The rising tide of hedge accounting

In an era marked by unpredictable financial landscapes and heightened risk, companies are increasingly turning to hedge accounting as a vital tool to help mitigate profit and loss volatility caused by the use of derivatives.

The demand for hedge accounting is not only growing but also evolving, driven by several key factors that underscore the complexity and importance of managing financial risks in today’s global economy.

Understanding hedge accounting

Hedge accounting is crucial for companies that use derivatives—financial instruments whose value is derived from underlying assets such as currencies, interest rates and commodities—to hedge against financial risks.

By aligning the accounting treatment of the hedge with the underlying exposure, hedge accounting helps companies better reflect their risk management activities in their financial statements and smooth profit and loss.

The surge in demand

A riskier world

The world today is fraught with economic uncertainties, geopolitical tensions and rapid market fluctuations. These factors compel companies to spend significant time and resources on risk mitigation strategies. Financial risks, in particular, are a major concern. Companies are increasingly relying on derivative contracts to manage their risk exposure. This reliance is evident from the staggering rise in the notional amount of over-the-counter (OTC) derivative contracts, which surged from approximately $500 trillion in 2016 to over $700 trillion by 2023.

The years 2022 and 2023 were particularly tumultuous, with significant global interest rate hikes and pervasive uncertainty about future rate cuts. Coupled with geopolitical instability, these factors created substantial volatility in derivative valuations, further amplifying the need for effective hedge accounting.

The chart below shows a bold line of actual UK interest rate fixings (LIBOR / SONIA) alongside dotted lines showing market expectations (known as forward curves) at those dates. The graph illustrates two key points –

1) financial markets are quite good at short-term forecasting, but long-term forecasting of interest rates is more difficult given the range of future geopolitical and economic events that can impact rates. This fundamental truth, that long-term economic forecasting is hard, reinforces the benefit of using derivatives to manage risk, particularly when you are exposed to financial risks over a multi-year time horizon;

2) the forward curves, which are a key component of derivative valuations, change continuously, resulting in large swings in derivative valuations that will impact profit and loss without the successful application of hedge accounting.

The changing regulatory landscape

Across the globe, increased regulatory scrutiny from auditors has heightened the focus on hedge accounting. The ever-increasing complexity and materiality of derivative accounting results in a need for audit teams to rely on specialised derivative valuation and treasury accounting teams to address the resulting audit risk, and these specialized teams have increased the rigour and sophistication of audit in relation to hedge accounting.

Auditors in the United States have long focused on strict compliance with US GAAP’s detailed hedge accounting guidance and increasingly we have seen auditors in other jurisdictions take a similar approach.

Anecdotally, over the last few years, we have seen a significant increase in auditor focus on hedge accounting and derivative valuation particularly in the UK, continental Europe, the Middle East, Australia and New Zealand.

Challenges in hedge accounting

Despite its benefits, hedge accounting presents several challenges that companies must navigate.

Complexity and expertise

Implementing hedge accounting requires a deep understanding of both accounting standards and the financial instruments involved. Companies need to invest in specialised expertise to ensure accurate and compliant hedge accounting practices. This can be particularly challenging for smaller firms that may lack the resources to hire or train personnel with the necessary skills.

Volatility and measurement

The inherent volatility in both the universe of financial risks and underlying derivative valuations poses a significant challenge for hedge accounting. Companies must regularly assess and adjust their hedging strategies to reflect changes in market conditions and that can result in more complex hedge accounting. Furthermore, accurate derivative valuation and hedge accounting documentation are crucial to ensure hedge accounting compliance, resulting in companies needing to invest in valuation expertise or technology tools to support their finance and treasury teams.

Disclosure requirements

Transparency in financial reporting is essential, but it also imposes additional burdens on companies. Hedge accounting requires detailed disclosures about the nature and extent of risks being hedged, the instruments used and the effectiveness of the hedging strategies. Preparing and presenting this information in a clear and comprehensive manner can be demanding, particularly for companies with extensive and complex hedging activities.

Conclusion

In an increasingly volatile and complex financial landscape, hedge accounting has emerged as a crucial tool for companies to manage their risk exposures. The growing demand for hedge accounting is driven by the need to navigate regulatory requirements, manage long-term financial risks and meet the expectations of global investors. While the practice presents several challenges, advances in technology are empowering companies to overcome these hurdles, significantly enhancing their hedge accounting practices and providing a clearer financial outlook.

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