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The Nitty‐Gritty of Commodity Hedge Accounting
June 2013
Aaron Cowan, CFA, CPA Steve Arveseth, CPA
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Webinar Administrative Details
• Technical Issues?• Contact WebEx: 1.866.569.3239
• CPE/CTP Credit• Listen to the entire broadcast• Answer 3 of 4 polling questions• Certificates will be emailed within 10 business days
• Slides• Will be sent out in follow up email
• Recording• Available on our website within the week: http://www.chathamfinancial.com/thought‐leadership/webinars/see‐all‐webinars/
• Questions?• Use the Q&A window provided to submit any questions to All Panelists• If we do not get to your question, we will answer them afterwards individually
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DisclaimerTRANSACTIONS IN OVER‐THE‐COUNTER DERIVATIVES (OR “SWAPS”) HAVE SIGNIFICANT RISKS, INCLUDING, BUT NOT LIMITED TO, SUBSTANTIAL RISK OF LOSS. YOU SHOULD CONSULT YOUR OWN BUSINESS, LEGAL, TAX AND ACCOUNTING ADVISERS WITH RESPECT TO PROPOSED SWAP TRANSACTION AND YOU SHOULD REFRAIN FROM ENTERING INTO ANY SWAP TRANSACTION UNLESS YOU HAVE FULLY UNDERSTOOD THE TERMS AND RISKS OF THE TRANSACTION, INCLUDING THE EXTENT OF YOUR POTENTIAL RISK OF LOSS.THIS MATERIAL HAS BEEN PREPARED BY A SALES OR TRADING EMPLOYEE OR AGENT OF CHATHAM HEDGING ADVISORS AND COULD BE DEEMED A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION. THIS MATERIAL IS NOT A RESEARCH REPORT PREPARED BY CHATHAM HEDGING ADVISORS. IF YOU ARE NOT AN EXPERIENCED USER OF THE DERIVATIVES MARKETS, CAPABLE OF MAKING INDEPENDENT TRADING DECISIONS, THEN YOU SHOULD NOT RELY SOLELY ON THIS COMMUNICATION IN MAKING TRADING DECISIONS.
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Today’s Speakers
Aaron CowanDirector,
Hedge Accounting
Steven ArvesethDirector,
Hedge Accounting
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Hedge Accounting Advisory Interest Rate Hedging FX Hedging Commodity Hedging Regulatory Advisory Debt & Capital Advisory
ChathamDirect, our SaaS platform Financial risk management modules Debt management module Covered by SSAE 16 audit
Serving 1000+ clients Trading > $300 billion annually 5 locations globally inU.S., Europe, and Asia
The Chatham Difference – Technology and Advisory from independent experts leading the derivatives and debt markets
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Today’s Agenda
1
2
Commodity Hedging Overview
Key Considerations for Commodity Hedge Accounting
Defining the Hedged Risk
Identifying the Hedged Forecasted Transactions
Hypothetical Derivative Method
Determining the Timing for Reclassifications to Earnings of Amounts Deferred in OCI
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On Track for a Best‐in‐Class Commodity Hedging Program
Procurement /Sales
Procurement /Sales AccountingAccounting TreasuryTreasury
Foundational KnowledgeCommon Language & Framework
Organizational Alignment
Policy Design
Core Risk Management
Execution
Accounting and ReportingASC 815 and ASC 820
Monitoring (Performance/Counterparties)
8
Case Study: DMP Electronics
Natural Gas RiskManufacturing facilityburns a significant
amount of natural gas
Gold RiskComponents use gold as a primary input
Fuel RiskFuel surcharges and direct fuel expenses
Manufacturing
Product
9
Hedging Program Focus
Manage margin risk from commodity inputs Limit cost of hedging through optimized program
DMP Electronics
Manufactures and sells electronic components
Natural Gas
Manufacturing facility burns significant amount of natural gas
Gold
Most COGS variability driven by spot gold (gold changes faster than customer pricing)
INPUTS
OUTPUT
Case Study: DMP Electronics
10
Identify Exposures and Quantify Risks
How much pain can I handle?Variation in key metrics,Variation from budget,
Debt covenants
How much can prices change?
Commodities have been volatile.
How much exposure do I have?
Effective cross‐functional forecasting is critical.
How much pain can I handle?Variation in key metrics,Variation from budget,
Debt covenants
How much can prices change?
Commodities have been volatile.
How much exposure do I have?
