When it comes to hedge accounting, most companies fall into two groups: those who’ve had issues and those who will. Currently, the SEC and audit firms are consumed with potential changes to accounting rules and the Dodd- Frank Act. However, when regulators re-focus their attention on hedge accounting within the next two to three years, we will see the next round of restatements focus on the finer points of hedge accounting. One of those areas involves releases from other comprehensive income (OCI).

ASC 815-30-35-39 (previously SFAS 133, Paragraph 31) states, “amounts in accumulated other comprehensive income shall be reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings (for example, when a forecasted sale actually occurs). If the hedged transaction results in the acquisition of an asset or the incurrence of a liability, the gains and losses in accumulated other comprehensive income shall be reclassified into earnings in the same period or periods during which the asset acquired or liability incurred affects earnings (such as in the periods that depreciation expense, interest expense, or cost of sales is recognized).”

The accounting standards are straightforward, stating that while a cash flow hedge relationship meets the provisions of hedge accounting, any amount recorded in OCI stays in OCI until the hedged item affects earnings. One caveat to this rule is when a hedge relationship no longer meets the provisions of hedge accounting, for example, when the hedged item is no longer possible of occurring (i.e., has less than a 20% chance of occurring). Otherwise, the OCI balances remain until the originally hedged item affects earnings. Note that the hedged item may not affect earnings when the hedge settles. This is frequently the case when the hedged item is a capital project or an inventory purchase. The restatement risk develops if a company releases OCI when the hedge settles rather than reviewing the release of OCI based on the hedged item.

Assume the following scenario related to a foreign currency cash flow hedge of a forecasted inventory purchase denominated in EURO:

The second restatement risk relates to tracking of the OCI balances. Many entities lack the systems and tools to appropriately track the build-up and release of the associated OCI balances. When entities have numerous inventory purchases, it can be time consuming to identify which inventory items have OCI attached to them, and it can also be difficult to track those balances on a go-forward basis. This is compounded by the business nature of some industries. For example, many energy and agricultural companies transact in fungible goods, where the identity of the hedged item is essentially lost when placed in inventory.

Accounting policies that provide practical expedients related to the application of hedge accounting rarely pass regulatory review. The specificity requirements of hedge accounting are higher than those of most accounting standards. In hedge accounting, the hedged item’s definition per the hedge documentation is specifically identified, and the OCI attached to those items should be specifically identified and tracked as well. As such, it is best practice for management to periodically review their accounting policies related to the topic.

Many airlines hedge their purchases of jet fuel through various means.   Some use OTC jet fuel contracts, others use OTC or exchange-traded heating oil contracts, others use OTC or ET crude oil contracts and most use a combination of all three.   All of this is perfectly fine.  Since the majority of airlines don’t want the unrealized gain/loss fluctuations on these contracts to be taken through the income statement each reporting period, many of them designate these contracts under hedge accounting rules under ASC 815 (FAS 133).

Many of these derivative contracts are not exactly the “perfect” (different locations, different grades, transportation surcharges, profit adders, etc.) hedges for the underlying physical purchases of jet fuel; therefore, airlines are commonly forced to apply the “long haul” method of hedge accounting on these strategies.  Since the rules for long-haul are fairly complex and this strategy in particular fails fairly commonly under the “easy” method of hedge effectiveness assessment (dollar offset, anyone?) many airlines properly try to use regression on this strategy.

So why are some airlines headed for restatement even when they are trying to use a robust method of assessment?

The “shortcut” (pun intended) many airlines try and take with assessment (most commonly regression analysis) is that they try and regress the changes in spot values of the value of the exposure (or hypothetical derivative) and the value of the derivative.   This is perfectly allowable.   However, what is not allowable under paragraph 63 is measuring ineffectiveness using the full fair value of both the exposure (hypothetical derivatives) as well as the derivative.    Using one method “excluding time value” for assessment and another for measurement “including time value” is expressly prohibited under ASC 815-20-25.

Airlines beware!

The keenly anticipated issuance of the new accounting standard on hedge accounting (Phase III of IFRS 9) has been delayed from June 2011 until sometime in Q3 2011, probably September. This is disappointing news for many; particularly the commodity and option hedgers who were hoping to take advantage of the more favourable provisions in the new standard as soon as possible. I know of some companies that had even documented their option hedges in accordance with IFRS 9 with the hope of applying hedge accounting for the financial period to June 2011 – this will no longer be possible.

Why the delay?

First, I think the IASB were surprised at some of the negative feedback on certain areas of the standard during the comment letter review process, particularly since they had done so much outreach prior to issuing the standard. Since the comment letter deadline, they already made tentative decisions to accommodate some of the feedback in the eventual standard. For instance, zero cost collar option structures will now be treated consistent with premium-paid options under the standard. Also, the proposed new fair value hedging mechanics have been removed to keep the same approach used currently under IAS 39. Furthermore, in a tight decision by the IASB, it looks like they will allow hedge accounting to be applied to risks that impact fair value through OCI as well as P&L.

Secondly, some key stakeholders have begun to react to the fact that the IASB and FASB have taken considerably different paths in their hedge accounting proposals as well as financial instruments accounting in general. Regulators such as the Securities and Exchange Commission (SEC) in the US are very concerned that the two Boards seem so misaligned on this topic when operating under a framework of convergence. Recently, both the IASB and FASB issued a press release stating the convergence would not be completed by June 2011 as initially indicated but more towards the end of the year. However, even that timeline looks ambitious when you compare the two hedge accounting proposals currently on the table, and there will need to be some key concessions on both sides to issue a joint standard.

Macro hedging also delayed

Another indicator of the challenges faced by the IASB has been the delay of the exposure draft on macro hedge accounting. This is the process of hedge accounting most often employed by banks when hedging the interest rate risk between deposits and loan assets. European banks in particular have been very critical of the current guidance under IAS 39 so the IASB has been trying to form a more practical, acceptable solution with this project. An exposure draft was due out in June 2011 but has now been pushed to the second half of 2011, and many predict this would be more likely December 2011, making it six months behind schedule. This is reflective of the complexity of the issues around macro hedge accounting and the strong vested interest of the banking lobby in getting a viable solution. In addition, the IASB must decide on its general hedge accounting model first before releasing a macro hedging framework, so the delays highlighted above have a waterfall effect on this project.

Sir David Tweedie ends his tenure as IASB Chairman in June 2011. One of his main priorities was to replace IAS 39 with IFRS 9. Sadly for him, this goal will remain unfulfilled by the end of his term. Sad for you too if you hedge commodity risk or use option derivatives. Let’s hope the new chairman, Hans Hoogervorst, has the same drive to keep the momentum in place for a better hedge accounting standard.