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Derivative toolkit: Hedging debt with derivatives · PwC's accounting podcast

• 0:00
  SPEAKER_01: Thought Leadership from PWC.
• 0:06
  SPEAKER_00: Welcome to PWC's Accounting Podcast.
• 0:09
  SPEAKER_00: I'm Heather Horn.
• 0:11
  SPEAKER_00: Thanks for tuning in to another episode in our Toolkit series where we're taking a deep dive each month into a single topic, recapping the basics, but also focusing in on frequently asked questions and judgmental areas.
• 0:25
  SPEAKER_00: The month July is one of my favorite topics, derivatives.
• 0:29
  SPEAKER_02: It's important to think broadly about applying hedge accounting like you would in any kind of reporting or accounting process.
• 0:39
  SPEAKER_02: Like think of your systems, think of your processes, think of your controls, and importantly, think about the training of your people that are going to over oversee this process.
• 0:50
  SPEAKER_03: Yeah, and you know, other things to think about.
• 0:53
  SPEAKER_03: You know, the company's always going to have to be able to compute change in fair value of the derivative.
• 0:57
  SPEAKER_03: So they're going to have to have systems, processes, controls around valuing the derivative on an ongoing basis.
• 1:03
  SPEAKER_03: And for fair value hedges, they'll also have to fair value the debt for the risk that they're hedging.
• 1:09
  SPEAKER_00: That was Brett Dooley and Chip Curry, both from PWC's national office.
• 1:14
  SPEAKER_00: They'll be continuing the series with discussion of applying the hedge accounting model for debt hedges.
• 1:20
  SPEAKER_00: A lot to cover, so let's get started.
• 1:29
  SPEAKER_00: So, Brett, Chip, thanks so much for joining me today.
• 1:32
  SPEAKER_00: And our topic is focusing on something that I know is a regular occurrence for many companies, and that's companies that are issuing debt and then thinking about hedging that debt.
• 1:43
  SPEAKER_00: So, where would you start in that circumstance?
• 1:45
  SPEAKER_00: Brett, maybe I'll go to you.
• 1:47
  SPEAKER_02: Sure.
• 1:48
  SPEAKER_02: So I know we're here to talk about accounting at some point, but I do want to start a step earlier and think about the economics of the debt issuance itself and decisions companies make when they're seeking funding.
• 2:01
  SPEAKER_02: And in thinking about the debt, generally there's two types of market risks that impact the cost of the debt or the amount of interest that a company is going to pay over time.
• 2:11
  SPEAKER_02: And that's interest rate risk and credit risk.
• 2:15
  SPEAKER_02: And there are other elements of risk I think that impact the cost of debt as well, such as liquidity risk.
• 2:22
  SPEAKER_02: But today we're going to kind of focus on interest rate risk.
• 2:26
  SPEAKER_02: And I mentioned credit risk.
• 2:28
  SPEAKER_02: You know, companies who seek to manage their own credit risk through derivatives, you know, doing that can be quite complex and raises a number of issues.
• 2:35
  SPEAKER_02: So it's frankly not something that we see that often as a risk management strategy.
• 2:41
  SPEAKER_02: And also, we should talk about foreign currency risk.
• 2:44
  SPEAKER_02: For a number of reasons, a company may choose to issue debt denominated in a currency other than their functional currency.
• 2:52
  SPEAKER_02: Maybe because of market opportunities that would issue debt cheaper in a different currency.
• 2:59
  SPEAKER_02: So this can also be an element in a company's risk management strategy.
• 3:03
  SPEAKER_02: So when treasurers and risk management professionals think about things like interest rate risk and foreign currency risk, they often consider the entity as a whole.
• 3:12
  SPEAKER_02: They're not just myopically thinking about this debt issuance and the terms of that debt.
• 3:17
  SPEAKER_02: They're thinking about the risk that they run across the entire organization.
• 3:23
  SPEAKER_02: For example, they may want to consider foreign currency exposures from foreign sales and from foreign subsidiaries when they're deciding whether they want to issue in US dollars or foreign currencies.
• 3:37
  SPEAKER_02: Similarly, when we think of interest rate risk, they're going to think about their investment portfolio, other debt issuances, and cash management needs in deciding whether they want to issue fixed or floating rate debt in the first place.
• 3:49
  SPEAKER_00: Well, and Brett, I would assume on that last point, it's also even what they're using the debt for may even feed into some of that, how they're structuring the debt.
• 3:59
  SPEAKER_02: Absolutely.
• 4:00
  SPEAKER_00: So, Chip, to that point of structuring, how do derivatives fit into this discussion?
• 4:06
  SPEAKER_03: Well, as Brett said, you know, one way you can create a risk profile with debt is through the actual terms of the debt.
• 4:12
  SPEAKER_03: So, like Brett said, fixed rate debt, floating rate debt, um, foreign denominated debt.
• 4:17
  SPEAKER_03: Um there are other terms within a debt agreement that that you can structure to that can impact your risk exposure.
