Financial institutions would be well advised to adopt a flexible approach to their hedge accounting portfolio, especially in light of the COVID-19 pandemic. That’s according to a new white paper from Wolters Kluwer’s Finance, Risk & Regulatory Reporting (FRR) business.
Hedge accounting is a way to align risk exposure with true economic and financial exposure. Hedge accounting ensures that an income statement reflects steps taken to mitigate risk in a loan portfolio. It achieves this by adjusting accounting figures to neutralize the portion of the realized or potential profit or loss that a bank has protected with a hedge.
According to the white paper, the pandemic will certainly have a significant impact on hedge accounting. Companies frequently turn to cash-flow hedges to offset transactions that have highly predictable outcomes. The use of hedge accounting can also be affected when the contractual terms of an underlying financial instrument are changed. A bank might apply fair-value hedge accounting to term deposits with conditions that include significant penalties for early withdrawals, for instance. If the bank no longer applies these penalties during the pandemic, then the hedging relationship practically dissolves as the term deposit turns into a demand deposit and there is no longer a fair-value exposure to hedge.
Another effect of COVID-19 might occur if an increase in a borrower’s credit risk reduces the effectiveness of a hedge. If a hedged asset becomes impaired, then the hedging relationship will end if the hedge can no longer be deemed effective.
Hedge accounting requirements and best practices evolve in line with market trends and are often complemented by amendments to accounting standards. There is, for example, the way in which money market rates and spreads behave and the impact of the overall interbank offered rates (IBOR) reform for financial institutions to consider. Equally important are the economic consequences of the COVID-19 pandemic, currently being addressed by government relief measures, which can impact the behavior of financial institutions and their counterparties. This, in turn, alters the measurement of instruments and projection of cash flows, affecting hedging and hedge accounting. A great deal of flexibility is therefore required to align hedging and hedge accounting with the new economic realities, the white paper notes.
“Hedge accounting rules try to tackle the thorny dilemma of how to represent real-time economic realities in accounting terms,” comments Frederik Roeland, Director of Product Management for Finance Solutions at Wolters Kluwer FRR and author of the white paper. “Market conditions are constantly changing and require a great deal of flexibility to resolve the discrepancies between the real world and the way it is depicted in a firm’s accounts. Businesses will need to continually monitor and be prepared to amend their hedge accounting processes to handle the frequent changes they are likely to face and be able to automate these processes wherever practicable, such as with recurrent hedge effectiveness testing.”
To help with this, Wolters Kluwer FRR’s clients are using its OneSumX for Finance solution. Through the use of the solution financial institutions are empowered to streamline and automate the finance chain and better manage complex business processes, including hedge accounting. This is achieved through the implementation of transparent policies coupled with an accounting engine capable of supporting multi-GAAP accounting schemes, generating rich content at the most granular level.
“A flexible data solution will have a modular design that can be reconfigured with new business and risk management strategies, and that can accommodate regulatory updates,” Roeland adds. “It will feature fully automated processes to ensure operational efficiency, and a detailed, reliable audit trail to keep track of hedge accounting procedures. Spreadsheets are not enough.”