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FRS102, the new UK GAAP standard, applicable mostly to non-listed entities since 1 January 2015, makes a number of major changes to the rules of accounting for derivatives. As a general principle, Sections 11 and 12 require derivatives to be recognised and measured at their fair value on the balance sheet and changes recorded in the income statement (P&L).
This new accounting regime can create significant P&L volatility, impacting reported EBITDA, and distributable reserves which can potentially affect dividend policies. It can also affect the interpretation and reporting of financial covenants, as well as tax. In order to mitigate that P&L volatility, hedge accounting can be applied in some circumstances if entities meet certain requirements.
The new rules present significant concerns for CFOs, Treasurers and Financial Directors who, under the old UK GAAP, did not have to place the same emphasis on the accounting implications of derivatives. As these were typically entered into to hedge against market risks, only the cash flows arising from the derivatives were accounted for and not their fair value (in effect derivatives were off balance sheet items).
This whitepaper will identify the key issues and impacts that may arise from the application of the new accounting rules to derivatives. Both the requirement to implement FRS102 and the use of hedge accounting for derivatives have been well documented elsewhere; instead this paper will address the common challenges and pitfalls associated with FRS102 and how these can be overcome with the right approach.
Common issues and challenges – understanding the impacts of FRS102
Accounting for derivatives at fair value under FRS102 fundamentally changes the way entities look at their derivative contracts and poses a series of challenges:
• The fair value of derivatives will have to be calculated, either by the reporting entity (if they have the in-house capability and experience) or by someone external such as a counterparty bank or an independent third party. That valuation should include all factors that affect its value (i.e. not only interest rates or FX rates, but also the credit risk of both counterparties to the derivative). Entities usually rely on counterparty banks that may not be fully transparent in terms of the inputs used in their valuations, nor do they typically take account of credit risk of both counterparties to the trade.
• The P&L volatility caused by recording derivatives at their fair value needs to be explained to both internal and external stakeholders.
• Entities often feel poorly equipped to explain how market conditions affect their earnings due to the use of derivatives.
• Hedge accounting may not be available to the reporting entity, depending on the type of derivative and the nature of the exposure being hedged. Therefore, it is key to understand if a certain hedging instrument can or cannot be accounted as a hedge for accounting purposes in order to make an informed hedging decision.
• Applying hedge accounting is potentially an onerous process. Hedging documentation and the demonstration of the existence of an economic relationship need to be put in place at the time of entering into the hedge, and measurement of the effectiveness needs to be undertaken periodically thereafter. Most entities do not have the in-house expertise and may struggle to meet these requirements which involve, at the very least, the use of a derivatives valuation system.
• The termination or restructuring of derivatives, often driven by cash optimisation, might have unintended accounting consequences for the entity. Cash events do not immediately translate as P&L impacts. This is dependent on whether or not hedge accounting has been applied to the derivatives being modified.
Entities must think thoroughly about the accounting impact of entering or modifying a derivative transaction, as well as the economic and financial objective of the hedge.
For example, entering into a new hedging instrument that has exotic features (such as knock in or knock out barriers or cancellability options) may allow an entity to achieve a certain cash flow objective. However, a derivative with exotic features may be deemed a ‘net written option’ which is not possible to designate as an accounting hedge and therefore produces undesired volatility in EBITDA.
Any hedging strategy requires a detailed analysis of the multi-faceted impact of derivatives on both the P&L and the balance sheet and a thorough understanding of hedge accounting. Fundamentally, it means that the accounting treatment of the derivative becomes an important factor in deciding which derivative strategy to deploy.
Why applying hedge accounting
Under FRS102, the changes in fair value of a derivative need to be recorded in the P&L as they occur. This accounting treatment does not consider that the derivative may have been entered into in order to offset cash flow exposures. Exposures might include future sales, purchases in foreign currency or variable interest payments and in most cases, these are not recognised in the balance sheet and not recorded or measured at fair value.
Entities entering into derivatives who opt to apply hedge accounting from the start can avoid the associated P&L volatility as the impact of the derivative instrument is recorded at the same time as the item that is being hedged.
There is a strong logic to this. Derivative hedges are used to manage the risk of an underlying exposure. By accounting for both the hedged item and the hedge simultaneously, volatility in earnings can be eliminated and show the combined offsetting impact in cash flows in the same reporting period, which is ultimately the objective of a hedging strategy.
That being said, some entities may choose not to utilise hedge accounting and believe that their P&L and KPIs can withstand the associated volatility. This may be the case particularly when exposures being hedged are already recognised in the balance sheet (i.e. foreign currency denominated liabilities, or payables and receivables) and the accounting of the derivative’s fair value into the P&L naturally offsets the P&L impact of the hedged item. Furthermore, when hedges are put in place with a maturity shorter than a reporting period, some entities may decide that the associated workload of applying hedge accounting is not worth the time and effort.
Business challenges of implementing hedge accounting
Although the theory of hedge accounting may sound sensible, implementation can be challenging. Entities need to invest significant time and potentially incur external costs in ensuring that they have put the right processes, people and technology in place:
• An entity’s accounting and treasury functions need to fully understand the principles behind hedge accounting, and how these should be applied.
• They need to be able to produce the relevant and required outputs such as documentation, valuation (adjusted for credit risk considerations) and quantitative analysis to prove there is an economic relationship between the derivatives and the hedged items, and that the level of effectiveness is accurately measured. Entities will need to ensure that they can produce all relevant disclosure requirements, particularly for hedge accounting, and ensure that these are built into their reporting processes.
Engagement with external auditors is key to ensuring they fully understand the changes that are being implemented and the potential impact on the audit process. Ultimately, the auditor’s view on the interpretation of the standard and the suitability of the accounting treatment adopted by the reporting entity is final. Reporting entities should therefore invest in presenting a robust, well documented, case to their auditors.
Five questions to ask your finance and accounting teams
Pragmatic solutions to pressing problems
Entities need to consider how they address the above challenges and it is important that they balance their internal capabilities and expertise with a full understanding of the resource impact of implementing hedge accounting. If they do not have the internal expertise or resources to implement hedge accounting, then they need to consider engaging a specialist third party.
Bringing existing expertise and established valuation systems and documentation, a specialist can help navigate the technical minefield and create a robust derivative valuation and hedge accounting process. Furthermore, entities must communicate the change in processes and valuations effectively to both their internal and external stakeholders. In the case of external auditors, it is essential to engage them early in the process to ensure that the audit review following any changes is smooth, error free and uncomplicated.
Critical to get right
Most importantly, entities need to ensure that they are reporting accurately once they decide to apply hedge accounting. If the calculations are inaccurate or incomplete, companies may be forced to restate their accounts.
A restatement is not just an embarrassing situation. In many cases, the reputational damage can also be significant and can undermine the confidence of external auditors, internal stakeholders and shareholders.
If hedge accounting is beneficial to the entity, it is of paramount importance to get it right first time, starting from the earliest stages of the transition to the new standard.
Looking to the future
While the rationale for implementing accounting rules that show the fair value of derivatives is obvious, the accounting treatment can lead to perverse outcomes and volatility on both the income statement and the balance sheet. Depending on the type of exposure, hedging instrument and the entity’s KPI’s, hedge accounting may be a logical solution to the challenge of hedging activities under FRS102 that create undesired P&L volatility.
The real test though, is to implement hedge accounting in a seamless and effective way. This means putting in place clear and robust processes to value and report and ensuring that all stakeholders fully understand and buy into the changes. Entities who successfully achieve this will be able to benefit from less volatile P&Ls and streamlined, accurate reporting.
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