Hedging strategies and GAAP: a marriage made in heaven? Canada's new hedge accounting rules create new ways in which to make sense of hedging activities in financial statements. Make sure you know where it works best.
One of the guiding principles of investors and executives who want to get rich is "Nothing ventured, nothing gained." And there are plenty of venture--or risk--opportunities around: foreign currency transactions, speculation on interest rates and derivatives transactions, to name but a few. However, the downside of these opportunities can sometimes be most unpleasant, unless you've covered yourself using hedging strategies.
Why hedge? A hedging strategy is designed to reduce an entity's exposure to a given risk. It consists of neutralizing the threat of incurring a loss following a detrimental fluctuation associated with the hedged risk. In theory, an effective hedging strategy smoothes out changes in profit levels that are due to the hedged risk. But is it really reflected in the entity's financial statements? Are generally accepted accounting principles (GAAP) suited to economic imperatives resulting from hedging strategies?
There are many cases of accounting misuse that have been publicized in recent years, and they have often involved a combination of accounting practices, including hedging. Companies like Fannie Mae and Enron have been singled out for improperly accounting for or misusing hedging instruments. This simply underscores the need to treat the practice with care.
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This article takes a look at the new Canadian accounting standards on hedging and shows in which circumstances they may be applied (to be applied in fiscal years beginning on or after October 1, 2007, for non-publicly accountable enterprises, October 2006 for other). It follows an article published in the June/July 2006 issue of CMA Management, which dealt with the new Canadian standards on financial instruments (with the exception of hedges).
Forms of risk
Currency risk occurs when some of an entity's operations are denominated in one or more foreign currencies. The risk results from the uncertainty attached to the Canadian-dollar equivalent of positions stemming from these operations.
Interest rates can expose an entity to two types of risk. First, when a security (asset or liability) bears interest at a floating rate, it generates a risk that is associated with fluctuations in monetary flows of interest. This type of risk is called "cash flow risk" under Canadian accounting standards. Second, when a security bears interest at a fixed rate, the resulting monetary flows of interest are known in advance, although they can turn out to be favourable or unfavourable, depending on actual changes in market interest rates. This uncertainty gives rise to a risk called "interest rate risk" under Canadian standards.
One of the challenges in interpreting the new accounting standards on hedges relates to the seemingly complex terminology used regarding financial instruments and the rules addressing hedges specifically. For instance, one section defines four major types of risk, whereas another pares hedge accounting opportunities down to two very specific contexts--the risk of changes in fair value and the risk of changes in cash flows. Table 1 summarizes these differences.
There are many potential hedging strategies. Basically, these strategies consist in creating a receivable position to offset a payable position, in light of one or more given risks; any loss in one position is accompanied by a gain in the other. Economically speaking, receivable and payable positions may take several forms. They may be existing assets or liabilities, including securities bearing interest at a fixed or floating rate. They may also take the form of forecasted assets and liabilities flowing from anticipated--but as yet unrealized--future transactions (e.g. sales projections or purchase commitments). Finally, they may result from transactions on derivatives such as futures or options.
Ideally, the offsetting positions of a hedging strategy should have the same characteristics, including the same amounts and terms, otherwise the hedge is only partial. Table 2 shows examples of positions that can be covered by strategies for the hedging of currency risk, interest rate risk (on fixed rate securities) and cash flow risk (on floating rate securities).
In practice, some organizations base their hedging strategies on portfolios of positions with exposure to the same risk. Such portfolios may include a combination of receivable and payable positions, so that hedging strategies are based on a net amount. GAAP preclude basing hedge accounting on a net amount. However, they do authorize the grouping together of assets, provided that they are consistent and exposed to one or more identified common risks; the same goes for liabilities. This creates substantial problems for organizations whose risk management systems are engineered on the basis of net amounts.
First, it is essential to understand the distinction between hedging strategies in economic terms and hedge accounting as defined by GAAP. As explained above, many types of transactions may constitute a hedging strategy in economic terms. In several cases, accounting standards generate results that make hedge accounting unnecessary. For instance, regular accounting standards on foreign currency translation ensure appropriate accounting treatment whenever the offsetting positions of hedging strategies are comprised of a monetary asset denominated in a foreign currency and carried on the balance sheet, along with a monetary liability denominated in the same currency and also carried on the balance sheet (as both positions are translated at current rate with exchange gains and losses charged immediately to income).
