Risk Management

More Companies Are Opting for Hedge Accounting

The new hedge accounting standard, designed in part to make hedge accounting more accessible to more companies, is making its mark.
David McCannFebruary 6, 2020
More Companies Are Opting for Hedge Accounting

Early adopters of the new hedge accounting standard that took effect for public companies’ 2019 fiscal years drove an uptick in the use of hedge accounting in 2018, new research shows.

Chatham Financial’s analysis of corporate hedging in 2018, the latest year for which hedging data can be compiled, indicates that 53% of U.S. public companies with commodities hedging programs applied hedge accounting to them.

That was up from 45% in 2015, when Chatham last performed the research.

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“The most substantial change in the hedge accounting standard is related to commodity hedging,” Chatham said in its report on the study, which looked at the hedge accounting practices of 1,402 companies. “Companies can now look to identify specific components within commodity contracts to apply hedge accounting.”

The new standard also increased the proportion of companies with foreign exchange (FX) hedging programs that applied hedge accounting to them, from 63% in 2015 to 70% in 2018.

Hedge accounting allows companies to avoid earnings volatility associated with the fluctuating value of assets underlying derivative contracts negotiated with financial institutions, which companies enter into for the purpose of hedging financial exposures. Gains and losses on derivatives are deferred into “Other Comprehensive Income,” a balance sheet line item reflecting as-yet-unrealized financial items.

The company does not then realize such gains and losses until the derivative contract is settled, which can be years after it was entered into.

However, not all companies that hedge financial exposures use hedge accounting, which is complex and challenging to apply correctly, according to Amol Dhargalkar, managing director and leader of the global corporate sector at Chatham, a risk management advisory and technology solutions firm specializing in the debt and derivatives markets.

Indeed, the new hedge accounting standard was designed “to make hedge accounting more accessible to more companies,” Dhargalkar says.

Many companies with financial exposures don’t even hedge. For example, among the 91% of companies facing interest rate risk, just 43% addressed it by hedging. The corresponding numbers were 73% and 59% for FX risk, and 47% and 37% for commodities risk.

Whether a company hedges is significantly influenced by its size. Larger companies “tend to have more administrative infrastructure and financial flexibility to operate a hedging program,” Chatham’s study report notes.

For example, among companies with more than $20 billion in revenue, 84% were exposed to FX risk in 2018, and 80% of those used hedging to manage it. On the other end of the size spectrum, companies with revenue between $500 million and $1 billion, among the 64% that had FX exposure, only 36% mitigated the risk with hedging.

With respect to commodities risk, 52% of the largest companies had it, while 67% of that group hedged against it. Among the smallest companies, 48% had commodities exposure, and a mere 23% of them managed it with hedging.

Commodity hedging is typically the most complicated, according to Chatham. “Quantifying commodity exposures can often be quite challenging for risk managers, requiring accurate forecasting,” the report says.

Pricing for commodities has been “phenomenally volatile” lately, says Dhargalkar. For example, he notes, copper prices have dropped about 8% in just the past few days, mainly because of coronavirus fears.

Meanwhile, according to Dhargalkar, there’s been a noticeable recent increase in hedging among companies that historically haven’t hedged.

“Maybe that has something to do with the new hedge accounting standard,” he says. “I think it has a lot more to do with CFOs not wanting to see volatility in their results, but hedge accounting comes along with that. When the CFO says, ‘I don’t want to see this anymore,’ everyone figures out a way.”