Commodity Hedge Accounting for Restaurants
Since the start of the COVID-19 pandemic, companies have struggled with budgeting and forecasting inventory purchases. Some of the challenges have been related to unpredictable supply availability, volatile pricing, and erratic purchasing trends by traditionally predictable customers. This chaos on the inflows and outflows of inventory creates havoc for accounting and finance departments as they try to manage their cash flows and profitability metrics.
Issues in Higher Inventory Levels
In recent years, inventory levels have slowly increased as companies have held onto more inventory than ever before. Traditionally, purchases were made on demand and correlated heavily with forecasted near-term sales. However, companies have been stockpiling inventory whenever available due to various factors, including recent supply chain failures. Unprecedented market fluctuations have also driven companies to purchase high volumes of raw materials when prices are considered to be low. Inventory stockpiling no longer corresponded to a known need or demand for those products. These changes in procurement are drastically decreasing the inventory turn ratios and increasing business risk. Higher inventory levels that turn at lower rates create risk of obsolescence or expiration for some products, and also increase carrying costs, such as warehouse rent, to store the inventory for longer periods. Increased inventory levels also create cash flow challenges, with the primary challenge being locked up capital in slow-moving inventory. Additionally, many companies have asset-based lending arrangements, whereby an entity’s inventory offsets the available borrowing base, which also lowers the access to capital.
How Commodity Hedging Can Help
Some businesses have explored commodity hedging options to address the pricing volatility. Entering into a hedging contract could allow management to lock in purchase prices for key inventory items and stabilize margins. In a hedging arrangement, a company buys into a fixed price swap, often with a financial institution, for a particular raw material. This creates a known future price. The fixed price swap synthetically converts variable commodity prices to be fixed. In the hedging arrangement, the company is protected against future price increases. Entering into this price swap allows for more stabilized cash flows and creates more predictable inventory costs. However, the primary business risk associated with commodity hedging arrangements is that there is no participation if the markets become more favorable.
Increasing Popularity for Restaurants and Grocers
Hedging contracts are industry-agnostic and can be used by manufacturers to farmers to restaurants. As hedging contracts increase in popularity, particularly with some grocers, food producers, and restaurant chains, these companies are locking in prices on key products like proteins and dairy. Hormel Foods Corp., Jack in the Box and Costco Wholesale Corp. are just a few large brands that have publicly stated they participate in such protection against future price increases. These agreements can be made with the suppliers themselves or in traditional hedging arrangements with a financial institution that may be willing to take a bigger risk on pricing.
For restaurant operators, protein costs are often the highest component of a menu item. By protecting themselves against sudden price movements, operators can set customer menu prices better and protect margins. As labor costs have steadily risen for operators over the past several years, the ability to control food costs has also been desirable to CFOs.
Accounting Standards and Commodity Hedging
The accounting treatment for hedging transactions has been simplified through accounting standards updates in recent years. Commodity contracts for restaurant operators are often designated as cash flow hedges, assuming all of the criteria in Accounting Standards Codification (ASC) 815: Derivative and Hedging (Topic 815) for hedge accounting are met. ASC 815-20-25-1 outlines the critical criteria for a contract to qualify for hedge accounting. The cash flow hedge manages the variability in future expected cash flows and can be related to a financial or nonfinancial item. For a restaurant operator, the exposure would result from a forecasted transaction (e.g., protein purchase). A cash flow hedge uses the hedging instrument to lock in the amount of future cash outflows that would otherwise have been impacted by market volatility. The purpose of cash flow hedge accounting is to link the gain and loss recognition of a hedging instrument (a derivative) and a hedged transaction, whose changes in cash flows are expected to offset each other. In a cash flow hedge, changes in the fair value of the hedged derivative are initially recorded in other comprehensive income. Eventually, the accumulation of other comprehensive income is reclassified to the income statement when the related hedged transaction affects earnings (i.e. when the forecasted purchase occurs). The reclassification should be recorded in the same income statement line item in which the hedge transaction is reported. This accounting treatment limits the volatility of earnings that may have otherwise occurred each month through the recognition of the unrealized gains and losses on the derivative in earnings.
For questions or more information on hedge accounting, please contact Maggie Wise, Windham Brannon’s Restaurant Industry leader.
