Nov 4, 2016

From the memories of a risk manager turned accountant:

The concept of economic hedging (fixing a price over time in order to ensure predictability of future cash flows) is fundamental to a market risk manager’s job. My more than four years’ experience in this area did not prove an exception. Focusing on the financial side, I often regarded the accounting implications of a hedge as issues of fairly subordinate importance.
Enjoying the comfort of having an accounting department in the company, I conveniently limited my activities to “I told you there will be some Profit and Loss (P&L) impact of the hedge” and “We are not doing any hedge accounting by company policy, as it is complex to set up”, forwarding any further inquiries in this regard to my colleagues. As people say, God works in mysterious ways, and after years of deliberate ignorance (as a punishment or not), I was given a chance to fill my knowledge gaps and fight on the opposite side of the barricade. To put it straight, I joined the commodity accounting department of the Group.

Almost in the twinkling of an eye I experienced a total paradigm change. I no longer received calls from frustrated management claiming, that hedging generates losses or destroys the P&L of the business unit or asset (after the derivatives are marked-to-market or have reached payment). Professional arguments that the placed hedges are not justified, as they destroy value resp. generate no gains ceased. Such are often raised especially if incentives (bonuses) of operational managers are conditioned upon the business unit’s results for the respective period and frequently escalate to the highest level of the company. There was no need for constant replies that the purpose of a hedge is not to make money but to reduce the volatility of earnings. I stopped acting as an advocate for the hedging strategy, even though it has already been incorporated in the company policy. Discussions around why fair value is shown in P&L accounts and not directly on the balance sheet took a new dimension…

If my new occupation seemed quite tranquil, please keep reading on, as things got even more complex, as I’ve entered the world of hedge accounting.

As many may have heard, a convenient way to avoid direct P&L impact of derivatives mark-to-markets is the application of hedge accounting (term different from economic hedge). The latter is used to recognise the offsetting effect of hedges, especially if there is a difference in the accounting practices for hedge instruments and hedged items (e.g. fair value vs. cost accounting) and this difference influences the profit and loss statement.

Claiming “own use” exemption, provided by the International Accounting Standard (IAS) 39, avoids fair value accounting and eliminates the resulting P&L volatility, which comes from revaluations of hedge products. This especially holds for negative impacts, as positive values don’t usually give rise to major inquiries. To qualify for “own use” exemption derivative contracts should be entered into for the purpose of hedging underlying physical positions from core business activities and should satisfy some additional conditions. This special treatment allows fair values to be recorded on the balance sheet, typically under Other Comprehensive Income or OCI.

Exemption, however, is not granted freely. It requires testing of the designated hedge relationship effectiveness and mandatory hedge documentation, which may prove to be costly and difficult to implement. Not to mention, the company’s auditors become your best friends (a fact that proved not to be as bad as it seems after all), as hedge relationships are subject to alignment and frequent reviews. These considerations explain the reluctance of high-level management to apply “own use” accounting, especially if impacts of fair value movements of derivatives on the total company P&L are not regarded material. This evaluation takes place prior to deciding about the accounting treatment of hedge instruments.

For someone familiar with all the facets of hedging (which I was taught, if not the difficult, then definitely the long way), the trade-off between dealing with the complexity and cost of hedge accounting and bearing the P&L volatility is a major consideration. Although the implications of using fair value might not be significant on a company or group level, they might form a significant part of an asset’s or portfolio’s profit and loss statement. This often raises questions by those, whose incentives are based on the performance of a particular profit centre. If not explicitly taken into account, e.g. as adjustments, potential impacts of hedging have to be at least communicated and well understood in advance to avoid any issues and misinterpretations in the future.

Written by Konstantin Grigorov
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