Effective cross‐functional forecasting is critical.
What are my objectives for hedging and how will I accomplish them?What are my objectives for hedging and how will I accomplish them?
11
Polling Question 1
• What is your company’s main objective for managing commodity risk? (Check all that apply)A. Reduce reported earnings volatilityB. Reduce cash flow/budgeting volatilityC. Provide pricing alternatives to customers while keeping our risk the
sameD. Provide disaster protectionE. Other objectivesF. Currently not hedging commodities; planning to hedgeG. Currently not hedging commodities; not planning to hedge
12
Case Study: DMP Electronics
Risk Owner Risk Management Approach Notes
Procurement Fixed‐Price Supply ContractProcurement and Treasury worked together considering efficiency of pricing and ability to get free credit.
Treasury OTC ForwardsTreasury consulted with Procurement, but financial contracts were a better way to manage the risk.
TBD TBDTreasury and Procurement have tabled this while they manage the other risks. Less significant overall.
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• DMP Electronics had a process in place that required significant contracts to be evaluated for accounting issues before final signing
• DMP Electronics determined that the supply contract was a derivative
• The contract qualified for NPNS• Terms were normal in relation to the
Company’s business• Past experience had shown that the
Company would take physical delivery
• When considering the use of a fixed‐price supply contract DMP Electronics was aware of the accounting ramifications and knew that this contract could avoid the need for hedge accounting
Evaluation Process
NPNS Election
Case Study: DMP Electronics
14
Polling Question 2
• What contracts does your organization use for commodity risk?A. Fixed‐price purchase/sale contracts with suppliers/customersB. All floating‐price contracts with suppliers and customersC. Mostly fixed, with some floatingD. Mostly floating, with some fixedE. Financial contracts to fix commodity exposures from floating‐price
contractsF. Unsure
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Gold forwards
Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12 Month 13 Month 14
DCA B
TODAY
Forward Execution
With the forwards, as gold prices go up the forward contracts offset the increase to maintain a fixed price locked via the forward contract.
OBJECTIVE: Protect margin from gold price risk = ACHIEVED
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Commodity Hedge AccountingKey Considerations
AccountingAccounting TreasuryTreasury
Determining the Timing for Reclassifications to Earnings of Amounts Deferred in OCI
Hypothetical Derivative Method
Identifying the Hedged Forecasted Transactions
Defining the Hedged Risk
Procurement /Sales
Procurement /Sales
17
Why Hedge Accounting?Without it, all MTM changes on hedges flow directly into earnings
Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8 Month 9 Month 10
Changes in MTMChanges in MTMEverything flows immediately
into earningsEverything flows immediately
into earnings
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Why Hedge Accounting?With hedge accounting, recognition of gains / losses on hedges is initially deferred in equity (other comprehensive income or “OCI”) and subsequently reclassified to earnings to align with the recognition of the associated hedged transactions
Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8 Month 9 Month 10
Equity
Hedge AccountingHedge Accounting• Effective portion of MTM changes flow to equity, equity
reclassified to earnings as hedged transactions occur• Ineffective portion of MTM changes flow to earnings
• Effective portion of MTM changes flow to equity, equity reclassified to earnings as hedged transactions occur
• Ineffective portion of MTM changes flow to earnings
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AccountingAccounting TreasuryTreasuryProcurement /
SalesProcurement /
Sales
Commodity Hedge AccountingKey Considerations
Determining the Timing for OCI Reclassifications to Earnings
Hypothetical Derivative Method
Identifying the Hedged Forecasted Transactions
Defining the Hedged Risk
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AccountingAccounting TreasuryTreasury
Determining the Timing for OCI Reclassifications to Earnings
Hypothetical Derivative Method
Identifying the Hedged Forecasted Transactions
Defining the Hedged Risk
Procurement /Sales
Procurement /Sales
Commodity Hedge AccountingKey Considerations
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Limitations for “Non‐financial” Items
ASC 815ASC 815For cash flow hedges of non-financial items (e.g. commodity price risk), ASC 815 only permits
designating the hedged risk as overall changes in cash flows relating to all changes in price.For cash flow hedges of non-financial items (e.g. commodity price risk), ASC 815 only permits
designating the hedged risk as overall changes in cash flows relating to all changes in price.
