An Update on Hedge Accounting: A Q&A With Deloitte’s Jon Howard

Deloitte’s Jon Howard discusses hedge accounting early adopters, foreign currency hedging, spot purchases, and more.


The new hedge accounting standard (ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities) takes effect for fiscal years beginning after December 15, 2018 for public companies and for fiscal years beginning after December 15, 2019 for private companies.

FEI Daily checked in with Jon Howard, Senior consultation partner in the Financial Instruments Group of Accounting Services in the Deloitte & Touche LLP national office for an update on the standard.

FEI Daily: Did many companies take advantage of the early adoption provision?

Jon Howard: We did see a handful that did it before year end. I was kind of surprised to see any do it to a great extent before year-end, because of the way transition works with the standard. Whatever existing hedging relationships you have, you apply this new standard to all of those, and do a, ‘What if I'd been applying this standard to those relationships all along?’ I think that was a primary reason that people were probably targeting the beginning of a fiscal year, just for simplicity. That they wouldn't have to push any of this transition back to prior quarters. 

There has been a fairly high level of people at least, and we'll have to see as we start looking at the 10Ks, or probably even more so the 10Qs for Q1. We'll see how many people actually went through with it, but we're seeing a fairly high amount of people trying to adopt in Q1. And I will say a lot of that is driven by these foreign currency hedging strategies. They want to get the hedges in place because of the pricing, and that is, to a great extent, driving them wanting to adopt the new standard. 

You can adopt it at a later quarter if you want, and then just push it back. But there's less volatility under the new standard for these hedges. And the pricing is right, so I think we're going to see a lot of Q1 adopters. 

FEI Daily: Any surprises for you so far? 

Howard: I'm getting a lot of questions and we're doing a lot of consultations on foreign currency hedging. And that's basically any multi-national, anybody who's got operations overseas, whether it's purchases or sales, that you're going to do in another currency. What's really popular right now, is hedging subsidiaries, your net investment and subsidiaries in Europe, and Great Britain, and Japan. 

And the reason I target those is actually the pricing is right for the source of derivatives because of the cross-currency base has spread, and the interest rate environments over there versus in the U.S. rates are generally lower. The pricing of the instruments is really good right now, and that combined with the simplified accounting under the standard has really caused a big spike. 

If you would have asked me when the standard came out if that was the biggest usage that we'd see, or the biggest level of excitement, I might not have even thought about it. But it's been really interesting how many people are moving to hedging their net investments in Europe and Japan right now. And wanting to adopt the new standard as well.

FEI Daily: What changes are we seeing in hedging strategies as a result of the new standard?

Howard: We're seeing a lot of foreign currency hedging right now. Not only entities that have been doing it and just want to apply the new standard, but entities that have not been doing it, wanting to adopt the new standard. 

The other thing that I haven't been able to see play out yet, but I'm expecting we're going to see, and this is probably more so the investors in fixed-rate debt, a lot of partial-term hedges, because this is a strategy that you couldn't do before. For example, it's very common for corporations when they issue fixed-rate debt to have, let's just say you issue 10 year debt, you can call it any time after year five. We know this debt is pretty much going to be outstanding for at least five years. Pre-adoption of this standard, you had to essentially hedge the full 10 years. If you wanted to put an interest rate swap on there, it had to be for the full 10 years. This standard is allowing you to do a partial-term, so a very common hedging strategy will be, ‘Let's just swap out those first five years, and now I don't even have to look at this as callable debt. I'm really only concerned about it making that a variable rate instrument, synthetically, for five years.’ And I think we're going to see a fair amount of that happening. 

The reason we've been getting a lot of questions on the foreign currency, is that these are entities that may not have been doing the hedging at all before. And so it's a combination of education of hedge accounting as a whole and how the standard is maybe easier than before. 

FEI Daily: Will people start moving towards commodity hedgers?

Howard: Manufacturing companies that need to buy a certain commodity and use it in production, and are worried about the cost of those commodities going up, doing hedges of non-financial assets was a bit more difficult before, because you had to hedge the all-in price risk, and this standard allows you to hedge contractually-specified components. 

The example we talk about the most is a lot of aluminum supply contracts will say, ‘The price that we pay will be based off of the Midwest Transaction price of aluminum. And then we'll have a different fixed amount added on top of that, depending on what grade you want. Or depending on what location we bring it to.’

It was very difficult for them to predict with a great level of detail, what grades they would want over the life. They might have these supply contracts for three years. And that variability and the different fixed amounts based on different locations or different grades, was too volatile for them to be able to get hedge accounting before. Now they can say, ‘I'm only concerned about hedging that Midwest Transaction price. It's in the contract, it is a variable, and this is something that standard specifically added.’ Something that wasn't even highly effective before, now is essentially perfectly effective. 

One thing that is still being debated is how does that apply to what we call ‘spot purchases’ and ‘spot sales,’ a transaction where you just buy at the market price. It's great when we have a contract that says, ‘You're paying for aluminum based on this Midwest Transaction price.’ But now think about a trucking company, or a car rental company, where they buy a lot of gas. Think about the different prices at different pumps all over the country. Is there really a base component of that? We don't have a contract with any individual gas station, right? That trucker may just pull up and fill the tank. They pay at the pump, whatever the pump price is. 

For these things where there isn't a contract ahead of time, can we infer that there is a component of that? The FASB did discuss it at the public Board meeting on Wednesday. They decided to create a project resource group to look into it. This group would also consider some of the issues that have arisen with the implementation of IFRS 9. It is important to note that IFRS 9 allows an entity to hedge a component if it is “separately identifiable and reliably measurable”. ASU 2017-12 says the component of a nonfinancial asset must be “contractually specified”. These are different criteria, but I think the Board wants this group to consider any lessons learned with the IFRS model to see if there is anything relevant to consider with U.S. GAAP – I guess including whether they would consider making any amendments to the U.S. GAAP model.

To read our earlier Q&A on hedge accounting with Jon Horward, click here