Hedging and new standards

By Ian P.N. Hague
Illustration : Geneviève Côté

New financial instruments standards will soon be adopted and it’s time to Prepare for their application

On the November issue, the Finance regular began consideration of new accounting standards comprehensively addressing the accounting for financial instruments, which are expected to be issued shortly. This month, we present some ideas as to how a company  might apply the aspects of the new standards addressing hedges.

Understand risk exposures and their effects on financial statements
Hedge accounting is optional. There is no requirement to adopt it. But many firms may do so to some extent to reflect the effects of certain financial risk management strategies in net income.

Hedging involves entering into one or more contracts designed to offset exposure to one or more risks. This is distinct from hedge accounting, which is special optional treatment available to ensure that the timing of income recognition on the hedging item matches that of the hedged item. Accordingly, a company needs to evaluate the risks to which it is exposed and how it is managing those risks, then consider whether it wishes to apply hedge accounting to reflect the effects of the risk management in net income. This may include alternatives to hedge accounting, such as the use of the option to measure any financial instrument at fair value on initial recognition, with gains and losses recognized in net income. In some instances this option may provide a more convenient way to achieve similar accounting if hedge accounting is chosen. The evaluation may also include considering the extent to which a company is concerned about possible income volatility, including investor perceptions.

Because the accounting consequences may differ and certain hedging relationships that previously qualified for hedge accounting in accordance with Accounting Guideline AcG-13, Hedging Relationships, will no longer qualify, a company may need to reevaluate the instances in which it wishes to use hedge accounting. Having made an evaluation of the possibilities, a firm may decide not to adopt hedge accounting or to do so only in limited circumstances. However, if it does choose to, it must do so within the parameters laid out in the new standards.

Designate/document hedge relationship
Having decided to adopt hedge accounting, a hedging relationship must be designated and documented. This is because hedge accounting is optional. It is necessary to know whether a particular financial instrument is to be accounted for in accordance with hedge accounting or otherwise. Documentation includes the risk management objective and strategy for the relationship as well as the method for assessing the effectiveness of the hedge (the correlation of changes in fair values or cash flows of the hedged and hedging items) on an ongoing basis. Documentation and designation must be in place before entering into the hedging relationship. If not, hedge accounting is precluded. Advance planning is, therefore, essential.

The designation and documentation requirements of the new standards are no different from those with which many companies may be familiar in applying AcG-13.

Account for the hedging relationship
Until the issue of the new standards, Canadian GAAP contained few requirements specifying how to account for a hedging relationship. In many cases, gains and losses on hedging instruments were deferred on the balance sheet or were kept off-balance-sheet until such time as it was appropriate to include them in net income. Also, the results of ineffective hedges were often not reflected in net income immediately. The issue of the new standards codifies the accounting and may cause a firm to reevaluate the circumstances in which it wishes to adopt hedge accounting.

There are two primary types of hedging relationship. The accounting differs for each. Accordingly, a company needs to clearly identify the exposures to which it is applying hedge accounting.

A fair-value hedge is a hedge of the exposure to changes in fair value of all or a portion of a recognized asset or liability or a previously unrecognized firm commitment attributable to a specified risk. In this case, all gains and losses from both the hedged item and the hedging item attributable to the hedged risk are recognized in current period net income. This is accomplished by making an additional adjustment to the carrying amount of the hedged item for the gain or loss attributable to the hedged risk, and reflecting that adjustment in net income in the same period as the corresponding gain or loss on the hedging item.

A cash-flow hedge is a hedge of the exposure to variability in cash flows of a recognized asset or liability or a highly probable forecasted transaction, attributable to a specified risk. In this case, the portion of the gain or loss on the hedging item designated as part of the hedging relationship is recognized in other comprehensive income. The gain or loss on any portion excluded from the hedging relationship is accounted for in the same manner as the instrument would be treated without hedge accounting. Accumulated gains or losses in other comprehensive income are recognized in net income generally in the same period that the resultant asset, liability or forecast transaction affects net income. A hedge of a net investment in a self-sustaining foreign operation is treated in a similar manner.

Throughout the hedging relationship, a company is required to consider whether the hedge remains effective. Gains and losses resulting from any ineffectiveness are reflected in net income. If the hedging relationship as a whole becomes ineffective, hedge accounting is discontinued.

Discontinue hedge accounting
When a hedging relationship becomes ineffective or is otherwise terminated — perhaps because the hedged or hedging item no longer exists or merely because the company chooses to no longer apply hedge accounting to that relationship — hedge accounting ceases. Hedge accounting generally ceases on a prospective basis, so that the accounting up to the date of discontinuance does not change. However, after that date, the hedging instrument and hedged item are accounted for in accordance with the normal requirements for those items, and the effects of the previous hedge accounting unwind in the manner they had originally been intended.

The discontinuance requirements of the new standards are not very different from those many companies may be familiar in applying AcG-13. However, they do provide some additional flexibility regarding the time at which an anticipated transaction actually occurs, versus the originally forecasted occurrence.

Provide disclosures
Because hedge accounting is optional, disclosure is required of the company’s objectives and strategies as well as sufficient information to understand hedge accounting’s effect on financial statements.

Transition
Companies using hedge accounting prior to adopting the new standards will need to assess whether their hedging relationships continue to qualify for hedge accounting in accordance with the new standards. If they don’t, then hedge accounting must be discontinued for those relationships — although new relationships may be designated. If the hedging relationship qualifies, but was previously accounted for in a different way, a  company will need to adjust opening balances of hedged items, hedging items, retained earnings and accumulated other comprehensive income, as necessary to place the accounting on the new basis. Transactions entered into before the new standards apply may not be retro-actively designated as hedges. Prior period financial statements are not restated.

As noted in last month’s article, the new financial instruments standards are not straightforward and in many cases will require significant advance planning to apply. Even though the implementation date seems some way off, companies should consider how to apply these new standards as soon as possible. Whether a firm is small or large, uses complex or straightforward financial instruments, the new standards will affect it. It is never too early to start planning for their implementation.