• 4:24
  SPEAKER_03: You know, for example, you could issue debt with a with a 10-year term, but make it callable by the issuer after five years.
• 4:31
  SPEAKER_03: And that would enable the company after five years to reevaluate whether there's cheaper financing in the marketplace and call the debt.
• 4:39
  SPEAKER_03: Um now, some of sometimes those things can be expensive, right?
• 4:44
  SPEAKER_03: So having to call your debt back from the marketplace and then issue new debt to the market, you incur costs in issuing that new debt.
• 4:52
  SPEAKER_03: And that strategy can be expensive.
• 4:54
  SPEAKER_03: And so sometimes it's easier to think about using derivatives to sort of manage your interest rate profile.
• 5:01
  SPEAKER_03: So, for example, you could issue five-year fixed rate debt, or alternatively, with derivatives, you could issue five-year floating rate debt and use an interest rate swap to layer on top of that debt and effectively convert that into five-year fixed rate debt.
• 5:20
  SPEAKER_03: So you can use derivatives to layer on top of debt agreements to create risk profiles, and sometimes you can do it in, you know, like I said, a cheaper, more efficient way than using the terms of the debt itself.
• 5:34
  SPEAKER_02: The other thing to think about here is that things change over time.
• 5:39
  SPEAKER_02: So a company may make a decision, uh, as Chip said, um, upon debt issuance, um, given their risk management views and profile at that time.
• 5:48
  SPEAKER_02: But that could change over time.
• 5:50
  SPEAKER_02: So maybe it's going to issue additional debt, uh, or maybe it changed there's changes in the investment portfolio, or they simply have a different view of where interest rates are headed.
• 6:00
  SPEAKER_02: Um, and derivatives are easier to enter into and exit than issuing and repurchasing debt or reissuing new debt.
• 6:09
  SPEAKER_02: So building off CHIPS example, a company may have issued floating rate debt and entered into an interest rate swap to replicate fixed rate debt over that term.
• 6:18
  SPEAKER_02: Um, but if the company's risk profile changed that they preferred to have floating interest payments, they could approach the derivative counterparty and simply terminate that swap agreement.
• 6:29
  SPEAKER_02: In another situation, a company may have issued fixed rate debt years ago and now wants to have a floating interest rate profile.
• 6:37
  SPEAKER_02: It's likely much less expensive to enter into an interest rate swap as opposed to going out repurchasing the fixed debt and issuing floating rate debt.
• 6:46
  SPEAKER_02: And remember, credit spread movements can play a factor in this too.
• 6:49
  SPEAKER_02: So a company may have issued debt at favorable credit spreads and it doesn't want to go and repurchase that debt just because its credit spreads may have widened, they can use interest rate swaps uh to change their risk profile without touching the debt.
• 7:05
  SPEAKER_00: So, Brett, or maybe Chip, I know this is not a podcast about market conditions.
• 7:11
  SPEAKER_00: However, I think we're all seeing in the newspapers, you know, rates keep going up.
• 7:16
  SPEAKER_00: Are you seeing a big change in the types of debt people are issuing or the instruments they're using, or not yet in terms of the impact of uh rising interest rates?
• 7:29
  SPEAKER_03: So, one of the things that you always hear people talking about when they're rising rate environments and things like that is by the time the rates have risen, it might already be too late to hedge.
• 7:39
  SPEAKER_03: Um, you know, now that being said, I think with um the volatility that you're seeing in the marketplace, we're certainly talking to more people about entering into hedges, like say, of, and we'll talk about a little bit later, uh, like a future debt offering to mitigate against interest rates, you know, significantly changing between, you know, further from now and the issuance date.
• 8:02
  SPEAKER_03: Um, so we've seen a little bit of uptick in those kinds of things, but you know, not really any major changes into the types of hedges that people are talking about.
• 8:11
  SPEAKER_02: I think it can be complex to unpack some of that, right?
• 8:14
  SPEAKER_02: You need a market strategist because there's so much going on beyond just rising interest rates.
• 8:19
  SPEAKER_02: You've got different funding needs, there's uncertainty about growth potential, and so companies are thinking about um how much funding they need, what their credit spreads look like in addition to the interest rate environment when they're when they're making these decisions.
• 8:34
  SPEAKER_00: Yeah, I think Brett, that's a really fair point.
• 8:36
  SPEAKER_00: Even when Chip was answering, I was thinking, oh, this seems like maybe, and I think this is your point, it's so company specific that we can't really say there are broad trends other than definitely people are still using these instruments because they're trying to manage one way or another whether interest rates are rising.
• 8:54
  SPEAKER_00: So, with all of that background, then I do think it's helpful, particularly when dealing with derivatives, to understand some of the motivations for why people are entering into these transactions.
• 9:03
  SPEAKER_00: I think it helps understand the actual accounting.
• 9:06
  SPEAKER_00: But with that said, Chip, how do we think about this from an accounting perspective?
• 9:12
  SPEAKER_03: Well, the first question that a company will want to answer from an accounting perspective is whether they want to apply hedge accounting or not.