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ASC 815ASC 815For cash flow hedges of non-financial items (e.g. commodity price risk), ASC 815 only permits
designating the hedged risk as overall changes in cash flows relating to all changes in price.For cash flow hedges of non-financial items (e.g. commodity price risk), ASC 815 only permits
designating the hedged risk as overall changes in cash flows relating to all changes in price.
Limitations for “Non‐financial” Items
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ASC 815ASC 815For cash flow hedges of non-financial items (e.g. commodity price risk), ASC 815 only permits
designating the hedged risk as overall changes in cash flows relating to all changes in price.For cash flow hedges of non-financial items (e.g. commodity price risk), ASC 815 only permits
designating the hedged risk as overall changes in cash flows relating to all changes in price.
Limitations for “Non‐financial” Items
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ASC 815ASC 815For cash flow hedges of non-financial items (e.g. commodity price risk), ASC 815 only permits
designating the hedged risk as overall changes in cash flows relating to all changes in price.For cash flow hedges of non-financial items (e.g. commodity price risk), ASC 815 only permits
designating the hedged risk as overall changes in cash flows relating to all changes in price.
While not a part of the economic hedging program, these items must be included as part of the hedged
risk for applying hedge accounting
Limitations for “Non‐financial” Items
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Limitations for “Non‐financial” ItemsFactoring in “All Changes in Price”
‐2.5
‐2
‐1.5
‐1
‐0.5
0
0.5
1
1.5
2
2.5
Price Va
riabiliyt p
er Unit ‐
USD
Au Mfg / Tport Total Au Contract
26
Limitations for “Non‐financial” ItemsFactoring in “All Changes in Price”
‐2.5
‐2
‐1.5
‐1
‐0.5
0
0.5
1
1.5
2
2.5
Price Va
riabiliyt p
er Unit ‐
USD
Au Mfg / Tport Total Au Contract
27
Limitations for “Non‐financial” ItemsFactoring in “All Changes in Price”
‐2.5
‐2
‐1.5
‐1
‐0.5
0
0.5
1
1.5
2
2.5
Price Va
riabiliyt p
er Unit ‐
USD
Au Mfg / Tport Total Au Contract
28
Limitations for “Non‐financial” ItemsFactoring in “All Changes in Price”
‐2.5
‐2
‐1.5
‐1
‐0.5
0
0.5
1
1.5
2
2.5
Price Va
riabiliyt p
er Unit ‐
USD
Au Mfg / Tport Total Au Contract
29
Limitations for “Non‐financial” ItemsFactoring in “All Changes in Price”
‐2.5
‐2
‐1.5
‐1
‐0.5
0
0.5
1
1.5
2
2.5
Price Va
riabiliyt p
er Unit ‐
USD
Au Mfg / Tport Total Au Contract
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The ability to aggregate or even hedge exposures arising from multiple contracts
Monitoring of hedging relationships from forecasts through earnings recognition
Assessing hedge effectiveness and measuring hedge ineffectiveness
Limitations for “Non‐financial” ItemsFactoring in “All Changes in Price”
Organization alignment across functional units (e.g. purchasing, accounting, treasury)
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Polling Question 3• IFRS 9 allows for bifurcation by risk for commodities. In the FASB’s project
to revisit hedge accounting, do you believe that the new guidance should include the option to bifurcate by risk for commodity exposures?A. Yes, new guidance should be based on the IFRS 9 approach. B. Yes, but not necessarily based on the IFRS 9 approach.C. Maybe. I don’t have strong feelings one way or the other.D. No. I think it is too difficult to identify the risk that should be hedged.
32
Factoring in “All Changes in Price”Defining the “Hypo”
• What is a hypothetical derivative?• A derivative that would perfectly
offset the variability in cashflowson the hedged transactions
• Must reflect the terms of the hedged transactions
• Let’s take another look at the DMP purchase contract, what would have been the “perfect” hedge?
33
Factoring in “All Changes in Price”Defining the “Hypo”
• What is a hypothetical derivative?• A derivative that would perfectly
offset the variability in cashflowson the hedged transactions
• Must reflect the terms of the hedged transactions
• Let’s take another look at the DMP purchase contract, what would have been the “perfect” hedge?
