

When implementing and operationalizing a new hedge accounting program, it is important to fully understand the facts and circumstances involved in the hedge accounting relationship and select the appropriate designation methodology. Key considerations include understanding the exposure being hedged, how and when that exposure impacts the company, and what method will be used to assess effectiveness. It is also critical to understand the company’s capital structure and strategy and how future decisions such as refinancings may impact the existing relationship. Hedge accounting designation strategies can be extremely nuanced, so if you do not have in-house expertise, you should seek expert guidance aligned with your goals and objectives to ensure your organization executes this critical step to applying hedge accounting properly.

Make an informed decision

Any designation approach includes both benefits and challenges. The Chatham hedge accounting team can help assess your situation and work with you to identify and implement a strategy that provides the correct accounting outcome while allowing for the flexibility today’s economic environment demands.

Chatham Financial Corporate Treasury Advisory

Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with your organization’s objectives. Our full range of services includes risk management strategy development, risk quantification, exposure management (interest rate, currency, and commodity), outsourced execution, technology solutions, and hedge accounting. We work with treasury teams to develop, evaluate, and enhance their risk management programs and to articulate the costs and benefits of strategic decisions.


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Disclaimers

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.

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