• 9:19
  SPEAKER_03: Um, so while the derivative may serve as an economic hedge of the debt, there's a big difference between um sort of the core accounting model for derivatives and sort of the core accounting model for the debt.
• 9:32
  SPEAKER_03: So derivatives are mark-to-market through PL.
• 9:35
  SPEAKER_03: That's the kind of standard model for derivative instruments, unless you elect to apply hedge accounting.
• 9:40
  SPEAKER_03: Whereas the standard model for debt is we follow accrual-based accounting.
• 9:46
  SPEAKER_03: So you can see right away that if a company elects not to apply hedge accounting, there could be a very significant difference between how they're accounting for the derivative and how they're accounting for the hedged item.
• 9:57
  SPEAKER_03: Every once in a while you'll hear people talk about fair value option, particularly with fixed-rate debt, as opposed to trying to go through the rigors of applying hedge accounting and meeting all the requirements to elect uh fair value option on the debt.
• 10:10
  SPEAKER_03: And that way they're fair valuing the debt and the derivative.
• 10:13
  SPEAKER_03: Um, but that's really the only other way to get PL sort of symmetry or some degree of offset outside of hedge accounting.
• 10:21
  SPEAKER_00: So, Chip, are you seeing much on the fair value option now?
• 10:25
  SPEAKER_03: We don't see that a lot in the debt space.
• 10:28
  SPEAKER_03: Um, it doesn't really help you much if it's floating rate debt and an interest rate swap because the mark on floating rate debt doesn't really change based upon interest rates.
• 10:35
  SPEAKER_03: Um, and the other thing about fair value option is when you're doing thinking about it, like I said, for fixed rate debt, you have to fair value the debt for all risks: interest rate, credit risk, liquidity risk.
• 10:47
  SPEAKER_03: And so sometimes that doesn't create that, you know, as perfect of an offset as people are looking for.
• 10:54
  SPEAKER_02: And remember that fair value option is is irrevocable.
• 10:59
  SPEAKER_02: So some of the things we talked about before with changing your risk management strategy and removing derivatives in some cases, um, you lose a lot of flexibility if your if your needs change.
• 11:11
  SPEAKER_00: Yes.
• 11:11
  SPEAKER_00: So, Brett, your point there being, okay, so I entered into hedge and I did fair value option because I've been trying to match them up.
• 11:17
  SPEAKER_00: And later I terminate my hedge early, and yet I'm still fair valuing my debt.
• 11:22
  SPEAKER_00: That that's not something you can really get out of unless you refinance and you may not be ready to do that.
• 11:27
  SPEAKER_02: Exactly right.
• 11:28
  SPEAKER_00: All right.
• 11:29
  SPEAKER_00: So, with all of that background, then let's assume or presume for this discussion that the company does want to apply hedge accounting.
• 11:37
  SPEAKER_00: And I think the best place to start would be to talk about our two different models that we can apply.
• 11:43
  SPEAKER_02: Sure.
• 11:43
  SPEAKER_02: Um, so we've got cash flow hedges and fair value hedges, and the accounting is quite different uh between the two.
• 11:50
  SPEAKER_02: So we're gonna spend time with both, but uh let's take them one by one and I'll start with the cash flow hedges.
• 11:56
  SPEAKER_02: The easiest way to think about a cash flow hedge is that you're looking to eliminate the risk you face that cash flows might change on your debt.
• 12:05
  SPEAKER_02: So, you know, specifically thinking about debt, uh, if I have variable rate debt, um hedging that interest rate risk is going to be a cash flow hedge because I've got the risk that interest rate will change over time, causing the cash flows on the debt to change.
• 12:22
  SPEAKER_02: And an interest rate swap would hedge against those changes.
• 12:25
  SPEAKER_02: It'll take those variable payments and exchange them for fixed payments.
• 12:30
  SPEAKER_02: So in this case, uh you'd be hedging the debt for changes in the index contractually specified in the debt agreement.
• 12:38
  SPEAKER_02: Now, for example, we see a lot of sofer debt issuances these days.
• 12:43
  SPEAKER_02: Another example of a cash flow hedge is when a company knows it's going to issue debt in the future, say in three months, and is going to look to hedge against the potential that interest rates may rise before they issue the debt.
• 12:56
  SPEAKER_02: Similar to hedging floating rate debt, this is a hedge of the variability of the future cash flows from that debt.
• 13:04
  SPEAKER_02: So if you apply, if you qualify uh to apply hedge accounting in a in a cash flow hedge, all of the changes in fair value of the derivative are recorded in OCI opposed to PL.
• 13:17
  SPEAKER_02: And this was a change created a few years ago by ASU 20 2017-12 for the for the uh accounting technicians listening.
• 13:29
  SPEAKER_02: Um and all those amounts in OCI will be reclassified to earnings as the hedged forecasted transaction affects earnings.
• 13:37
  SPEAKER_02: So if I'm thinking again about variable rate debt, as that interest expense is accrued.
• 13:42
  SPEAKER_02: So the way I think I step away from this and think about cash flow hedges is that we use OCI as a holding tank to hold changes in fair value of that derivative until the hedged item impacts PL.