• Actual trade is the trade you get done with the bank or on the exchange• Based on liquid and/or available
indices• Close, but doesn’t always match
your actual exposure
34
Limitations for “Non‐financial” ItemsFactoring in “All Changes in Price”
Delivery LocationDerivative based on delivery at point A, hedged forecasted purchase expected to occur at point B
Off‐Market HedgesDerivatives with a fair value other than zero at the
inception of the hedging relationship
Product SpecificationDifferences in grade and/or quality between the
hedging derivative and the hedged CF’s
Settlement DatesSwap contracts (derivatives) may settle on the 2nd day of the delivery month, while hedged purchases
may settle 60 days after that month end
PricingIndex Reference Date or Period, Fixed spreads, caps
or floors, transportation costs (if included)
35
AccountingAccounting TreasuryTreasury
Determining the Timing for OCI Reclassifications to Earnings
Hypothetical Derivative Method
Identifying the Hedged Forecasted Transactions
Defining the Hedged Risk
Procurement /Sales
Procurement /Sales
Commodity Hedge AccountingKey Considerations
36
Grouping Forecasted Transactions
• CF hedging guidance doesn’t explicitly define what sharing the same risk means, which gives rise to diversity
• Shared risk can affect the level of aggregation of forecasted transactions, which can impact the way that other requirements of hedge accounting are met and supported
ASC 815ASC 815Forecasted transactions may be grouped and hedged together if they share the same risk exposure for which they are hedged.Forecasted transactions may be grouped and hedged together if they share the same risk exposure for which they are hedged.
Qualitative Factors:
• Similar product type, indexation, pricing, etc.
• Exposures are managed together as part of a program and/or hedged with same derivatives
• Time period covered
Quantitative Factors:
• Simple analysis of pricing characteristics and cash flows
• Regression or other more complex analysis
37
Case Study: DMP ElectronicsDMP has 3 products that it is considering hedging as a group
• Product 1 Price = 0.01 t oz.* gold price + freight + manufacturing• Product 2 Price = 0.0098 t oz.* gold price + freight + manufacturing• Product 3 Price = 0.06 t oz.* gold price + 0.002 lbs. * copper price
+ freight + manufacturing
ASC 815ASC 815Forecasted transactions may be grouped and hedged together if they share the same risk exposure for which they are hedged.Forecasted transactions may be grouped and hedged together if they share the same risk exposure for which they are hedged.
Qualitative Factors:
• Indexation: Products 1 and 2 have similar weights, purity, and index for gold
• Other Variability: Products 1 and 2 have other charges that are similar in terms of the absolute size and the variability of the charge
Quantitative Factors:
• Simple Analysis: Products 1 and 2 have similar changes in $ and %
• Regression: Products 1 and 2 have a strong relationship as measured by correlation and the slope is close to 1
38
Grouping Forecasted Transactions
• As an example, DMP could look at the products that it determines to analyze using a quantitative approach to support that they share the same risk
• The Company performs its analysis to show that the cash flows of the various product types share the same risk (see example below) – if they do, then they can be grouped together
ASC 815ASC 815Forecasted transactions may be grouped and hedged together if they share the same risk exposure for which they are hedged.Forecasted transactions may be grouped and hedged together if they share the same risk exposure for which they are hedged.
y = 0.8624x + 1.2051R² = 0.988
14
17
20
14 17 20
Price Product 1 vs. 2
39
Grouping Forecasted Transactions
• As an example, DMP could look at the products that it determines to analyze using a quantitative approach to support that they share the same risk
• The Company performs its analysis to show that the cash flows of the various product types share the same risk (see example below) – if they do, then they can be grouped together
ASC 815ASC 815Forecasted transactions may be grouped and hedged together if they share the same risk exposure for which they are hedged.Forecasted transactions may be grouped and hedged together if they share the same risk exposure for which they are hedged.
y = 0.8624x + 1.2051R² = 0.988
14
17
20
14 17 20
Price Product 1 vs. 2
y = 2.3459x ‐ 0.558R² = 0.9859
30
40
50
13 18 23
Price Product 1 vs. 3
40
Grouping Forecasted Transactions
• As an example, DMP could look at the products that it determines to analyze using a quantitative approach to support that they share the same risk
• The Company performs its analysis to show that the cash flows of the various product types share the same risk (see example below) – if they do, then they can be grouped together
ASC 815ASC 815Forecasted transactions may be grouped and hedged together if they share the same risk exposure for which they are hedged.Forecasted transactions may be grouped and hedged together if they share the same risk exposure for which they are hedged.
