Today, we’ll explore some possible accounting effects of the coronavirus disease 2019 (COVID-19) under Topic 815, Derivatives and Hedging.
The value of a derivative generally fluctuates based on changes in one or more underlying items. For instance, the value of a derivative may vary based on a specific interest rate, security price, commodity price, foreign exchange rate, index, or other item. In the current economic environment:
- Interest rates: Interest rates are moving. The Federal Reserve has issued emergency rate cuts. However, risk and uncertainty have skyrocketed. Lenders are grappling with the appropriate amount of risk premium to include in interest rates.
- Security prices: The coronavirus has been brutal for stock prices. A great example is Carnival Corporation & Plc (CCL), a major player in the cruise line industry. CCL began the year trading at $51.35 a share and closed yesterday (April 2, 2020) at an abysmal $7.97 a share.
- Commodity prices: Commodity prices also have not been spared. Oil prices are near 20-year lows. Although oil prices are driven by numerous factors (including trade wars), the fear of recession due to the coronavirus contributes significantly to the decline.
- Foreign exchange rates: Foreign exchange rates have been affected as the world tries to gauge the impacts of the coronavirus on specific countries. Currencies may have swings downwards or upwards based on how hard their related issuing countries have been hit by the virus and the effectiveness of that country’s response.
- Indices: Indices are also moving due to the above fluctuations in rates or prices.
Ultimately, we are witnessing extreme instability.
Topic 815 requires a reporting entity to measure all derivative instruments at fair value. Derivatives are measured at fair value both upon initial recognition and in subsequent periods. This is true regardless of whether a reporting entity uses hedge accounting. The requirement to measure derivatives at fair value creates volatility in the income statement. This volatility is alleviated if a reporting entity uses hedge accounting.
Under hedge accounting, a reporting entity generally can match the timing of recognizing gains or losses on derivative instruments with recognizing either:
- The changes in the fair value of the hedged item that are attributable to the hedged risk; or
- The effect of a hedged forecasted transaction in earnings.
There are three basic types of hedges under hedge accounting: cash flow hedges, fair value hedges, and hedges of net investments in foreign operations. Each type has different accounting rules and requirements in Topic 815. For instance, there are different rules on how to record gains and losses (for the derivative and the related hedged item) depending on the type of hedge. Regardless of the type of hedge, however, a few themes are:
- Designation and documentation of a hedge: At the inception of a hedge, a reporting entity must formally designate and document a hedge;
- Hedged items and transactions: Only certain hedged items and hedged transactions qualify for hedge accounting;
- Hedging instruments: Only certain hedging instruments (derivatives) are eligible for hedge accounting;
- Hedge effectiveness: A reporting entity must expect a hedge to be highly effective, both at the inception of the hedge and on an ongoing basis.
- Stopping hedge accounting: If a reporting entity no longer qualifies for hedge accounting, it must stop applying hedge accounting.
Hedge Accounting and the Coronavirus
In light of the coronavirus, a few areas to consider are:
- Hedging strategies: In periods of market turmoil, reporting entities may look for alternative ways to manage risks or make money. They may enter into new or different types of instruments. A few derivative instruments in high demand due to the pandemic are:
- Foreign currency swaps: Many foreign lenders have been eager to acquire US dollars. These lenders have been entering into foreign currency swaps with American companies.
- Credit default swaps: As the creditworthiness of reputable businesses falls, reporting entities have scrambled to buy credit protection. For example, lenders have bought credit default swaps, which would provide compensation to the lender if the borrower defaults.
- Puts: The stock market has plummeted. Someone concerned with additional declines might enter into puts for downside protection. For instance, buying a put option on an individual stock would give you an option to sell that stock at a specific price on or before a certain date.
- Collars: No one has a crystal ball showing where the market goes from here. Reporting entities may buy collars to mitigate their exposure to significant swings (up or down). A collar protects against substantial losses, but also limits potential gains in the event of a market upswing.
A reporting entity must consider if any new instruments are considered derivatives (or embedded derivatives) within the scope of Topic 815. Also, if the reporting entity hopes to use hedge accounting, it must meet the specific criteria in Topic 815 to qualify for hedge accounting.
- Hedge effectiveness: One requirement for hedge accounting is that a reporting entity must expect a hedge to be highly (but not perfectly) effective. A reporting entity must consider if a hedge is highly effective both at the inception of the hedge and in subsequent periods. A couple items to mull here are:
- Highly effective: The coronavirus has caused drastic changes in many variables simultaneously. For instance, interest rates, security prices, commodity prices, foreign exchange rates, and counterparty creditworthiness are all moving. Given the various factors at play, a hedging instrument may not be moving in tandem with the hedged item. If an existing hedge is no longer expected to be highly effective, a reporting entity must discontinue hedge accounting. For new hedges, it also may be more difficult to conclude that the hedge will be highly effective.