• 13:55
  SPEAKER_02: That way we we get matching in the PL, but the derivative is still reported on the balance sheet at fair value, which was one of the goals that the FASB had in creating this guidance.
• 14:05
  SPEAKER_00: So before we go into fair value then, I think Brett, is it fair to say that sort of a perfect hedge, then you would have full offset and you wouldn't be really seeing an income statement impact?
• 14:17
  SPEAKER_00: Or what are you really trying to achieve here?
• 14:20
  SPEAKER_02: Um that's the goal that you're trying to achieve.
• 14:23
  SPEAKER_02: Um often we find like when you say a perfect hedge, like a lot of people of risk management want to think of these hedges as just the exact same as issuing fixed rate debt.
• 14:34
  SPEAKER_02: And it's not always that simple, uh, but that's that's generally the goal.
• 14:39
  SPEAKER_02: You know, sometimes it'll it'll it'll matter uh whether you've got basis differences between your derivative and your hedge.
• 14:47
  SPEAKER_02: You could have time or between the derivative and your hedged item, you could have cash flow timing differences between the two.
• 14:54
  SPEAKER_02: So often perfection is not actually achieved.
• 14:58
  SPEAKER_03: And that's the change that came with that 2017-12 that Brett mentioned was prior to that, if the hedge wasn't perfect, but it was still highly effective, we tried to measure that ineffectiveness and run that through PL.
• 15:13
  SPEAKER_03: Um, but post-2017-12, as long as the hedge is highly effective, we no longer try to capture that ineffectiveness due to interim changes in fair value.
• 15:24
  SPEAKER_03: Instead, we we do we still treat the hedge almost as if it was perfectly effective and put all amounts into OCI.
• 15:31
  SPEAKER_03: But the ineffectiveness will manifest itself when the amounts that we pull out of OCI, if they don't perfectly offset the accruals that we're booking, that's where you'll see the hedge ineffectiveness sort of leak its way in in PL.
• 15:44
  SPEAKER_03: And the rules require that that all gets reported in interest expense.
• 15:48
  SPEAKER_03: So that that volatility of for lack of a perfect hedge will be sitting in interest expense.
• 15:54
  SPEAKER_00: Well, I think to that point, although now it's easier to, because you don't have to do as much measurement, if your hedge, if there is any type of mismatch, ultimately those differences in cash flow have to hit the income statement.
• 16:06
  SPEAKER_00: There's really no other place for them to go.
• 16:08
  SPEAKER_00: So something to think about there.
• 16:10
  SPEAKER_00: But I think it's kind of helpful to understand, again, uh the economics of what we're trying to achieve.
• 16:15
  SPEAKER_00: So then, Chip, on that note, how about fair value hedging?
• 16:20
  SPEAKER_03: So, so yeah, so similar to Brett's, you know, kind of laying it out, I think the simplest way to think about a fair value hedge is you're not necessarily worried about variability in cash flows.
• 16:31
  SPEAKER_03: What you're hedging under the model is the instrument you're hedging, you're you're trying to get protection for.
• 16:38
  SPEAKER_03: It's exposed to changes in fair value due to interest rates.
• 16:42
  SPEAKER_03: So in the debt space, what you're talking about is hedging fixed rate debt and using a swap that kind of converts that fixed rate debt to floating.
• 16:50
  SPEAKER_03: Um, that's a fair value hedge because it's fixed rate debt, there's no variability in cash flows.
• 16:55
  SPEAKER_03: However, as interest rates move up, down, left, right, or sidewise, the fair value of that debt will change.
• 17:02
  SPEAKER_03: Um for fair value hedging, uh, what we do is we generally we mark to market the derivative through PL, just like we would if it wasn't in the hedging relationship.
• 17:11
  SPEAKER_03: Um, and we put that through the interest expense line because it's hedging debt and that's where interest gets recorded.
• 17:19
  SPEAKER_03: But but what we do is we actually change the underlying accounting for the hedged item.
• 17:24
  SPEAKER_03: So as I said earlier, normally we account for debt at amortized cost, but when it's the hedged item and a fair value hedge, we record changes in fair value of the hedged item, so debt, for the hedge risk, which is interest rates in PL.
• 17:37
  SPEAKER_03: Um, and to use the the nomenclature from the standard, uh, when you're hedging debt against changes in a benchmark interest rate, we record changes in fair value of the debt for changes in benchmark interest rates through PL.
• 17:51
  SPEAKER_03: Um, that now creates a basis adjustment.
• 17:53
  SPEAKER_03: So the debt's no longer carried at amortized costs.
• 17:56
  SPEAKER_03: We create either effectively a premium or discount on the debt as a result of doing it.
• 18:01
  SPEAKER_03: Now we achieve the same objective that Brett went through the derivatives on the balance sheet at fair value check.
• 18:06
  SPEAKER_03: Um, and we've got PL symmetry because we're marking to market the debt for changes in interest rates.
