Overcoming the Challenges of Hedge Accounting in an Uncertain Regulatory Environment

For many corporate treasurers, hedge accounting is an excruciating and daunting process. According to a research report by the Financial Analysis Lab at the Georgia Institute of Technology1, there are five main reasons why companies may decide not to apply hedge accounting under existing standards:

  1. The considerable costs of documentation and ongoing monitoring of designated hedges.
  2. The availability of natural hedges that can be highly effective.
  3. New accounting standards that extend the use of natural or economic hedges.
  4. Qualifying hedges are not available (or are too expensive) and the documentation is inadequate.
  5. The increased risk of financial restatements associated with hedge accounting.

Recent market developments and proposed updates to hedge accounting standards have led organisations to believe that hedge accounting will soon be simplified. However, in a recent survey, 73% of treasuries who conducted hedge effectiveness testing saw it as their biggest challenge – even greater than accurate risk assessment or independent valuations2. Why does hedge accounting continually rank as one the most difficult processes faced by corporate finance teams? Let’s look at some of these challenges in more detail.

Challenge One: Uncertainty Surrounding New Hedge Accounting Standards

Although hedge accounting has been around for over a decade, recent exposure drafts issued by both the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) propose to better disclose:

  • Risks being managed.
  • How those risks are managed.
  • The outcomes of risk management activities.

The challenge has been getting both standards boards to come to a single, common set of rules. Despite this (ideal) convergence, several organisations have demonstrated a clear preference toward the IASB proposal, as it more closely aligns risk management strategies and allows firms to more easily comply with hedge accounting rules.

Even though the new rules will make it easier for companies to apply for hedge accounting, the uncertainty as to when they will become effective is challenging. While some organisations are waiting for the new standards to be finalised, they are facing an increased exposure given the current state of financial markets. Treasurers need to identify a solution that can be cost effective and used today, but be flexible enough to adapt to tomorrow’s standards – a situation that creates additional challenges.

Challenge Two: Lack of Internal Expertise

When it comes to hedge accounting, one area of significant consternation for organisations relates to the level of knowledge required to run hedge effectiveness testing, a critical component of hedge accounting. At the same time, ensuring that the right processes are in place may also be an extremely challenging problem to overcome. Some of the typical scenarios include the knowledge being concentrated within one key person (and when that person leaves, an information hole opens up), as well as the tools used for hedge accounting are a collection of internal spreadsheets and adhoc processes.

While many organisations may rely on one single person to create the workflow, select the tools for hedge effectiveness testing and become the designated expert when it comes to compliance issues, the challenge truly materialises when this person exits the organisation.

Corporate treasurers can mitigate this risk by employing an in-house hedge accounting solution or by outsourcing this process to an external consultant. This brings us to the next challenge – use of consultants.

Challenge Three: High Cost of Consultants

What can corporate financial professionals do when they must comply with hedge accounting regulations, but do not have the in-house expertise? A common approach has been to hire a consultant.

Outsourcing the hedge accounting process may provide a number of benefits surrounding training (organisations are not required to retain the specialised knowledge necessary to apply hedge accounting) and time (hedge accounting has traditionally required a significant investment of time to run given its complexity). However, hiring specialists may raise significant issues:

  • No control over your hedge accounting process: by outsourcing the activity, treasurers might not have a thorough understanding of their hedge effectiveness calculations.
  • Higher costs for the organisation: consultants tend to be more expensive than an in-house solution, particularly if an organisation is required to run hedge accounting reports on a more frequent basis.
  • Lack of a timely response: consultants may also be less flexible with what can be delivered outside of regularly scheduled dates.

With consultants being expensive and treasuries wanting more control, the next step is to find a solution in house. Unfortunately, treasurers often turn to the ubiquitous spreadsheet – a tool that has operational risks associated with it.

Challenge Four: Operational Risk Associated with Spreadsheets

Spreadsheets are a common tool used in treasuries. As a result, this is a natural extension for hedge accounting. Although there is an inherent flexibility and comfort with spreadsheets, using this tool for hedge effectiveness calculations can be a risky proposition:

1. Operational risk due to human error

Spreadsheets are highly manual. Common issues associated with manual approaches include contracts not being captured correctly, incorrect assumptions for the calculations being used or spreadsheets not being calculated at all, frequently leading to costly mistakes and financial restatements. Although most of these will be due to unintentional user errors, the risk still remains that an intentional error could be introduced. Since the person assessing the hedge’s effectiveness may not be the one producing the reports, it is crucial to generate hedge accounting documentation that is clear and easy to understand.

2. Spreadsheets are time consuming

As spreadsheets require high user input, treasurers would time and again realise that they were spending more time on hedge accounting than originally expected. Tasks such as setting up a spreadsheet, verifying the accuracy of the data (and of the results) and distributing reports to the relevant stakeholders would rapidly become time consuming. Furthermore, treasurers would also find themselves spending considerable time scrutinising the process to ensure they would meet their auditor’s requirements. If financial professionals are spending days running the results, they might not be able to invest the necessary time to analyse the results.

3. Spreadsheets do not provide the necessary documentation

Given the complexity surrounding hedge effectiveness testing, spreadsheets also fail to provide the documentation that may be used as proof when key stakeholders – such as auditors – start asking questions. Regardless of how frequently an organisation may be audited, treasurers are still required to explain what model they used for their hedge effectiveness calculations, as well as how the model works – which could quickly turn into a cumbersome process when using manual tools.

Overcoming the Challenges

As evidenced in this article, there are many challenges for companies wanting to implement hedge accounting. Treasuries need to find an in-house system that fits their needs and meets the following challenges:

Flexible solution to meet future needs

Given the current state of financial markets, organisations should look for a solution that allows them to meet today’s standards, but is flexible enough to adapt to future changes in the standards.

Easy to use so internal staff can manage the process

While hedge accounting may not be easy, a system needs to be easy to use so staff can manage the process and provide the documentation necessary. Treasuries need to avoid a one-size-fits-all system that requires extensive training and introduces more complexity into the department than it solves. A simple to use system means that more than one person can manage the process for the department and reduces dependency on key personnel.

Lower cost to fit your budget

Companies must determine if outsourcing to a consultant makes sense, as asking for more information may end up creating additional costs. Consultants may seem like the right solution if treasurers lack the time to implement a new system. However, consultants can be more expensive than an easy to use solution, and less flexible with what can be delivered outside of regularly scheduled dates. Treasurers need to find a solution that will allow them to comply with hedge accounting and still fit their budget in the long term.

Stable system that will reduce operational risk

While spreadsheets will always be important for treasuries, they are not appropriate for hedge accounting. A system will not only reduce the operational risks associated with spreadsheets, it also provides the necessary tests for hedge accounting.

Conclusion

Hedge accounting is particularly useful for organisations that experience financial statement volatility today as a result of using derivatives to hedge underlying risks. It does, nevertheless, require a level of expertise to ensure it is being applied appropriately.

The consequences of not applying hedge accounting appropriately can be significant, often resulting in financial restatements. Nonetheless, when applied appropriately, hedge accounting can result in a better alignment of an organisation’s financial reporting and economic realities. Treasurers should implement a solution that overcomes the challenges above, so they can capitalise on the inherent benefits of hedge accounting.

12008 Georgia Institute of Technology, ‘The Non-designation of Derivatives as Hedges for Accounting Purposes’.

22011 FINCAD Corporate Survey.

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