Interest in hedge accounting in the metals sector has risen in recent months and will be amplified by accounting standards introduced in late 2017 that make it easier to hedge commodity and raw material price risks, according to hedge accounting experts from HedgeStar.
Interest in hedge accounting in the metals sector, particularly the steel industry, has steadily risen in recent months and will be amplified by accounting standards introduced in late 2017 that make it easier to hedge commodity and raw material price risks, according to two hedge accounting experts from HedgeStar.
“People are showing more interest in hedging at conferences, especially folks in the steel market,” HedgeStar manager of valuation Merc Morse told American Metal Market. “We have seen a significant increase in the last six months.”
HedgeStar - an Eden Prairie, Minnesota-based consulting firm that specializes in valuation and hedge accounting services - also has seen a “real uptick” in its hedge accounting education and training business, according to manager of hedging Tim Potter.
Steel price volatility has driven the run-up in interest, caused by factors such as the Section 232 steel and aluminium tariffs, as well as the general unpredictability of the Trump administration, according to Morse. However, volatility in the steel industry is likely to last beyond these current trends, he said.
“This interest won’t run out of steam,” Morse said. “There is a picture that we’re starting to see emerge here: OEMs [original equipment manufacturers] are looking at getting more fixed prices.”
In essence, hedge accounting is the management of accounting gains and losses that arises from risk management activity, which is especially important for any entity looking to stabilize its earnings and enhance enterprise value, according to Morse.
Hedging is possible without hedge accounting, but hedge accounting isn’t possible without hedging, he noted. However, hedge accounting “is about making sure that your earnings represent your business operations,” he said.
Without hedge accounting, companies look significantly riskier to investors, creditors and even trading counterparties because the value of hedging derivatives will flow through directly to the income statement, resulting in increased volatility period to period, Potter noted. “Hedge accounting basically allows you to flatline that visibility on your income statement,” he said.
Up until now, not being able to qualify for hedge accounting had been a major barrier to entry for many companies, but new standards issued by the Financial Accounting Standards Board (FASB) in August 2017 will help change that, according to Potter. The new standards will take effect for fiscal years starting after December 15 2018 for public companies, and for fiscal years beginning after December 15 2019 for private companies, he said.
The new rules will specifically allow hedgers to:
1. Hedge any contractually specified component related to its non-financial hedged item.
Previously, hedgers only were allowed to hedge the total variable cash flows related to the non-financial item being hedged, according to Potter. “Companies had to prove their hedging index was highly correlated to total prices, inclusive of basis risks above and beyond the primary market component, enough in order to keep unrealized gains and losses out of the income statement,” he said. “Now you can hedge a specific component, which greatly enhances the ability to prove the existence of an effective hedge for accounting purposes.”
2. Record the hedging instrument’s entire change in fair value in Other Comprehensive Income.
Under the long-standing rules, the fair value must be split between the effective and ineffective portion at each assessment date, Potter said. That concept of an ineffective portion was confusing for financial statement users and at times out of the entity’s control. The new rules eliminate this burden and reduce the ambiguity for entities presenting effective hedge relationships in their financials, according to Potter.
3. Post gains or losses on the same income statement line as the hedged item.
Formerly, no specific guidance was present regarding the location of recording gains or losses, Potter said. Now, the effects of hedging are explicitly allowed to be netted within the same income statement line item being hedged, eliminating potential confusion in the effects of hedges on the income statement, he said.