• 18:15
  SPEAKER_03: Now, unlike cash flow hedges, to the extent that those marks are not perfect with each other, that will cause PL volatility.
• 18:23
  SPEAKER_03: Um, and that PL volatility will similarly be reported in um interest expense.
• 18:30
  SPEAKER_03: Now, we've simplified things.
• 18:31
  SPEAKER_03: There's a whole bunch of other complexities with the model of unexcluded components and things like that.
• 18:36
  SPEAKER_03: But broadly speaking, that's the fair value in cash flow hedging models.
• 18:40
  SPEAKER_00: So, Ched, let me ask you a question because cash flow hedges have always intuitively made more sense to me because coming from a commodities background.
• 18:49
  SPEAKER_00: And so if you're purchasing electricity or gas or something else and you're using uh hedges to hedge, you're entering into derivatives to hedge those, you typically follow a cash flow hedge model.
• 19:01
  SPEAKER_00: In dealing with debt, how do you sort of decide if you should be using a cash flow hedge and a fair value hedge?
• 19:08
  SPEAKER_00: And I recognize that's probably a whole podcast in and of itself, but can you give us sort of high level why you would use one or the other?
• 19:16
  SPEAKER_03: So, with the exception of certain hedges in the foreign currency space, which we won't get into that complexity, there's not really a choice.
• 19:23
  SPEAKER_03: The nature of the hedging relationship will tell you this is a fair value hedge or this is a cash flow hedge.
• 19:29
  SPEAKER_03: So I go back to what we had said earlier.
• 19:32
  SPEAKER_03: If you're worried about that, cash flows might change, the actual dollar amount of interest payments that you're making might change because you have variable rate debt or you're gonna issue debt in the future, that's a cash flow hedge.
• 19:44
  SPEAKER_03: If you're hedging something where the payments are not going to change, they're not variable, like fixed rate debt, it's fair value hedging.
• 19:52
  SPEAKER_03: Now, I agree with you, Heather, and all treasurers say the same thing you did.
• 19:55
  SPEAKER_03: Is like I get my head around cash flow hedging.
• 19:58
  SPEAKER_03: Why it's because I'm worried about changes in cash flows, and so I'm looking to lock those in.
• 20:02
  SPEAKER_03: When I issue debt, am I really that worried about interim changes in fair value of the debt?
• 20:08
  SPEAKER_03: No, because I issue the debt and I'm probably gonna leave that outstanding until maturity.
• 20:12
  SPEAKER_03: So do I really care if the fair value changes?
• 20:14
  SPEAKER_03: No.
• 20:15
  SPEAKER_03: But the accountants tell me I'm hedging the change in fair value.
• 20:18
  SPEAKER_03: Exactly.
• 20:18
  SPEAKER_03: So it's kind of hard, like you said, to get your head around.
• 20:21
  SPEAKER_03: I just think about that as yes, I understand that may not be the way you're thinking about it from a risk management standpoint.
• 20:27
  SPEAKER_03: But in the world of where hedge accounting's got two boxes, you know, fixed rate debt fits into the fair value box.
• 20:33
  SPEAKER_00: All right.
• 20:34
  SPEAKER_00: I think that's helpful.
• 20:35
  SPEAKER_00: And I do think just the emphasis of like listen carefully to what Brett and Chip said of when you use one or the other.
• 20:41
  SPEAKER_00: And you'll probably have answered the question I asked, but I think it's worth talking about.
• 20:46
  SPEAKER_00: So let's move on then.
• 20:48
  SPEAKER_00: So now we've said in both models, you get the derivative on the balance sheet and you have, let's call it matching or offsetting, at least close enough.
• 20:56
  SPEAKER_00: Um, but what some of the other risks we mentioned previously included foreign currency risk.
• 21:02
  SPEAKER_00: So, Brett, how do you think about that if that's also sort of in the equation here?
• 21:06
  SPEAKER_02: Right.
• 21:06
  SPEAKER_02: And before we get into the mechanics of it, um, let's remember that hedge accounting is only relevant in this space if you've issued debt in a currency other than your functional currency.
• 21:17
  SPEAKER_02: So, for example, you're a US dollar functional currency company and you issued euro denominated debt, you could hedge that FX risk to bring it back to US dollars.
• 21:29
  SPEAKER_02: On the other hand, if a US dollar functional currency company issued US dollar debt and for whatever reason wanted to use derivatives to create euro denominated risk, you can't apply hedge accounting because that's considered creating foreign currency risk, not hedging the risk.
• 21:50
  SPEAKER_03: Yeah, and as I mentioned just a minute ago, I think depending on the nature of the hedge in the FX space for debt, you'll either be in the fair value or the cash flow model.
• 22:00
  SPEAKER_03: Probably a shorthand way to think about it is if you take debt plus derivative and you look at the total cash flows, if you've fixed the cash flow, so you end up with sort of US dollar fixed rate debt, you're probably gonna be in the cash flow model.
• 22:20
  SPEAKER_03: If you haven't fixed all the cash flows, if you're ending up with variable rate US dollar payments, when you add the two derivatives together, you're probably gonna be in the fair value hedge model.
