The prices of crops, livestock, and other agricultural commodities constantly fluctuate based on perceived or actual changes in supply or demand. These ever-changing prices often create a tumultuous market for farmers and agribusiness providers, making it difficult for them to:
- Mitigate commodity price risk
- Accurately project cash flows
- Attract lenders and investors
A risk-mitigation strategy called hedging may help agribusiness owners navigate these challenges. For agribusiness, effective hedging may be accomplished through using a derivative instrument, which is a contract between two or more parties that’s valued by the performance of certain underlying assets, such as commodities, interest rates, or foreign currency indices. It’s a way to stabilize revenues or operating costs in an otherwise volatile pricing environment. Recent updates to the accounting standards may simplify the process of accounting for derivative instruments going forward.
Here’s what you need to know about how derivative instruments work, their key benefits, potential pitfalls, and relevant regulations.
How Derivative Instruments Can Help
Why should members of the agribusiness community use derivative instruments? In many ways, the use of derivative instruments is analogous to the employment of an insurance contract.
In an insurance contract, the insured party pays a premium as a precaution against unforeseen events with negative consequences. Similarly, a user of a derivative contract will either pay an up-front cash payment, also known as a premium, or they’ll surrender certain cash flow upside to implement a ceiling or a floor price related to future projected purchases or sales of commodities.
How to Account for Derivative Instruments
The accounting for derivative instruments can be complex and may introduce significant volatility in an entity’s earnings. That’s because the accounting rules generally require the holder of a derivative instrument to recognize in current period earnings the noncash changes in the fair value of the derivative instrument each reporting period.
However, there are two derivative accounting elections that organizations may find helpful in reducing the complexity in derivative accounting and reporting: normal purchase and normal sale (NPNS) and designation of cash-flow hedge accounting treatment. Here’s how they work.
Normal Purchase and Normal Sale Exemption
The normal purchase and normal sale (NPNS) exemption provides an opportunity to account for qualifying derivative contracts on an accrual basis. Contracts aren’t recorded in the financial statements until the settlement or delivery period.
This strategy can be helpful to your business because it more closely mirrors the actual cash inflows and outflows associated with the derivative instruments. Under this method of accounting, derivative instruments are generally accounted for in the same accrual-based manner as the purchase or sale transactions being hedged, and gains or losses associated with these derivative instruments are only recognized at the time of trade settlement.
To qualify for this exemption, the derivative contract employed in this strategy must meet the following requirements:
- The purchase or sale of a physically delivered commodity will be delivered in quantities expected to be used or sold by the reporting entity over a reasonable period in the normal course of business within normal operating parameters.
- The underlying price of the contract is clearly and closely related to the physical product being delivered under the contract.
- The volumes to be purchased or sold don’t contain optionality to increase or decrease the quantities, with a few limited exceptions.
- Appropriate accounting election documentation is created and maintained over the life of the contract to elect the NPNS exemption and to monitor compliance with its requirements.
Designation of Cash-Flow Hedge Accounting Treatment
The second accounting election is the designation of cash-flow hedge accounting treatment. An agribusiness might choose this option because it eliminates the variability in earnings caused by the noncash changes in the fair value of the derivative instruments.
To qualify for hedge accounting, the hedge designation should have the following information documented:
- Risk management objective
- Identification of the designated derivative contract
- Forecasted purchase or sale of the commodity being hedged
- The likelihood that the forecasted transaction will occur
- The volumes and time horizons of the strategy
- The effective date of the hedge designation
The reporting entity must also include their plan for measuring how effectively the hedging relationship is at minimizing the variability in future projected cash flows as well as their expectations for this effectiveness, starting at the time of hedge designation.
In August 2017, The Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, which included improvements that simplified previous hedge accounting requirements and made the adoption of hedge accounting more attractive for certain types of derivative instruments.
Some of the specific changes in this update include the following:
Reporting of Effectiveness
Previously, entities were required to measure, record, and report hedge ineffectiveness each reporting period, separating the effective and ineffective portions of the changes in the fair value of derivative instruments and report those through other comprehensive income (OCI) and earnings, respectively.
The FASB eliminated the need for this time-consuming step. Now, as long as the hedging relationship remains highly effective, all changes in the fair value of the derivative instrument can be reported through OCI.
Allowance of Quantitative Measurements
Previously, entities were required to assess the effectiveness of their hedging strategies through quantitative calculations, such as regression analysis each reporting period. This was generally interpreted to be on a quarterly basis, at a minimum.
Now, a reporting entity can save time by simply electing to qualitatively—rather than quantitatively—measure hedge effectiveness after initial recognition.
Increased Allowance of Critical-Terms Match Method
The critical-terms match method for measuring the effectiveness of a derivative hedging strategy allows users to assume the hedging instrument is essentially 100% effective without quantitative assessment if the following criteria are met:
- The notional volume of the derivative and the hedged item must be equal
- The maturity date of the derivative must coincide with the maturity of the hedged item
- The underlying of the derivative must match the underlying of the hedged risk
- The derivative must have a fair value at or near zero at the inception of the contract
The FASB now provides reporting entities the ability to use the critical-terms match method for a cash flow hedge when the timing of the hedged transactions doesn't perfectly match the hedging instrument’s settlement date.
Ability to Hedge Specified Components
Previously, the entire projected cash flow purchase or sale was required to be designated in a hedging relationship. The FASB introduced the ability to hedge contractually specified components of the price of a forecasted purchase or sale, such as a locational basis differential.
Option for Delay of Assessment
Previously, all hedge-designation documentation and quantitative assessment analysis were required to be completed contemporaneously with the initial designation of the hedging strategy. The FASB now allows certain private companies to delay completion of the initial quantitative hedge effectiveness assessment until the first set of interim or annual financial statement is available to be issued after the hedge designation.
For public business entities, these changes were effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. For all other entities, these changes are effective for fiscal years beginning after December 15, 2019, and interim periods beginning after December 15, 2020. Early adoption is permitted.
Hedging can be an effective strategy to help mitigate some of the biggest challenges the agribusiness community faces. However, the process can be complicated and expensive if it isn’t appropriately implemented.
To enter into a derivative contract, users are generally required to either make an up-front cash payment or surrender certain upside due to positive movements of commodity prices to the counterparty. Additionally, certain counterparties or exchanges may require a margin retainer be held with respect to derivative trades until a sufficient trading and credit history is established.
There are also personnel costs to manage contracts and settlements, value unrealized positions, record entries, draft applicable financial footnotes, and monitor and document hedging strategies.
Stakeholders don’t always understand the impact of derivative assets and liabilities—or the associated noncash unrealized gains and losses.
A professional with relevant experience in derivative instruments can help make the process more time and cost effective. Before hiring externally, however, look for a firm that can assist you with all aspects of your derivative accounting and provide a wide variety of insight, including:
- Implications of potential strategies prior to trade execution
- Calculation of the fair value
- Hedge or NPNS designation documentation and monitoring
- Implementation of relevant internal control procedures
- Drafting of financial statement disclosures
We’re Here to Help
If you have questions about hedging or would like assistance finding a hedging solution customized to your business, please contact your Moss Adams professional.