Top 3 Hedge Accounting impacts from COVID-19
Not since the global financial crisis (GFC) have we seen this level of disruption to the economy and volatility in financial markets.
Hedge accounting programs are directly impacted in several key areas:
1. Mark-to-market derivative valuations
Due to the extreme level of volatility seen recently, your derivative positions will likely be either significantly Out-The-Money (OTM) or In-The-Money (ITM).
Some banks and brokers have been forced to ask clients to post collateral against OTM positions. In a time when liquidity for clients is crucial this is an added outflow they can do without. However, bank and brokers have to protect their balance sheets and we have already had some companies file from creditor assistance due to client OTM positions gone bad.
If you have ITM positions and are short of liquidity you can closeout trades to release cash, then this might be a lever you need to pull but this should only be done with careful consideration. You will potentially be locking in new hedges at a poor hedge rate (short-term gain for long-term pain) and new hedge documentation will need to be produced for the new relationship and accounting treatment understood.
For real-time valuations of your derivative book and strategic advice on closing out positions or negotiating collateral requirements, you should speak to a trusted treasury and accounting professional.
2. Cash-flow forecasting variations
Now more than ever cash-flow forecasting needs to be optimised and regularly updated due to the uncertain economic environment all businesses are facing.
For example, if you are now anticipating a shortfall in upcoming sales then this may impact your cash flow hedge accounting program. You could find that you are in an over hedged position, which if left unmanaged, can have serious consequences for your hedge accounting program.
This is the time to be proactively managing your hedge program and assessing the probability of your forecasts. Forecasts need to be highly probably to meet the criteria for cash flow hedge accounting. It should be noted, the accounting treatment of your derivative book can change if certain criteria is not met, which could impact profit or loss.
If you’re unsure what your options are then reach out to a hedge accounting specialist and get on the front foot before your auditors are driving the conversation.
3. Increased auditor scrutiny on its way
Make no mistake, your hedging program will likely be scrutinised in greater detail by your auditors at the next reporting date due to the impact of COVID-19.
We foresee the focus areas to be around counterparty credit risk and as we have discussed, the accuracy of the forecasting and whether the hedge program meets the highly probable assessment from a cash flow hedge accounting perspective.
To comply with IFRS 13, credit risk (CVA) should be incorporated into the valuation of derivatives. Excluding the financial services sector, in practice auditors have in the most part deemed the credit risk associated with their client’s hedge book to be immaterial and therefore CVA adjustments are invariably posted. With the sharp increase in credit spreads seen over the last few months we envisage this trend to reduce and CVA adjustments will be required by all.
IFRS 13 does not specify a method to calculate CVA adjustments and some methodologies are overly complex and expensive to run. Getting expert in this area is a logical step for many as it saves time and dollars!
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