• 22:32
  SPEAKER_03: Now, this is an area where a lot of times we see people not elect to apply hedge accounting.
• 22:39
  SPEAKER_03: Because go back to what Brett said earlier, it's only even available if you've got a debt agreement that is denominated in something other than your functional currency and you're swapping it back to your functional currency.
• 22:52
  SPEAKER_03: If you forget hedge accounting, we have to revalue through earnings for changes in FX rates debt that's not denominated in my foreign currency because that's what the foreign currency guidance says.
• 23:05
  SPEAKER_03: You have a monetary liability, we market the spot effectively through PL.
• 23:09
  SPEAKER_03: So even before you apply hedge accounting or think about hedge accounting, the FX risk of the debt in the derivative, there will be some natural offset in earnings because of what the foreign currency translation guidance tells you to do.
• 23:24
  SPEAKER_03: So this is an area where we do see sometimes people electing not to apply hedge accounting, because even without hedge accounting, there's some degree of natural offset.
• 23:33
  SPEAKER_00: So uh Chip and Brad on that particular point, I think I needed this podcast back when I was a manager and I had a client issuing debt and like every foreign currency imaginable and hedging pre-133 days.
• 23:46
  SPEAKER_00: I have to admit, at that time I never understood exactly what they were doing.
• 23:49
  SPEAKER_00: So this podcast would have helped me, helped me then.
• 23:53
  SPEAKER_00: That all said then, and kind of on the point that I just made, you know, applying hedge accounting can be very challenging.
• 24:02
  SPEAKER_00: And so can you give me an example, Brett?
• 24:05
  SPEAKER_00: If you're dealing with debt, what are some of the complexities that you're dealing with?
• 24:09
  SPEAKER_02: Sure.
• 24:09
  SPEAKER_02: Um, you know, and all hedge relationships require extensive documentation, you know, up front in order to be able to qualify and apply hedge accounting.
• 24:18
  SPEAKER_02: Um so going through that documentation process up front is often challenging.
• 24:23
  SPEAKER_02: But one of the areas that we've seen a number of issues relates to cash flow hedges specifically.
• 24:30
  SPEAKER_02: Um so, you know, reminder like let's think of the scenario where I'm hedging variability of the contractual cash flows of a debt instrument.
• 24:38
  SPEAKER_02: I've issued floating rate debt, I'm swapping it back to fixed rate with a derivative instrument.
• 24:45
  SPEAKER_02: And in order to apply cash flow hedging to that transaction, in this case, you know, the interest payments, those interest payments have to be probable of occurring.
• 24:55
  SPEAKER_02: So if I've issued uh five-year floating rate debt and use a five-year interest rate swap, all five years of those interest payments need to be probable of occurring and need to remain probable for the entire life of the hedge.
• 25:11
  SPEAKER_02: Now remember, most floating rate debt is prepayable, and sometimes companies will prepay their debt either to take advantage of the ability to obtain cheaper funding, maybe due to changes and credit spreads, um, or they they have a decreased need for funding.
• 25:27
  SPEAKER_02: Uh, and so you need to consider all of those scenarios in your probability analysis.
• 25:32
  SPEAKER_02: Um, and I think companies will think about this often when they're deciding how much of their flowing rate debt to hedge in the first place, because they need to be able to assert that whatever they're hedging and apply hedge accounting to uh is going to remain probable uh over that entire hedge period.
• 25:52
  SPEAKER_02: In some cases, being thoughtful of how you document the hedge can be useful.
• 25:58
  SPEAKER_02: For example, documenting it as a hedge of an existing debt issuance or the debt that replaces that debt issuance can be helpful in cases where you may um you know uh prepay one piece of debt and extend it to another.
• 26:12
  SPEAKER_02: Uh but in any case, a company is going to be able to need a company will need to be able to assert the forecasted transaction as probable of occurring.
• 26:20
  SPEAKER_02: Uh and if it becomes less than probable of occurring, uh hedge accounting must stop.
• 26:26
  SPEAKER_02: And in the extreme, if it becomes probable of not occurring, then any amounts in OCI, remember that's our holding tank for the change in fair value of the derivative, is going to get immediately reported in earnings.
• 26:40
  SPEAKER_02: It needs to be disclosed.
• 26:41
  SPEAKER_02: In fact, in some cases, it can impact the company's ability to hedge or to apply hedge accounting in the future.
• 26:48
  SPEAKER_02: So maintaining this probability of uh forecasted transactions is is really important.
• 26:54
  SPEAKER_00: And I think, Brett, a key point there, and it may have slipped by when you're speaking for our listeners, is there's a difference between something that is less than probable of occurring and something that is probable of not occurring.
• 27:10
  SPEAKER_00: So we sort of start with something that's probable of occurring of, sorry, we start with something that's probable of occurring, then you qualify for your hedge.
• 27:18
  SPEAKER_00: Then maybe you get to it's less than probable of occurring, which means you have to discontinue your hedge accounting.
