Home The C-SuiteChief Financial Officer (CFO) Hedge Accounting Should Be Easier in the Future

Hedge Accounting Should Be Easier in the Future

by internationaldirector

Written By: Morgan Jones – Corporate Finance

Hedging its operations and portfolios should be common and easy for a bank, as it meets the “cautiousness” requirements of any bank. The objective of hedge accounting is to represent, in financial statements, the effect of an entity’s risk-management activities: the bank uses financial instruments (interest or currency swaps, options, forwards) to manage its own exposures arising from particular risks that could affect its profit and/or loss—its own loans, securities, currency contracts, other assets and liabilities. For instance, hedging a long-term loan with a variable rate by contracting an interest-rate swap so as to neutralize the bank’s interest risk should be a normal and good practice in a bank’s operations.

However, according to the existing international accounting principles (mainly IFRS 9 Financial Instruments), netting of the two operations (initial and hedging) is not accomplished so easily.

Derivatives instruments used to hedge operations are considered volatile instruments that should be measured at fair value. And netting their result with another operation is not easily accepted by regulators. The purpose of the accounting rules is to oblige banks to book immediately the market values of their operations in their financial statements—unless the bank can prove that the hedging is a perfect hedging, each operation mirroring the other perfectly. The regulator thus sets preconditions to be followed by the bank if it does not want the results of the two operations to lead to significant variations in results in its books at each closing date.

Among those conditions are:

  • extensive documentation: to qualify for hedge accounting, an entity must clearly document at the inception of a hedging relationship its risk-management objectives and strategy for entering into the derivatives transaction;
  • performing regularly hedge-effectiveness assessments (and documenting that analyses) both at the outset of the hedge transaction and on an ongoing basis (at least quarterly). The assessment must include an evaluation of whether the relationship between the hedging instrument and the hedged item is considered highly effective;
  • choosing only allowed methodologies to process the evaluation;
  • schemes and evaluations must be regularly audited by statutory auditors.

Given the nature of the hedge-accounting criteria, it should be presumed that in absence of contemporaneous, formal and complete documentation, a hedging instrument does not qualify for hedge accounting. Those conditions are quite difficult to respect. And tax consequences of the hedging scheme can be different from the accounting results, generating tax/accounting result discrepancies along the duration of the hedging scheme. Often banks need the help of accounting firms to put in place a dedicated model of evaluation and reporting, so that the statutory auditors cannot reject the hedge accounting and force the bank to book the market values of two operations at each closing.

Finally, the last consequence is that the chief accounting officer and accounting team will hesitate before using the hedge-accounting principle, reserving this technique for very specific operations and portfolios that are likely to remain over a certain duration. Many middle or small banks hesitate to put in place hedge accounting.

Hedge accounting allows banks to greatly reduce the volatility of derivatives on financial statements, though many banks currently avoid the practice due to onerous documentation requirements. It is a pity for a bank to hesitate hedging its operations in order to answer to the need for cautious management. This should rather have been encouraged by regulators.

The good news is that at the end of March, the Financial Accounting Standards Board (FASB) signalled that it would continue easing the way for banks to hedge their interest-rate risks with derivatives.

The FASB in 2016 issued a proposal that would soften the eligibility and documentation requirements of hedge accounting. And based on a recent feedback letter from the American Bankers Association (ABA), the FASB has decided to further expand hedge-accounting opportunities.

The most significant topics that will soften regulatory requirements are:

  • the proposed expansion of component hedging, such as hedging specifically for the interest-rate risk of an instrument instead of its full contractual cash flows, will likely provide bankers with more opportunities to operationalize hedge accounting in a cost-effective manner;
  • the expansion of indices eligible for hedge designation, which should improve risk-management reporting;
  • the retention of the Shortcut Method;
  • the reduced timing and documentation requirements.

All these propositions are considered to be helpful by the ABA “to remove a big deterrent from those entities that may want to apply hedge accounting for the first time or consider expanding its use”.

The FASB is expected to issue its conclusion on modifications to the hedge-accounting standard by July 2017.


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