However, when a receivable position doesn't receive the same accounting treatment as a payable position that is part of a hedging strategy, hedge accounting can be useful. Hedge accounting is designed to ensure that a number of strategies eligible under GAAP are recorded in a fashion that adequately reflects their economic substance. More specifically, Canadian GAAP stipulate that hedge accounting is a method under which certain gains and losses are recognized in net income during the same period, when they would otherwise be recorded during different periods. This is a departure from regular accounting treatments and thus comes with a plethora of conditions.
Prerequisites for hedge accounting
Positions that are eligible for hedge accounting are very narrowly defined. On the one hand, several types of transactions are eligible as hedged positions, including anticipated transactions. On the other hand, the only items eligible as hedging positions are derivatives, along with financial assets and liabilities for the hedging of currency risk. See Table 3.
The conditions for applying hedge accounting are very strict and can be summarized as follows:
* A hedging strategy must have been previously identified and documented by management (nature of the risk or risks being hedged, in accordance with the organization's risk management strategy; amounts and other characteristics of hedged and hedging positions; anticipated and designated period during which hedge accounting will be applied).
* It must be ensured, from the start, that any transactions identified are probable and that the hedging relationship will be reasonably effective during the expected term of the hedge.
* The effectiveness of a hedge must be reliably measurable and subject to regular checks (at least every three months) until the end of the designated hedge period.
Rationale for hedge accounting
The rationale for hedge accounting derives from the fact that regular GAAP provide different treatment for the offsetting positions that make up some hedging strategies. In particular, all gains and losses on derivatives are recognized immediately in income while unrealized gains and losses on some hedged items would not under regular GAAP. To address this inconsistency, GAAP provide hedge accounting to allow the simultaneous matching of offsetting gains and losses in the income statement. This can be achieved using two hedge accounting techniques: one based on fair value and the other, on cash flows. Either technique can be used, depending on the risk to be hedged.
Fair value hedges measure both positions of the designated hedging relationship at fair value and recognize any gains and losses, whether realized or not, immediately in net income. This type of accounting is required when a hedged position is not measured at fair value with recognition of gains/losses in income in accordance with regular GAAP. For instance, it is used for items measured at cost, for assets available for sale and for anticipated transactions (firm commitment) that are off-balance sheet prior to their realization. Hedge accounting in this case consists of simply departing from the usual treatment of hedged positions so that they may be accounted for in the same manner.
Cash flow hedges delay the recognition in net income of all gains and losses on both positions of the hedging strategy until the cash flows covered by the hedge have been realized. Hedge accounting in this case charges such gains and losses to "other comprehensive income." Thus, offsetting gains and losses on both sides of the hedge are not recognized in net income until cash flows from the hedged position have been realized. It is only then that gains/losses charged to other comprehensive income may be transferred to income.
These two types of hedge accounting produce a similar net effect on income. In both cases, the technique consists in ensuring a match between offsetting gains and losses on hedging strategy positions in net income for the same periods. The main difference is a matter of timing. In a fair value hedge, all offsetting gains and losses are recognized in net income immediately, based on fair values. Thus, both positions covered by the hedging strategy are readjusted on the balance sheet (under assets or liabilities, as the case may be) to compensate for the offsetting gains and losses. In a cash flow hedge, a match is ensured between gains and losses by recognizing immediately in net income any gains or losses that have been realized or recorded for accounting purposes on both sides of the hedging strategy, while those that have been recorded on only one side are deferred. See Table 4.
A few simple rules
The following major points should be kept in mind by readers and preparers of financial statements when considering Canadian GAAP hedge accounting.
Hedge accounting is optional
The application of hedge accounting is subjective and based on intent; two identical situations could be given different accounting treatments, depending on whether or not an entity's management intends to apply hedge accounting. However, there must be an effective hedging relationship in place for hedge accounting to be applied, although the opposite is not true--an effective hedging relationship is not necessarily accompanied by hedge accounting.