• 27:25
  SPEAKER_00: And then if you get all the way to it's probable of not occurring, then you would release your amounts in OCI.
• 27:31
  SPEAKER_00: So again, I always think this is something when I'm answering questions about hedging, it's so easy to get caught in the word.
• 27:37
  SPEAKER_00: So I just wanted to emphasize that point.
• 27:39
  SPEAKER_03: Great.
• 27:40
  SPEAKER_00: All right, Chip.
• 27:42
  SPEAKER_03: Yeah, so on the fair value hedging side, um, unless you qualify for what's known as the shortcut method, which is which is very limited, um, you'll need to compute changes in fair value of the debt for changes in the benchmark interest rate, in addition to change in fair value of the swap.
• 27:58
  SPEAKER_03: So you'll have two fair value calculations to do, not just one.
• 28:03
  SPEAKER_03: Um, when thinking about computing changes in fair value of the debt, there is some optionality in the accounting literature for how companies might calculate that change in fair value.
• 28:13
  SPEAKER_03: Um, some of the things might involve whether you want to include all or just the benchmark component proportion of the coupons of the debt.
• 28:22
  SPEAKER_03: Um, how you think about prepayment options and what factors and forces might cause a company to prepay the debt.
• 28:28
  SPEAKER_03: Um, and there's different methods in computing fair value.
• 28:31
  SPEAKER_03: Um, some of these choices may impact how effective the hedge is.
• 28:37
  SPEAKER_03: You know, it might impact how much PL volatility or PL noise would be.
• 28:42
  SPEAKER_03: But not all systems can perform these calculations since they're not changes in the overall fair value.
• 28:49
  SPEAKER_03: They're sort of changes in an isolated risk as defined by uh, you know, ASC 815.
• 28:57
  SPEAKER_00: All right.
• 28:58
  SPEAKER_00: So that's definitely helpful.
• 29:00
  SPEAKER_00: Now, if I take a step back and I'm listening, I'm thinking, oh, like my company's thinking about setting up a hedging program, or maybe we have one and it's maybe not uh functioning the way I'd like it to.
• 29:11
  SPEAKER_00: What's the advice that you would give to the controller or or to the controller's team?
• 29:16
  SPEAKER_00: Brett, I'll go to you first for that.
• 29:19
  SPEAKER_02: I I think a couple things.
• 29:21
  SPEAKER_02: First, it's important to think broadly about um applying hedge accounting like you would in any kind of reporting or accounting process.
• 29:31
  SPEAKER_02: Like think of your systems, think of your processes, think of your controls, and importantly, think about the training of your people that are going to over oversee this process.
• 29:42
  SPEAKER_02: Um the driven standard is is complicated, even for basic um hedges of debt.
• 29:48
  SPEAKER_02: Um, we've talked a little bit about documentation requirements, and there are a lot of them.
• 29:52
  SPEAKER_02: And the accounting guidance requires you to maintain documentation for each hedging relationship.
• 29:58
  SPEAKER_02: Uh, and without that documentation that's hedge by hedge, a company can't apply hedge accounting.
• 30:04
  SPEAKER_02: Um, in some cases, you know, the manner in which that hedge is documented can have big implications for the application of hedge accounting down the road.
• 30:13
  SPEAKER_02: So it's important to be thoughtful about how that hedge is documented in the first place.
• 30:19
  SPEAKER_02: We've talked about in the cash flow hedge, you know, how you document that transaction can have implications and have impacts on your accounting if you ever choose to refinance uh that particular debt issuance.
• 30:32
  SPEAKER_02: Um in addition, there's a number of things companies have to monitor over the life of the hedge.
• 30:37
  SPEAKER_02: Um, you know, is the hedge still effective at its goal and keeping your eye on those kind of things.
• 30:44
  SPEAKER_03: Yeah, and and you know, other things to think about, you know, the company's always going to be have to be able to compute change in fair value of the derivative.
• 30:51
  SPEAKER_03: So they're gonna have to have systems, processes, controls around valuing the derivative on an ongoing basis.
• 30:57
  SPEAKER_03: And for fair value hedges, they'll also have to fair value the debt for the risk that they're hedging.
• 31:02
  SPEAKER_03: Um, for cash flow hedges, you know, Brett talked about OCI as sort of like a holding tank.
• 31:07
  SPEAKER_03: You need to be able to track what's in that holding tank and determine when you should release that into earnings.
• 31:13
  SPEAKER_03: Um and disclosures.
• 31:15
  SPEAKER_03: There, there's a number of disclosures that are required when you are applying hedge accounting.
• 31:19
  SPEAKER_02: And with all these requirements to apply hedge accounting, uh, I don't want to be too daunting in it.
• 31:26
  SPEAKER_02: It's tough, but it's it's not impossible.
• 31:28
  SPEAKER_02: Um, and back to what I mentioned earlier around training, I think that's a that's an important piece of this, um, especially for companies that are entering into hedge accounting for the first time.
• 31:39
  SPEAKER_02: A lot of time, there's there's a lot of energy spent at inception of the hedge to get the documentation right, to understand the hedging strategy.
