Hedge Accounting TEXPO2015

Sanjay Thoppil

Solution Consultant, Reval

April 21, 2015

Hedge Accounting for Effective Risk Management

Agenda

o Introduction to Hedge Accountingo Benefits of Hedge Accountingo Framework for Implementing a Program

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What is Hedge Accounting?

o “Special accounting treatment that alters the normal accounting for one or more components of a hedge so that counterbalancing changes in the fair values of hedged items and hedging instruments, from the date the hedge is established, are not included in earnings in different periods.” (formerly SFAS 133, par 320)

Basic Treatment

o “An entity shall recognize all of its derivative instruments in its statement of financial position as either assets or liabilities depending on the rights or obligations under the contracts. All derivative instruments shall be measured at fair value.” (formerly SFAS 133, par 17)

Hedge Accounting

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Introduction

CFHedge

Derivative?Yes

MtM

No

Accrual

FVHedge

Definition of a Derivative:Characteristics of a derivative ASC 815-10-15

(formerly SFAS 133, par 6)83(a) Underlying83(a) Notional amount83(b) No (or minimal) initial net investment83(c) Net settlement

Basic Accounting Treatment:Derivatives are recorded at FMV, with changes in FMV recognized currently in earnings

Hedge Types:• Cash flow hedges are recorded at FMV with

effective changes in FMV deferred in OCI

• Fair value hedges are recorded at FMV with offsetting gains and losses on the hedged item recognized currently in earnings

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Major Provisions of Hedge Accounting

o Documentation– Risk Management Strategy and Objective– Nature of the Hedged Risk– Hedging Instrument Identified– Hedged Item Defined– Effectiveness Assessments and Ineffectiveness Measurement

o Effectiveness Assessments– Regression, Dollar Offset, Critical Terms, Shortcut

o Ineffectiveness Measurement– Lesser of the cumulative change

o Disclosures

Agenda


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Benefits of Hedge Accounting

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Cash Flow Hedge

Trade Date Settlement

Hedge

Hedged Item

Fair Value Hedge

Trade Date Settlement

Hedge

Hedged Item

Recognize in Earnings

Recognize in Earnings

Changes in derivative value are deferred to OCI until the hedged item impacts the income statement.

Changes in the hedged item value are booked to earnings at the same time as when the derivative changes.

Benefit 1: Alignment of Derivative and Hedged Item Impacts on Income Statement


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Benefit 2: P&L Volatility Reduction

Forecast SalesLo

ss/G

ain

FX rate at fcst date

FX Rate

FX Forward Net Acctg Impact

No Hedge Accounting Lo

ss/G

ain

FX Fwd Rate

FX Rate

Loss

/Gai

n

FX Fwd Rate

FX Rate

Loss

/Gai

n

FX rate at fcst date

FX RateWith Hedge Accounting Lo

ss/G

ain

FX Fwd Rate

FX Rate

Loss

/Gai

n

FX Fwd Rate

FX Rate

Cash Flow Hedge


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Benefit 3: Improved Economic Hedging Performance

Transaction Timeline:

Txn Event

t0 t1

Quote Order

t2

Sale/ Revenue Recognized

t3

Cash Received

Rates Planning Acctg1 Acctg2

Hedge Type Cash Flow Fair Value Balance Sheet

Objective: Minimize the difference between the hedge rate and planning rate

Potential P&L Impact

Economic Risk Accounting + Economic Risk


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Other benefits of implementing a hedge accounting programo Improved insight into underlying business exposures

– Companies are forced to analyze, measure and monitor business transactions on an ongoing basis

o Process controllership– Companies are required to have proper processes and controls

Agenda


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Risk Management Framework

Hedge Accounting Lifecycle

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Risk Identification

Risk Appetite

Business Goals and Objectives

Assessment and Strategy

DefinitionExecution Reporting

Roles and Responsibilities

Policies and Procedures Technology

Hedge Accounting Lifecycle

High Level Derivative Lifecycle

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Reporting

Designation Maintenance Termination

• Policy definition

• Exposure tracking

• Trade execution

• Hedge documentation

• Prospective and retrospective effectiveness testing

• Valuations

• Measurement

• Documentation of hedge termination

• OCI management

Implementation Framework

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o Policy definition:– Types of exposures, policy for hedging, operational controls– Embed key HA language into policy and refer trade to this

o Exposure tracking:– Need repository to store exposure information (date, amount,

revision history, actuals etc.)o Trade execution:

– Consider hedge accounting structure when executing trades (e.g. are internal derivatives needed)



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FX Hedges Eligible for HA? Type

Unrecognized firm commitment with an unrelated party Yes Fair Value

Foreign currency denominated asset or liability Yes Fair Value

Non-financial asset (e.g.,inventory or a fixed asset) Yes Fair Value

Firm commitment to purchase a nonfinancial asset Yes Fair Value

forecasted purchase or sale of a foreign currency-denominated financial asset with a third party

Yes Cash Flow

Forecasted intercompany purchase or sale of a foreign currency denominated financial asset

Yes Cash Flow

Receipt or payment of interest on a foreign currency denominated debt instrument

Yes Cash Flow

Forecasted intercompany dividend No

Hedge of a forecast/firm commitment to purchase a foreign equity method Investment or business combination

