FSR Insights Hedging considerations for 2016 and beyond March 2016

FSR Insights
Financial Instruments, Structured Products & Real Estate Insights
March 2016
Hedging considerations for 2016 and beyond
Reporting entities face many uncertainties in the
markets in 2016 – including volatility in the
equity markets, tightness in the credit markets,
rising interest rates, and foreign currency and
commodity volatility resulting from weak
demand and uncertainty surrounding central
bank policy. Companies are evaluating their risk
management strategies, and we wanted to share
with you some insights on hedging.
There are potential GAAP issues and changes on
the horizon.
Qualifying for hedge accounting may
be getting easier
The FASB is expected to release a proposal that
would modify the quantitative testing required to
“prove” that a relationship qualifies for hedge
accounting. Currently, entities applying “long
haul” hedge accounting apply quantitative
testing contemporaneously at hedge inception
and, at minimum, each reporting date during the
term of the hedging relationship. Going forward
the calculations would need to be performed
within the three month reporting period in which
the hedge is designated (e.g., the initial
quantitative assessment of effectiveness for a
hedge designated on October 17th would need to
be performed by December 31st).
Ongoing quarterly assessments of effectiveness
may be qualitative - unless facts and
circumstances around the hedge relationship
change. This may provide some operational relief
for entities seeking hedge accounting. Entities
that have quantitative testing processes may
continue to rely on those processes to support
hedge effectiveness going forward.
GAAP hedges of interest rate risk may
be getting expanded
The FASB’s upcoming proposal is expected to
enhance a reporting entity ’s ability to hedge callable
debt, changes in benchmark interest rates, and a
partial term of a debt instrument’s life.
Given the nature of the interest rate
environment, reporting entities may be able to
better match their accounting to their interest
rate risk management strategies. We continue to
see strategies focused on effective matching of
asset and liability cash flows for risk
management and capital optimization purposes.
These changes may make the hedging of interest
rate risk on assets or liabilities more manageable
than under current GAAP.
Hedging of non-financial component
risk presents new possibilities
The FASB’s upcoming proposal is expected to
allow an entity to hedge a contractually specified
component or ingredient linked to an index or
rate in a contract. This change represents a
significant shift from current GAAP and would
permit significantly more hedging relationships
of non-financial items.
The FASB’s upcoming proposal is also expected
to provide for increased flexibility when hedging
interest rate risk for cash flow hedges of
forecasted transactions. Specifically, the
upcoming proposal is expected to allow an entity
to hedge a contractually specified interest rate
index in a debt agreement, even if that
contractually specified interest rate index is not
considered a “benchmark” interest rate.
FSR Insights March 2016
The change would allow companies to better align
the accounting treatment with the hedged risks –
and avoid some ineffectiveness in the hedging
relationship.
Complexity in GAAP cash flow hedging
remains – don’t miss your forecast
The FASB’s upcoming proposal is not expected to
change GAAP in the area of missed forecasted
transactions. For cash flow hedges of forecasted
transactions, the probability assertion around the
forecasted transaction remains paramount.
Missed forecasts and over-hedging call into
question the probability of the future transactions
in the hedge program, and the entity ’s ability to
apply cash flow hedge accounting in the future.
We encourage entities to continue to pay close
attention to these items to avoid common pitfalls
as they apply cash flow hedge accounting on
forecasted transactions (e.g., hedges of forecasted
foreign currency denominated revenues or
expenses).
Capital optimization, regulatory
change, and changes in the credit
markets continue to influence hedging
behavior
The regulatory framework continues to evolve and
is affecting the origination, servicing, and
investing in credit products. Companies are
exploring opportunities to hedge and/or syndicate
credit risk. Applying hedge accounting to these
strategies can be challenging, and we anticipate it
to be a focal point in 2016 and thereafter.
Risk management also impacts your tax positions
and there are some key differences between Tax
and GAAP hedging:
All GAAP and tax hedges are not created
equal
The tax rules do not require a specific degree of
risk reduction or “hedge effectiveness.” A
transaction qualifies as a tax hedge if it is entered
into primarily to manage the risk of price or
interest rate changes or currency fluctuations.
Tax rules require that a hedge manage risk with
respect to an ordinary asset or ordinary
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obligation. Hedges of capital assets are not
permitted for tax purposes.
Finally, a hedge must be timely identified for tax
purposes. Hedge identification for non-tax purposes
(e.g., financial accounting or regulatory purposes)
may not be sufficient to meet this requirement.
Tax hedges can influence character of
income
Properly identifying a transaction as a tax hedge
can eliminate timing and character issues. Any
gain or loss recognized with respect to the tax
hedge will be ordinary and will generally be
recognized in the same period that the offsetting
loss or gain is recognized with respect to the
hedged item.
Need for holistic view on risk
management and the tax position
There are other tax provisions that may apply to
certain risk management transactions regardless
of whether these transactions would otherwise
qualify as tax hedges.
These provisions can be used to simplify the
taxpayer’s tax accounting (e.g., the integration
provisions) or better manage the taxpayer’s
taxable income (e.g., the mixed straddle
rules).The integration provisions allow taxpayers
to tax account for a hedge and the hedged item as
a single transaction – and can be used to eliminate
currency gain or loss and simplify the taxpayer’s
tax accounting.
The integration provisions have a detailed set of
requirements that must be satisfied before a
transaction can be integrated. The mixed straddle
rules can be used to trigger built-in gain or loss
with respect to the taxpayer’s financial positions
(capital or ordinary) and can provide mark-tomarket tax accounting for such positions (along
with the associated risk management
transactions) on a going forward basis. There are
very specific requirements that must be satisfied
to qualify for these rules.
We hope that you find these insights helpful as
you manage through financial markets
uncertainty in 2016.
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FSR Insights March 2016
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Who can be involved in a continued dialogue?
Frank Serravalli
Partner
646 471 2669
[email protected]
Trent Johnson
Principal
202 414 1484
[email protected]
Dave Lukach
Partner
646 471 3150
[email protected]
Jonathan Bergeson
Director
415 498 6776
[email protected]
Nick Milone
Partner
646 471 4813
[email protected]
Matt Keller
Manager
646 471 6742
[email protected]
Sanjeev Magoon
Principal
646 471 8792
[email protected]
Ross Drucker
Manager
646 471 5947
[email protected]
Contributor: Jeanna Yu
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