At a recent BravoSolution roundtable discussion that I facilitated on commodity management strategies, one piece of advice I presented generated a good degree of discussion and debate. My point, the importance of understanding the accounting implications of anything an organization might consider doing, seems simple enough. But few procurement heads that I know are fully versed on what qualifies for a more attractive hedge accounting model than a mark to market approach for commodity hedges where one's balance sheet will move with the volatility of the market based on the actual forward position taken. The bottom line is that before implementing a commodity hedging strategy, please take the time to fully understand the potential accounting costs of commodity risk management strategies (e.g., when you can use hedge accounting versus not).
As background, Investopedia simplifies the definition of hedge accounting, describing it as a "method of accounting where entries for the ownership of a security and the opposing hedge are treated as one. Hedge accounting attempts to reduce the volatility created by the repeated adjustment of a financial instrument's value, known as marking to market. This reduced volatility is done by combining the instrument and the hedge as one entry, which offsets the opposing movements ... when accounting for complex financial instruments, such as derivatives, the value is adjusted by marking to market; this creates large swings in the profit and loss account. Hedge accounting treats the reciprocal hedge and the derivative as one entry so that the large swings are balanced out."
Spend Matters has spoken with CPOs deeply familiar with commodity risk management strategies who were not able to act when they wanted to, due to concerns over the quarterly earnings balance sheet impact of certain hedging strategies. Consider, for example, if a forward hedged position moves against you temporarily and you can't use a hedge accounting treatment and must mark the underlying instrument/security to fair market value on a daily basis, you could find yourself with a successful commodity risk mitigation strategy in the long run, but one that proves quite costly from a GAAP accounting perspective in the interim. Still, some heads of procurement don't care. One individual that I spoke with at the BravoSolution event decided to hedge natural gas recently to cover the energy/heating costs of many of his company's facilities. He's letting his accounting guys worry about the mark to market accounting requirements of the position, but he's confident in having made the right decision, taking significant risk off the table for his shareholders.
Stay tuned as we continue this analysis on commodity risk management strategy. Up next: the importance of tracking local prices versus supposedly "global indexes" or exchanges and price escalation/de-escalation clauses.