- Quantitative versus qualitative assessments: Accounting Standards Update (ASU) No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, simplified effectiveness testing. Under this ASU, if the initial evaluation of hedge effective is quantitative, a reporting entity may be allowed to perform subsequent evaluations on a qualitative basis. An election to perform qualitative assessments is made on a hedge-by-hedge basis and must be documented at the inception of the hedge. If facts and circumstances change, however, a subsequent evaluation may have to be quantitative. The quantitative method used is the method indicated in the entity’s initial hedge documentation. Due to the pandemic, a reporting entity may need to rethink if a qualitative assessment is appropriate. It may be more difficult to conclude that a hedge continues to be highly effective based on merely a qualitative assessment.
- Forecasted transactions: A popular cash flow hedge is a hedge of a forecasted transaction. A forecasted transaction is expected to occur, but there is no firm commitment. For instance, a reporting entity might expect a sales transaction, supply purchase, or debt issuance to happen in the future. To qualify for hedge accounting, a forecasted transaction must be probable of occurring. “Probable” is a significantly greater likelihood than “more likely than not.” The coronavirus has turned many companies’ current operations and future outlooks on their head. Events once expected to occur may not happen. Consequently, it may be difficult to assert that a forecasted transaction is probable. Some items to consider here are:
- Counterparty creditworthiness: The creditworthiness of the counterparty must be considered in determining if a forecasted transaction is probable. A counterparty’s credit may have deteriorated to an extent where a forecasted transaction is no longer probable.
- Expected timing of the forecasted transaction: A forecasted transaction can be probable even if there is some uncertainty regarding the timing of the transaction. However, at the inception of the hedge, a reporting entity must document the date on or time period in which the forecasted transaction is expected to occur. Due to the coronavirus, the expected timing of a forecasted transaction might be delayed.
If a forecasted transaction is no longer probable, a reporting entity must discontinue hedge accounting. Likewise, if a forecasted transaction is no longer expected to happen within the originally specified window, the hedge is discontinued. When hedge accounting is discontinued, a reporting entity must follow Topic 815 to derecognize the hedge. In particular, Topic 815 discusses how to account for any derivative gain or loss in accumulated other comprehensive income (AOCI) if the forecasted transaction is still probable of occurring within two months of the originally specified window.
- Fair value: Fair value is a cornerstone in accounting for derivatives. A derivative is measured at fair value initially and in subsequent periods. The coronavirus poses numerous challenges for fair value measurements, which are explored in our posts on fair value measurements and the fair value hierarchy.
- Portfolios: The hedged item in a fair value hedge can be a portfolio of similar assets or similar liabilities. Examples of characteristics used to identify portfolios are loan type, loan size, collateral, interest rate, maturity date, and prepayments. The implementation guidance in Topic 815 also describes a quantitative test for determining if assets or liabilities are similar for this purpose. Due to the coronavirus, a reporting entity may need to revisit its portfolios. It’s important to ensure that the assets or liabilities are still considered similar under the specific rules in Topic 815.
- Normal purchases and normal sales scope exception: A contract for a normal purchase or sale of goods and services is excluded from the scope of Topic 815. Various requirements must be met to qualify for this scope exception. For instance, the goods and services under the contract must be expected to be used or sold by the entity in its usual business operations within a reasonable time frame. Also, physical settlement of the contract must be probable. The coronavirus has upended sales and supplies channels. This may affect whether a contract qualifies for the scope exception. In particular, physical settlement (delivery) may no longer be probable.
- Other potential business impacts: Due to the severity of recent market swings, reporting entities may have made or lost significant sums of money on derivatives. Reporting entities also may have had to post additional collateral related to derivatives. This may notably impact the cash or other resources available to an entity, causing downstream effects on its business.
The accounting for derivatives is complex. This post is just the tip of the iceberg. Be sure to consult the Codification to understand the full implications of the coronavirus on your accounting.
Also, remember to provide appropriate disclosures for the users of financial statements, including how the coronavirus has affected your accounting for derivatives and the related financial statement impacts.
COVID-19 is a rapidly evolving situation. In the coming weeks and months, we may witness additional accounting effects as the full impact of this disease manifests itself. We encourage you to stay informed on accounting and financial reporting developments.
Please also check out our other posts on the accounting effects of the coronavirus. We have posts on revenue, fair value measurements and disclosure, current expected credit losses (CECL) and disclosure, and pensions.