OCI Releases: Restatement Risk from the Finer Points of Hedge Accounting

When it comes to hedge accounting, most companies fall into two groups: those who’ve had issues and those who will. Currently, the SEC and audit firms are consumed with potential changes to accounting rules and the Dodd- Frank Act. However, when regulators re-focus their attention on hedge accounting within the next two to three years, we will see the next round of restatements focus on the finer points of hedge accounting. One of those areas involves releases from other comprehensive income (OCI).

ASC 815-30-35-39 (previously SFAS 133, Paragraph 31) states, “amounts in accumulated other comprehensive income shall be reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings (for example, when a forecasted sale actually occurs). If the hedged transaction results in the acquisition of an asset or the incurrence of a liability, the gains and losses in accumulated other comprehensive income shall be reclassified into earnings in the same period or periods during which the asset acquired or liability incurred affects earnings (such as in the periods that depreciation expense, interest expense, or cost of sales is recognized).”

The accounting standards are straightforward, stating that while a cash flow hedge relationship meets the provisions of hedge accounting, any amount recorded in OCI stays in OCI until the hedged item affects earnings. One caveat to this rule is when a hedge relationship no longer meets the provisions of hedge accounting, for example, when the hedged item is no longer possible of occurring (i.e., has less than a 20% chance of occurring). Otherwise, the OCI balances remain until the originally hedged item affects earnings. Note that the hedged item may not affect earnings when the hedge settles. This is frequently the case when the hedged item is a capital project or an inventory purchase. The restatement risk develops if a company releases OCI when the hedge settles rather than reviewing the release of OCI based on the hedged item.

Assume the following scenario related to a foreign currency cash flow hedge of a forecasted inventory purchase denominated in EURO:

The second restatement risk relates to tracking of the OCI balances. Many entities lack the systems and tools to appropriately track the build-up and release of the associated OCI balances. When entities have numerous inventory purchases, it can be time consuming to identify which inventory items have OCI attached to them, and it can also be difficult to track those balances on a go-forward basis. This is compounded by the business nature of some industries. For example, many energy and agricultural companies transact in fungible goods, where the identity of the hedged item is essentially lost when placed in inventory.

Accounting policies that provide practical expedients related to the application of hedge accounting rarely pass regulatory review. The specificity requirements of hedge accounting are higher than those of most accounting standards. In hedge accounting, the hedged item’s definition per the hedge documentation is specifically identified, and the OCI attached to those items should be specifically identified and tracked as well. As such, it is best practice for management to periodically review their accounting policies related to the topic.