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Complex Financial Reporting: Accounting for Derivatives

Precious Metals Mining Company (PMM Co.) is a domestic publicly listed precious metals producer focused on mining, developing, and exploring properties.  It currently operates a wholly owned gold mine, in addition to a number of early and advanced stage exploration properties in the U.S.  PMM Co. consumes a significant amount of diesel fuel in its daily operating activities for transporting waste rock and ore in large haul trucks and for the expansion of its mining facilities.  As the market price of diesel can adversely impact the company’s production costs and hence earnings, the company economically hedges its forecasted diesel fuel consumption with Gulf Coast Ultra Low Sulphur (GC ULS) diesel swaps.  Under U.S. Generally Accepted Accounting Principles (GAAP), these diesel swaps have to be accounted for under mark to market accounting with all changes in their fair value recognized currently in earnings, thereby potentially increasing earnings volatility.  However, if the company was able to qualify the swaps for cash flow hedge accounting treatment, then changes in the effective portion of the swaps’ fair value could be deferred in other comprehensive income instead and not have an impact on earnings until the underlying forecasted diesel consumption actually impacted earnings.  PMM Co. approached Opportune’s derivative valuation team to assist with the complex and extensive requirements for qualifying its diesel swaps for hedge accounting treatment under US GAAP.

Opportune analyzed PMM Co.’s historical diesel fuel invoices to estimate the cash flows that will be associated with the company’s forecasted diesel fuel consumption in order to define and model the hedged item.  Next, the derivatives team performed prospective and retrospective effectiveness assessments to demonstrate that the hedge relationship between the diesel swaps and the company’s forecasted diesel consumption expenses met the highly effective criteria required for hedge accounting.  Opportune then drafted the contemporaneous hedge documentation designating the cash flow hedge relationship, stating the nature of the risk management strategy and objective, clearly identifying the hedging instrument and the hedged item, as well as the methods to be used for effectiveness assessment and ineffectiveness measurement.  Subsequent to the initial setup and designation, every quarter Opportune’s derivative valuation team performs the required quarterly effectiveness testing, ineffectiveness measurement, and balance sheet remeasurement calculations.

Additionally, PMM Co. maintains a fixed rate Canadian dollar (CAD) denominated senior note debt agreement that matures in 2019 on which it has to make semi-annual Canadian dollar denominated interest payments.  Since PMM Co’s functional and reporting currency is the U.S. dollar (USD), the company is exposed to the risk of changes in the USD/CAD exchange rates, adversely impacting the cash flows associated with this debt.  PMM Co. Management wanted to hedge the changes in the USD/CAD exchange rates in order to reduce the variability of associated cash flows.  For this purpose, PMM Co. purchased a fixed-for-fixed cross currency swap that requires an exchange of principal at maturity.  Opportune assisted with the requirements to designate this cross currency interest rate swap under cash flow hedge accounting.  This included preparing the documentation, quarterly effectiveness testing, ineffectiveness measurement, and the associated hedge accounting journal entries.

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Josh Sherman

PartnerOpportune LLP