y = 1.1241x + 0.0027R² = 0.8545
(1.5)
‐
1.5
(1.0) ‐ 1.0 2.0
Price Product 1 vs. 2
41
Grouping Forecasted Transactions
• As an example, DMP could look at the products that it determines to analyze using a quantitative approach to support that they share the same risk
• The Company performs its analysis to show that the cash flows of the various product types share the same risk (see example below) – if they do, then they can be grouped together
ASC 815ASC 815Forecasted transactions may be grouped and hedged together if they share the same risk exposure for which they are hedged.Forecasted transactions may be grouped and hedged together if they share the same risk exposure for which they are hedged.
y = 1.1241x + 0.0027R² = 0.8545
(1.5)
‐
1.5
(1.0) ‐ 1.0 2.0
Price Product 1 vs. 2
y = 2.0785x + 0.0105R² = 0.8753
(3.0)
‐
3.0
6.0
(1.0) ‐ 1.0 2.0 3.0
Price Product 1 vs. 3
42
Impact on the Hypo from Grouping Transactions
Delivery Location
Product Specification
Settlement Dates
Pricing / Indexation
Grouping transactions adds complexity to the hypoThe key features of each transaction in the group will influence the hypo
43
Probability of Occurrence
Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12 Month 13 Month 14
DCA B
TODAY
Forward Execution
Hedged forecasted transactions must be “probable” of occurringGenerally interpreted as >80% likely to occur
Consider tradeoffs between level of transaction grouping, probability assertion, OCI release, and shared risk assessment.
44
Probability of Occurrence
Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12 Month 13 Month 14
DCA B
TODAY
Forward Execution
6
8
10
12
14
16
6 7 8 9 10 11 12 13 14
Thou
sand
s of U
nits
Forecast Actual
45
Probability of Occurrence
Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12 Month 13 Month 14
DCA B
TODAY
Forward Execution
6
8
10
12
14
16
6 7 8 9 10 11 12 13 14
Thou
sand
s of U
nits
Forecast Actual
46
Probability of Occurrence
Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12 Month 13 Month 14
DCA B
TODAY
Forward Execution
6
8
10
12
14
16
6 7 8 9 10 11 12 13 14
Thou
sand
s of U
nits
Forecast Actual
47
Probability of Occurrence
Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12 Month 13 Month 14
DCA B
TODAY
Forward Execution
6
8
10
12
14
16
6 7 8 9 10 11 12 13 14
Thou
sand
s of U
nits
Forecast Actual
48
AccountingAccounting TreasuryTreasury
Determining the Timing for OCI Reclassifications to Earnings
Hypothetical Derivative Method
Identifying the Hedged Forecasted Transactions
Defining the Hedged Risk
Procurement /Sales
Procurement /Sales
Commodity Hedge AccountingKey Considerations
49
Hypo Revisited
Delivery Location
Product Specification
Settlement Dates
Pricing / Indexation
50
Building Hypo Curves
ASC 815ASC 815The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important.The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important.
Select a “base” forward curve to use
• DMP Electronics’ case is fairly easy, the base curve would be the gold forward curve
• It often makes sense to use the index in the actual hedging derivative as the base
Step 1 Find and summarize the relationship between the actual and the hypo (i.e., the exposure)
• DMP Electronics has a few options, but they opted to look at the spot prices of gold compared to the actual prices paid for its components to establish the relationship
• There are a few different approaches that could be used (discussed later)
Step 2 Apply the findings in Step 2 to the base curve to develop the hypothetical forward curve
• DMP Electronics found a relationship between gold spot prices and its components’ pricing that it applied to the gold forward curve to calculate the hypothetical forward curve
Step 3
Various approaches can be used to calculate a hypo curve.
51
Building Hypo Curves
ASC 815ASC 815The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important.The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important.
1,380
1,410
1,440
1,470
1,500
1w 1m 2m 3m 6m 9m 12m 2y 3y 5y
Base CurveGold Fwd Curve
52
Building Hypo Curves
ASC 815ASC 815The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important.The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important.
1,380
1,410
1,440
1,470
1,500
1w 1m 2m 3m 6m 9m 12m 2y 3y 5y
1,670
1,700
1,730
1,760
1w 1m 2m 3m 6m 9m 12m 2y 3y 5y
T3M Regression Flat Curve
Base CurveGold Fwd Curve
Hypo CurveGold Fwd + T3M Basis
53
Building Hypo Curves
ASC 815ASC 815The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important.The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important.