• 31:47
  SPEAKER_02: It's important that the people involved in in the hedge accounting are trained on those requirements, not only up front, but also over time.
• 31:55
  SPEAKER_02: As those people move on to different roles in the organization and new people come on board, it's important that that training is evergreen.
• 32:04
  SPEAKER_02: And so it's not just a bunch of requirements that are established up front and you can put on autopilot.
• 32:12
  SPEAKER_02: You need to make sure that people are refreshed on that process uh over time.
• 32:17
  SPEAKER_02: And like accounting for a lot of complex transactions, you need to establish processes to comply with the rules.
• 32:24
  SPEAKER_02: Um, Chip mentioned disclosures.
• 32:26
  SPEAKER_02: There'll be a lot of ongoing information that's required and making sure you have the right controls over the data and over the processes, um, including appropriate levels of review.
• 32:37
  SPEAKER_02: There are systems that assess that will assist in all of these processes.
• 32:43
  SPEAKER_02: Um, some are designed specifically to apply hedge accounting.
• 32:47
  SPEAKER_02: Um, and so some treasury systems have specific accounting um hedge accounting modules that that will help in a lot of this.
• 32:54
  SPEAKER_00: All right, definitely a lot to think about, but I do think helpful from a background point of view, and I do think you've made it not so daunting.
• 33:03
  SPEAKER_00: So someone wouldn't want to take this on.
• 33:05
  SPEAKER_00: So thanks for that.
• 33:06
  SPEAKER_00: And for our listeners' benefit, if you would like to know more in terms of disclosures, you can look at chapter 19 of our financial statement presentation guide.
• 33:15
  SPEAKER_00: And then uh for more on hedging, you can look at PwC's derivatives and hedging guide.
• 33:21
  SPEAKER_00: Now, Chip and Brett, I do have a final question for you.
• 33:24
  SPEAKER_00: And I'm sure you're wondering or thinking I'm going to try to stump you because that's what we normally do at the end of these podcasts.
• 33:31
  SPEAKER_00: However, since it's summer, I thought we'd do something a little more fun, a little more relaxed.
• 33:36
  SPEAKER_00: And the question I have is I was laughing this morning because both my kids, their friends, are out of town.
• 33:44
  SPEAKER_00: So I have teenagers, and I know you both have teenagers.
• 33:46
  SPEAKER_00: So all their friends are out of town, so they're resorting to go to an amusement park, the two of them.
• 33:52
  SPEAKER_00: This is their way of amusing each other.
• 33:54
  SPEAKER_00: And I was thinking about some of our family traditions and some of the things we do in the summer.
• 33:59
  SPEAKER_00: So I guess my question for you is what is uh something you like about summer or a family tradition that you would be willing to share?
• 34:08
  SPEAKER_00: And Brett, I'll go to you first.
• 34:11
  SPEAKER_02: Um a couple of things.
• 34:12
  SPEAKER_02: I I've got a son uh playing baseball, and we're in, so we're in the in the uh practices and games almost every day.
• 34:19
  SPEAKER_02: And so there's a lot of baseball going on in my house right now.
• 34:23
  SPEAKER_02: Um, and something we always like to do in the summer, aside from kids' activities, is uh get away for a little bit.
• 34:29
  SPEAKER_02: Uh we tend to be mountain vacationers, not beach vacationers.
• 34:33
  SPEAKER_02: And so uh we're headed we're headed to the mountains uh a little later in August.
• 34:37
  SPEAKER_02: I'm looking forward to that.
• 34:38
  SPEAKER_00: Very nice.
• 34:39
  SPEAKER_00: Both I'd say summer quintessential activities.
• 34:42
  SPEAKER_00: How about you, Chip?
• 34:43
  SPEAKER_03: Well, they're like uh I think similar to you, Mike, my kids are both teenagers.
• 34:48
  SPEAKER_03: Uh they can both drive.
• 34:49
  SPEAKER_03: So there is a new summer tradition, and they both have jobs this summer.
• 34:54
  SPEAKER_03: So I'm looking forward to some source of money coming into my kids' pockets that isn't so new tradition.
• 35:02
  SPEAKER_00: I am so with you, and I will clarify my kids are both off from their jobs today, hence why they were looking for something to do.
• 35:09
  SPEAKER_00: So, anyway, both as always, I really appreciate your insight.
• 35:13
  SPEAKER_00: Thanks so much for joining me today.
• 35:17
  SPEAKER_00: That does it for today.
• 35:19
  SPEAKER_00: Join me back here on Thursday when we'll have more EHD reporting content for you with a comparison of the SEC's climate disclosure proposal to the global proposals that are currently out from the ISSB and EFRAG.
• 35:32
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• 35:35
  SPEAKER_00: audience because of their potential impact on companies with operations abroad, as well as changing expectations from investors.
• 35:44
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• 35:46
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• 35:51
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• 35:59
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• 36:01
  SPEAKER_00: From Thought Leadership at PWC, I'm Heather Horn.
• 36:05
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