No


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Documentation Requirement

Details

Hedge Type Cash Flow, Fair Value or Net Investment Hedge

Objective and strategy

Need to define what the risk of the hedged item is along with the mitigation strategy

Risk Changes in FX, interest flows attributable to the benchmark rate, price

Assessment of Effectiveness

Company expects that both at inception and on an ongoing basis the relationship will be highly effective…Methods: 1) critical terms/shortcut, 2) dollar offset, 3) regression

Hedged Item Need to be specific as to what the exposure is

Hedge Instrument Need to refer to the specific derivative

Timing Designation must be made contemporaneously


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o Prospective/Retrospective Effectiveness Testing– Must be performed at least quarterly– Optimal method is regression– Specific guidance for options, forward contracts– Impact of basis on commodities

o Valuations– Source of market data– Confidence in pricing models

o Measurement– Book to ledger after adjusting for excluded components, ineffectiveness,

lesser of the cumulative change– Result is set of GL bookings



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o Cash Flow Hedges:– Regular Termination (e.g. at expiry of hedge contract)

• Amounts in OCI are reclassified from OCI to income statement in same period as which the hedged item impacts the income statement

– Irregular Termination (e.g. failed effectiveness)• Cumulative gain/loss on the derivative is discharged immediately from OCI to P&L

– Management Decision (e.g. de-designation prior to maturity)• Amounts in OCI are reclassified from OCI to income statement in same period as which

the hedged item impacts the income statement

o Fair Value Hedges:– Cease adjusting the carrying value of the asset/liability/firm commitment– An adjustment to the carrying value of hedged item is accounted for in the same

manner as the hedged instrument itself (e.g. adjustment to inventory is held until the inventory is sold)



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Other Considerationso Advanced FAS topics

– DIG Issues– Treasury Center/Netting– Intercompany Transactions– Commodities– Cross Currency Swaps

o FAS 157– De-minimus testing– Credit adjusted values (at contract or on a net basis)


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The Power of SaaS TRM

CASH MANAGEMENT• Bank statement retrieval• Bank account management• Cash positioning and reconciliation• Payments and Payment Factory• In-house banking and Pooling• Multi-lateral Netting• Forecast and Liquidity Planning

• Debt & Investments Management• Intercompany Loans• Limit Monitoring

• Accounting

• Performance Evaluation and Reporting

LIQUIDITY MANAGEMENT

ACCOUNTING AND COMPLIANCE

RISK MANAGEMENT• Integrated Market Data• Exposure Quantification / Management• Multi-Asset Class Derivative Valuation

including IR, structured rates, FX, energy, agriculture, metal, equity, credit)

• Credit adjusted valuations• Hedging Strategy• Back Office and Accounting• Strategy Evaluation and Performance

Measurement

• Compliance with ASC 815(FAS 133 and FAS 161), ASC 820(FAS 157), IAS 39, IFRS 7, IFRS 9, and IFRS 13

• EMIR and Dodd-Frank Reporting

• Inventory & Activity Reporting• General Ledger• Audit Controls

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Questions?

Sanjay ThoppilSolution [email protected] 646.376.4095

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Visit us in the Exhibit Hall at Booth #616

mailto:[email protected]

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Role of Commodity Risk Management Within Treasury

Commodity Risk Operating Models

BasicManager

Silo risk manager

Proprietary trader

Portfolio risk manager

• Risks ignored or addressed inconsistently through the organization

• Exposures inaccurately identified

• Material risks managed centrally

• Focus on policy compliance with timely and cost effective execution

• Supports organization's objectives

• Manages entire portfolio incorporating asset correlations

• Specialist risk managers

Value Add

• Trades for profit using value add strategies optimizing key drivers

• Alignment of risk management and organization strategy

• Organization has competitive edge on the market

• Specialized proprietary traders

Business Alignment

Typically only specialized oil,

gas, mining and electricity trading

companies

Typical corporate commodity risk manager

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• Ongoing volatility• Systems and data

infrastructure• Skilled staff• Hedge accounting• EMIR

Transformation Objectives

o Ultimately deliver greater shareholder value through:– Commodity risk management in line with risk appetite– Greater visibility and certainty of exposures– Enhanced control environment– Holistic management of company financial risks

• Business case• Budget• Governance• Controls• Efficiency• Change• Business unit buy in

External ChallengesInternal Challenges

Corporate Commodity Risk

o Procurement manages relationship with supplier, both supply chain risk and price risk

o Forces supplier to manage commodity price risko Supplier will add a pricing premium for the serviceo Corporates may have better negotiation leverage than suppliero Supplier may not be any better at understanding and managing price

risk

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Corporate Commodity Risk

o Decouples commodity supply risk from price risk. o Supplier and procurement focuses on delivery logistics.o Treasury generally maintains risk management knowledge and resources.

They are better equipped to manage price risk. o Allows treasury to select hedge horizon and adjust hedge coverage at their

will.o Treasury may have historically focused on FX and IR risk and will need to

develop commodity expertise.o Creates increased accounting demands for tracking hedges.

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Hedge Accounting TEXPO2015

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