1,380
1,410
1,440
1,470
1,500
1w 1m 2m 3m 6m 9m 12m 2y 3y 5y
Base CurveGold Fwd Curve
Hypo Curve0.87* Gold Fwd + 272
14.00
16.00
18.00
20.00
22.00
11.00 13.00 15.00 17.00 19.00
Product Price vs. Gold Price
y = mx + b
54
Building Hypo Curves
ASC 815ASC 815The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important.The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important.
1,380
1,410
1,440
1,470
1,500
1w 1m 2m 3m 6m 9m 12m 2y 3y 5y
1,670
1,700
1,730
1,760
1w 1m 2m 3m 6m 9m 12m 2y 3y 5y
T3M Regression Flat Curve
Base CurveGold Fwd Curve
Hypo Curve0.87* Gold Fwd + 272
55
Building Hypo Curves
ASC 815ASC 815The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important.The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important.
1,380
1,410
1,440
1,470
1,500
1w 1m 2m 3m 6m 9m 12m 2y 3y 5y
Base CurveGold Fwd Curve
Hypo CurveGold Spot+T3M Basis
1,670
1,700
1,730
1,760
1w 1m 2m 3m 6m 9m 12m 2y 3y 5y
T3M Regression Flat Curve
56
Challenges in Building Hypo Curves
ASC 815ASC 815The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important………The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important………
Gathering DataHow many contracts are there and are they easily accessible?How do contracts change over time and how often are the negotiated?
Analyzing Purchase DataIs purchase data captured for analysis and is it accurate/reliable?How well is it organized and is it granular enough?How long is the history? Does historical data represent expectations going forward?
Developing forward basis estimates and forward curves for hedged exposuresDetermining approach for calculating forward basisProcess for updating dataUnderstanding potential for ineffectiveness
57
What does assessing effectiveness mean?
ASC 815ASC 815The guidance requires that a hedge be highly effective at offsetting cash flows for the risk being hedged.The guidance requires that a hedge be highly effective at offsetting cash flows for the risk being hedged.
Changes in MTMChanges in MTM
Everything flows immediately into earnings
Everything flows immediately into earnings
Equity
Hedge AccountingHedge Accounting
• Effective portion of MTM changes flow to equity, equity reclassified to earnings as hedged transactions occur
• Ineffective portion of MTM changes flow to earnings
• Effective portion of MTM changes flow to equity, equity reclassified to earnings as hedged transactions occur
• Ineffective portion of MTM changes flow to earnings
NOTHighly Effective
An effectiveness assessment is the means to hedge accountingIt demonstrates that a hedge is highly effective and eligible for hedge accounting
58
Assessing Effectiveness
Long Haul Methods:
ASC 815ASC 815The guidance does not prescribe a specific method for assessing the effectiveness of hedge accounting relationships.The guidance does not prescribe a specific method for assessing the effectiveness of hedge accounting relationships.
Reg
ress
ion
Ana
lysi
sR
egre
ssio
n A
naly
sis Pro: Robust approach with greater flexibility
Con: Higher degree of difficulty to apply and interpret
Pro: Robust approach with greater flexibility
Con: Higher degree of difficulty to apply and interpret
One
-Per
iod
Dol
lar O
ffset
One
-Per
iod
Dol
lar O
ffset Pro: Simple to perform and straightforward to interpret
Con: Easier to fail the effectiveness assessment, especially when small changes occur
Pro: Simple to perform and straightforward to interpret
Con: Easier to fail the effectiveness assessment, especially when small changes occur
Cum
ulat
ive
Dol
lar O
ffset
Cum
ulat
ive
Dol
lar O
ffset Pro: Simple to perform and straightforward to interpret
Con: Easier to fail the effectiveness assessment, especially when small changes occur
Pro: Simple to perform and straightforward to interpret
Con: Easier to fail the effectiveness assessment, especially when small changes occur
REGRESSION ANALYSIS
y = 0.988x + 92.54R2 = 0.9995
-150,000
-100,000
-50,000
0
50,000
100,000
150,000
200,000
-150,000 -100,000 -50,000 0 50,000 100,000 150,000 200,000
Hypothetical Derivative Change
Hedg
e Ch
ange
REGRESSION ANALYSIS
y = 0.988x + 92.54R2 = 0.9995
-150,000
-100,000
-50,000
0
50,000
100,000
150,000
200,000
-150,000 -100,000 -50,000 0 50,000 100,000 150,000 200,000
Hypothetical Derivative Change
Hedg
e Ch
ange
∆∆
∆∆
59
Assessing Effectiveness
ASC 815ASC 815The guidance does not prescribe a specific method for assessing the effectiveness of hedge accounting relationships.The guidance does not prescribe a specific method for assessing the effectiveness of hedge accounting relationships.
