How Hedging Can Be An Effective Risk Management Strategy 

During times of market volatility, hedging can be an effective way to counter changes in raw material prices, foreign exchange rates, and interest rates. Updated guidance on how to report hedging strategies goes into effect for public entities in 2023 and for private entities in 2024. CSH expert, Michelle Smith, summarizes these new accounting rules which may cause your organization to reconsider hedging strategies today.

Round one

Companies sometimes buy derivatives, such as futures, options or swaps to hedge against market uncertainty. For example, airlines may use commodity price swaps (a derivative) to save on fuel costs (the hedged item). Alternatively, a business could purchase interest rate swaps (a derivative) to hedge against increases in payments on loans with variable interest rates (the hedged item).

Accounting Standards Update (ASU) No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, was issued to simplify the complex rules for reporting hedging transactions and more accurately reflect the economics of hedging strategies. The complexity of the old rules led to diversity in practice, and hedging has historically been a common cause of financial restatements. 

Changes in the value of the derivatives must be recorded at fair value on the income statement under existing U.S. Generally Accepted Accounting Principles. But, under certain conditions, companies are allowed to use so-called “hedge accounting.” This keeps the price swings of derivatives out of reported earnings by designating a derivative instrument to a hedged item and then recognizing gains and losses from both items in the same period. 

Important: The application of hedge accounting isn’t mandatory. It’s something that companies may elect to apply to minimize artificial swings in earnings from unrealized gains and losses on derivatives. 

Hedge accounting effectively allows the deferral of gains and losses. To qualify for this treatment, the relationship between a hedging instrument and the hedged item must be “highly effective” in achieving offsetting changes in fair value or cash flows attributable to the hedged risk.

The updated guidance expanded the strategies that qualify for hedge accounting. It also introduced the last-of-layer model for reporting hedging transactions. This method provides a strategy to more easily hedge portfolios of prepayable financial assets and beneficial interests secured by portfolios of prepayable financial instruments, such as residential mortgages or mortgage-backed securities. The updated standard took effect in 2019 for calendar-year public companies. Because of the COVID-19 pandemic, calendar-year private companies were granted a deferral from 2020 to 2021.

Round two

Last year, the FASB issued additional guidance on hedging transactions. Specifically, ASU No. 2022-01, Derivatives and Hedging (Topic 815): Fair Value Hedging – Portfolio Layer Method, clarifies the updated guidance from 2017. It expands the last-of-layer method (now called the “portfolio layer” method) that permitted only one hedged layer, now allowing multiple hedged layers of a single closed portfolio. A multiple-layer model helps align hedge accounting with an entity’s risk management activities, which, in turn, provides more-meaningful information to financial statement users.

The recent update helps bridge the gap between hedge accounting and the credit loss standard to clarify that an entity is prohibited from including hedge accounting impact in the credit loss calculations. It also specifies how to consider hedge basis adjustments when determining credit losses for the assets included in a closed portfolio. The second round of changes goes into effect in 2023 for public entities and in 2024 for private ones.

Conditions ripe for hedging

Today’s market conditions may cause organizations that have historically shied away from using hedging strategies to reconsider them. First, the use of derivatives can be an effective risk management strategy against inflation, exchange rate volatility, and interest rate hikes, essentially all the risks that businesses are facing today. Second, the accounting rules for hedging transactions have become simpler and better aligned with the needs of financial statement users. 

Contact our CSH experts to evaluate whether your organization should incorporate hedging into your risk management practices and, if so, how to comply with the financial reporting requirements.