Hedge accounting is a departure from regular GAAP
Several hedging relationships that are valid in management terms are not covered by hedge accounting, since the usual treatment under GAAP already provides adequate matching of offsetting gains and losses. The only cases that require a departure from standard procedure to apply hedge accounting are those for which matching to net income may be inadequate according to regular GAAP.
Hedge accounting consists in matching gains and losses to net income
Hedge accounting consists in changing accounting treatment from what would normally be applied according to regular GAAP to enable a simultaneous matching of certain offsetting gains and losses to net income. One procedure consists in measuring both positions at fair value and in recognizing the offsetting changes in value immediately in net income; this is a fair value hedge. Another procedure, called a cash flow hedge, consists in temporarily charging unrealized gains and losses on hedging positions to "other comprehensive income" until they can be transferred to net income as soon as the offsetting losses/gains on the hedged positions are themselves realized in net income.
Hedge accounting requires rigorous documentation
Documentation must be compiled from the earliest stages and updated regularly.
The new GAAP on hedges are well suited to the economic realities that stem from the hedging strategies implemented by businesses, except in some situations such as strategies based on a net position. In addition, guidance regarding financial statement or note disclosure is sufficiently detailed, but the format is left to the discretion of individual businesses; this will probably contribute to keeping such disclosure relatively complex and beyond the grasp of most users of financial statements. Hopefully, accounting disclosure formats will be standardized in future, making it easier to understand and compare information on hedging strategies.
Michel Blanchette, CMA, FCMA, CA (firstname.lastname@example.org) is a professor at Universite du Quebec en Outaouais.
(1) Anticipated transactions must be covered by a firm commitment in the case of fair value hedges.
By Michel Blanchette, CMA, FCMA
TABLE 2 -- HEDGING STRATEGIES AGAINST CURRENCY RISK Sample receivable positions Sample payable positions - Cash denominated in a foreign - Accounts payable denominated in an currency (FC) FC - Accounts receivable denominated - Other liabilities denominated in in an FC an FC - Other receivables denominated in - Future accounts payable in an FC an FC resulting from purchases that are - Future accounts receivable in an projected, but as yet unrealized FC resulting from sales that are - Futures involving CDN$ receivable projected, but as yet unrealized in exchange for FCs payable - Investments in equities - Options to sell FCs in exchange denominated in an FC for CDN$ - Investments in bonds denominated in an FC - Futures involving FCs receivable in exchange for CDN$ payable - Options to purchase FCs in exchange for CDN$ HEDGING STRATEGIES AGAINST INTEREST RATE RISK Sample receivable positions Sample payable positions - Financial securities held and - Fixed rate debt bearing interest at a fixed rate - Swaps involving payments (bonds or other) determined on the basis of a fixed - Swaps involving receipts interest rate in exchange for determined at a fixed rate in floating rate receipts exchange for floating rate payments HEDGING STRATEGIES AGAINST CASH FLOW RISK Sample receivable positions Sample payable positions - Financial securities held and - Floating rate debt bearing interest at a floating - Swaps involving payments rate determined on the basis of a - Swaps involving receipts floating interest rate in exchange determined on the basis of a for fixed rate receipts floating rate in exchange for fixed rate payments Table 3 -- Positions eligible for hedge accounting under GAAP Hedged positions Hedging positions Assets Derivatives Liabilities and Anticipated transactions (1) Financial assets to hedge currency Financial liabilities risk only TABLE 4 -- COMPARISON OF BOTH TYPES OF HEDGE ACCOUNTING Fair value hedge Gains/losses on Cash flow hedge Balance sheet changes in fair Balance sheet accounting measure value accounting measure Hedged Fair value Recognized Cost or off-balance position immediately in net sheet (anticipated income transactions) Hedging Fair value Recognized position immediately in net Fair value income Cash flow hedge Realized gains/losses and cash Unrealized gains/losses flows Hedged Not recorded, therefore Recognized in net income position excluded from net income Hedging Recognized in other Transferred from other position comprehensive income comprehensive income to net income
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|Date:||Oct 1, 2006|
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