Even with regression assessments there are different approaches to consider:Sp
ot v
s.
Spot
Spot
vs.
Sp
ot
Pros: Simple to implement, easier data gathering exercise
Con: Only supports deferral of changes in spot rates (i.e., changes for other components would run through P&L)
Pros: Simple to implement, easier data gathering exercise
Con: Only supports deferral of changes in spot rates (i.e., changes for other components would run through P&L)
Forw
ard
vs.
Forw
ard
Forw
ard
vs.
Forw
ard Pro: Provides a more robust basis to defer full changes in FV (avoid P&L
volatility)
Cons: Does not consider discounting and misses some sources of ineffectiveness like “offmarket” elements
Pro: Provides a more robust basis to defer full changes in FV (avoid P&L volatility)
Cons: Does not consider discounting and misses some sources of ineffectiveness like “offmarket” elements
Fair
Valu
eFa
ir Va
lue Pro: Captures all components of fair value and resulting ineffectiveness,
most robust
Con: Most complicated method since trades are fully valued (calculation intense)
Pro: Captures all components of fair value and resulting ineffectiveness, most robust
Con: Most complicated method since trades are fully valued (calculation intense)
60
Measuring Ineffectiveness
ASC 815ASC 815ASC 815’s hypothetical derivative method is the most common method for measuring ineffectiveness.ASC 815’s hypothetical derivative method is the most common method for measuring ineffectiveness.
Ineffectiveness measurement is the degree to which the hedge actually offsets the risk being hedged
OCI Ineffectiveness
None
61
AccountingAccounting TreasuryTreasury
Determining the Timing for OCI Reclassifications to Earnings
Hypothetical Derivative Method
Identifying the Hedged Forecasted Transactions
Defining the Hedged Risk
Procurement /Sales
Procurement /Sales
Commodity Hedge AccountingKey Considerations
62
Reclassifying Amounts Deferred in OCI
• How do the hedged transactions affect earnings?• Are the hedged commodities part of overhead, inventory, and/or sales?• For inventory, the earnings is unaffected until cost of goods sold is recognized based on a sale to an
external party.
• Other inventory considerations• What inventory includes the commodities that are hedged?• How long will it take for the hedged commodities in inventory to be included in a transaction with an
external party that will affect earnings?• Does the inventory behave in a predictable way such that inventory turnover can be used to
determine the timing for OCI reclassifications?
ASC 815ASC 815Amounts deferred in OCI related to cash flow hedges are reclassified to earnings as the hedged transactions affect earnings.Amounts deferred in OCI related to cash flow hedges are reclassified to earnings as the hedged transactions affect earnings.
Earnings
OCI
63
Reclassifying Amounts Deferred in OCI
OCI Reclass
HypoDesign
Probability
Interrelationships among hedge accounting decision points
Grouping transactions may help probability assertions, but increases the complexity of hypo design and OCI reclasses.
Grouping Transactions
64
Polling Question 4
• What is the greatest challenge your company faces in applying hedge accounting for commodities? (Check all that apply)A. Challenges with flow of data and analyzing data in a timely and
effective mannerB. Assessing effectiveness is difficult (e.g., building and performing
regressions)C. Assessing sources of ineffectiveness is difficult, including building the
hypothetical derivative with its unique forward curvesD. Internal knowledge and processes for hedge accounting are limitedE. Other challenges not listed above
65
Connecting with Chatham
Aaron Cowan, CFA, CPADirector, Corporate Hedge Accountingacowan@chathamfinancial.comT: 720.221.3514
Kennett Square235 Whitehorse LaneKennett Square, PA 19348610.925.3120
Denver10026 West San Juan Way, Ste 150Littleton, CO 80127United States720.221.3500
London4th Floor, 16 Garrick StreetLondon WC2E 9BAUnited Kingdom+44 (0)20.7557.7000
Singapore20 Cross StreetChina Square Central #02‐16/17Singapore, 048422+65 6507.0680
Krakowul. Rakowicka 7, III p.31‐511 KrakówPoland+48 (0)12.294.6160
www.ChathamFinancial.com
Steve Arveseth, CPADirector, Corporate Hedge Accountingsarveseth@chathamfinancial.comT: 484.731.0033
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