The Complexity of Financial Risk Management

Introduction: The Overlooked Complexity of Financial Risk Continuity

In the world of mergers and acquisitions, hedge accounting is rarely the headline topic. But for acquirers inheriting interest rate swaps, currency hedges, or commodity derivatives, the decision to retain or terminate existing hedges has real consequences—on both the financial statements and the risk profile of the combined entity. The handling of hedge rollovers impacts earnings volatility, compliance with ASC 815, and alignment with treasury risk strategy.

Identifying Existing Hedges: A Diligence Imperative

Before an acquirer can decide on hedge strategy, it must understand what hedges exist, why they were put in place, and how effective they have been. In one acquisition, we found six interest rate swaps layered across different subsidiaries, with varying maturity profiles and counterparties. None had been assessed for hedge effectiveness in the past year.

Effective diligence includes:

• Inventory of all derivative instruments
• Valuation as of close
• Hedge documentation, including designation memos
• Historical effectiveness testing results
• Counterparty exposure and credit risk

This information informs both mark-to-market accounting and the decision on whether hedge relationships can or should be continued post-close.

ASC 815 Compliance: Continuity or De-designation

Under ASC 815, hedge accounting allows companies to reduce P&L volatility by matching derivative gains/losses with the hedged item. But to qualify, strict documentation and effectiveness requirements must be met.

In a merger, these requirements often break. A change in the underlying exposure (such as extinguished debt) or counterparty can require de-designation. That, in turn, may trigger immediate income statement recognition of OCI amounts.

In one case, we inherited a cash flow hedge on floating-rate debt that was refinanced at close. Without timely de-designation and re-designation, we would have recorded a $4 million hit to earnings.

Buyers should:

• Reassess hedge designation post-close
• Consider if new documentation is needed
• Determine whether derivatives align with the new treasury strategy

Swap Rollover or Termination: Strategic Choice

The buyer faces a choice: keep the swap (and roll it over), terminate it (and realize gain/loss), or re-establish a new hedge.

We often use three criteria:

1. Alignment: Does the hedge align with the acquirer’s risk strategy?
2. Valuation: Is the derivative in or out of the money?
3. Economics: What are the termination costs vs benefits?

In one transaction, we chose to terminate a legacy interest rate swap that was deeply out of the money and re-established a hedge more aligned to our debt portfolio. The termination cost was booked at close, but the forward benefit was clarity and reduced mismatch risk.

Pushdown and Consolidation Considerations

If pushdown accounting is used, derivative positions may need to be re-evaluated at the subsidiary level. Moreover, intercompany hedges require special attention under ASC 815.

In consolidated financials, proper elimination and documentation are critical. Missteps here have triggered auditor reviews and delayed 10-Q filings.

Conclusion: Don’t Let the Tail Wag the Dog—But Don’t Ignore the Tail

Hedge accounting and derivative continuity may not drive deal value, but they can erode it if neglected. For CFOs, the message is clear: include treasury and technical accounting early in diligence. Map the hedge positions. Make intentional choices. What seems like a footnote today can become an earnings surprise tomorrow.

Insight

Over the years, I have come to view hedge accounting as the silent linchpin in any M&A transaction involving financial instruments. It may never surface in board-level strategy decks, but when mishandled, it creates waves that ripple through earnings, audit cycles, and even executive compensation metrics. Hedge rollovers and ASC 815 compliance are not matters of simple accounting hygiene; they are integral to financial integrity post-deal.

I know a colleague who was involved in a $400 million acquisition in which they assumed a portfolio of interest rate swaps tied to legacy floating-rate debt. On paper, these were straightforward cash flow hedges. But upon inspection, their diligence team found two key issues: first, the swaps had not undergone effectiveness testing in over a year, and second, the documentation trail was incomplete. One counterparty was no longer extending credit facilities to the target. That discovery saved them from absorbing a potentially significant OCI adjustment directly to the profit and loss (P&L) statement.

This is a lesson that has repeated itself in other forms. Foreign currency hedges, for instance, often reflect assumptions about geographic revenue exposure that may not hold post-acquisition. In one cross-border transaction, the target had hedged euro revenues via forward contracts. Post-close, we centralized sales through a U.S. entity and billed in dollars. The result: the hedges no longer aligned to exposures and had to be de-designated. We took a hit on earnings that, while explainable, affected our internal rate of return and investor commentary.

What I have learned is that ASC 815 is unforgiving to approximation. If your hedge documentation is not specific, timely, and back-tested, your right to hedge accounting may be lost. And with it goes your ability to smooth earnings in a justifiable way.

This is where the role of the CFO becomes not just procedural but strategic. When stepping into an acquisition, I now ask for a full derivative inventory on day one of diligence. I want valuations marked to market. I want to know if the derivatives are in the money, at the money, or underwater. This matters not just for optics but for decision-making. If a legacy swap is $3 million out of the money and its hedged exposure no longer exists, I would rather terminate and take the loss now than carry forward volatility that clouds financial performance.

We also take great care in assessing the post-close risk profile. In many cases, we de-designate existing hedges, then re-document under our own treasury strategy and systems. This ensures continuity in financial reporting and tighter alignment with treasury execution. But it also means short-term cost—termination fees, re-designation audits, and potential earnings charges. You must model this explicitly.

One tool we have adopted is a “hedge continuity matrix” that lays out for each derivative:

• Its existing exposure
• The likelihood that exposure persists post-close
• Valuation impact of termination
• Accounting treatment under ASC 815

This matrix enables us to make decisions not in a vacuum but in context. It has helped avoid auditor disputes and integration confusion.

Pushdown accounting adds another layer. If you push down the purchase price and revalue assets at the subsidiary level, any intercompany hedges must be re-examined. I have seen errors here delay financial close by weeks. Intercompany eliminations must reconcile to designated hedges, and systems must be updated to reflect new notional amounts and maturities.

Let us also not ignore the people side. Treasury teams are often excluded from M&A conversations until the eleventh hour. That is a mistake. In one deal, the treasury lead flagged a swap mismatch that saved us from a $2 million mark-to-market adjustment. That insight came from a 30-minute review of the counterparty schedule. These teams hold valuable institutional knowledge that diligence VDRs do not capture.

Moreover, hedge accounting impacts key metrics. If a de-designation leads to OCI reclassification to earnings, your EBITDA could take a hit. If you are mid-fundraise or in post-close reporting cycles, this matters. I have sat in board meetings where our ETR unexpectedly rose, only to trace it back to hedge misalignment. The embarrassment is avoidable.

The forward-looking strategy should be clear: embed hedge diligence into financial modeling. Make hedge treatment a line item in integration planning. And ensure that valuation, accounting, and treasury are in lockstep when derivative decisions are made.

Conclusion: Don’t Let the Tail Wag the Dog—But Don’t Ignore the Tail

Hedge accounting and derivative continuity may not drive deal value, but they can erode it if neglected. For CFOs, the message is clear: include treasury and technical accounting early in diligence. Map the hedge positions. Make intentional choices. What seems like a footnote today can become an earnings surprise tomorrow.

Disclaimer: This article is for informational purposes only and does not constitute legal, tax, or financial advice. Always consult with qualified advisors before implementing hedge accounting or treasury policies post-acquisition.