Private companies to get limited exemption from hedge accounting standard’s documentation requirements

Private companies will get a limited set of exemptions from the paperwork requirements in the FASB’s planned revision to the hedge accounting standard, the accounting board decided on Feb. 15, 2017.

The board agreed that instead of having to provide all the documents that support their risk management activities as soon as they start, private companies would prepare a “statement of intent to hedge.” Private companies also would not have to perform so-called “effectiveness” testing to prove that a hedge accounting method is working until their financial statements are to be issued.

Furthermore, private companies would be allowed to wait to choose which method they use to assess effectiveness until the actual testing is performed, a majority of the board agreed.

Privately held banks would not be allowed to avail of these breaks, the board agreed. The statement of intent to hedge would include the hedging instrument, the hedged item or transaction, the nature of the risk being hedged, and the method that would be used to assess effectiveness, both at hedge inception and subsequently, the board agreed.

The decisions were part of the FASB’s project to make one of the most complex areas of U.S. GAAP easier to understand. The board in September 2016 released Proposed Accounting Standards Update (ASU) No. 2016-310, Derivatives and Hedging (Topic 815) — Targeted Improvements to Accounting for Hedging Activities, to call for several changes to hedge accounting. The exemptions the board approved fell short of the demands from private companies that they be completely freed of documentation requirements for hedge accounting.

Businesses will have up to three months to complete an initial test to determine how effective a hedge is, depending on when the hedge is designated. After that, a company only would have to assess every three months that the hedge was working. Private companies told the FASB, however, that this feature does not offer them much relief because most private companies do not prepare financial statements on a quarterly basis. They also said that in casual private company transactions, there may not be formal paperwork readily available to document deals. (See Private Company Council Calls for More Exemptions in Hedging Proposal in the Dec. 15, 2016, edition of Accounting & Compliance Alert.)

A complete elimination of documentation requirements for private companies, however, was a nonstarter for FASB members. The option was listed on the board’s papers for the meeting, but board members did not discuss it. A FASB staffer read the option aloud and said that getting rid of documentation requirements could lead to companies retrospectively designating hedging relationships, which could manipulate financial results. FASB members in the past have also said that the intent to mitigate risk was a cornerstone of hedge accounting, and proof is necessary to back up that intent.

A majority of the FASB said slightly scaling back the timing of documentation requirements and allowing private companies to provide a statement of intent to hedge would help more private companies qualify for hedge accounting.

“It keeps the smaller companies from being penalized because they just didn’t get to it — to do the math — until they had to,” FASB member Harold Monk said. “You know, life happens and they’ve got a lot of things on the plate, and they don’t have the stable of talent to be able to just have somebody assigned to it, necessarily.”

U.S. GAAP requires businesses to measure all derivatives at fair value on the balance sheet, but for some qualifying transactions, gains and losses may be matched in earnings to avoid swings on the income statement. The matched hedge may cover changes in the price of the instrument being hedged, changes in the value of a commodity futures contract, or changes in a foreign exchange rate.

Because hedge accounting allows deferral of gains and losses, companies have to meet a high threshold to qualify for it. The transaction must be documented at inception and must be considered “highly effective.” Some businesses criticize the high threshold to qualify for the specialized accounting treatment because it prevents them from accurately reporting their financial performance. The FASB’s September proposal was an attempt to simplify some of the requirements and permit more risk management activities to qualify for hedge accounting.

FASB member Harold Schroeder voted against any breaks for private companies. He said Proposed ASU No. 2016-310 offered enough relief to both public and private companies. He also questioned how much of a break the altered plan would offer, as private companies asked the board to exempt them from paperwork altogether.

“So we’re talking about a relatively narrow fact pattern for questionable value, but it adds complexity to accounting standards,” Schroeder said.

Matt Esposito, the FASB’s assistant director for technical activities, said the board’s research staff also struggled to find examples of situations where the modified documentation requirements would help private companies. Most small private companies do not engage in complex derivatives transactions. They may enter into interest rate swaps to secure better rates on loans, but accounting requirements for these transactions are already covered by a separate standard tailored specifically for private companies. The FASB staff asked what specific transactions were causing problems and did not get any examples, Esposito said.

“So I think we are trying to come up with a solution where it’s not entirely clear to me what we’re trying to solve,” he said.

A majority of FASB members, however, said they were convinced that the accounting board was on the right track.

FASB Vice Chairman James Kroeker said the plan the board developed was close to existing practice.

“I think this conforms GAAP to saying, effectively, ‘the practice you’ve been doing that allows you to keep highly effective hedges and achieve hedge accounting could continue,’” he said. “Or we can go and emphasize, ‘No, you have highly effective hedges, but because you don’t have in-house expertise and can't do it quarterly, you can’t do hedge accounting,’ and get worse financial reporting results.”

In addition to the private company issue, the FASB also discussed a provision related to the test to determine whether a risk management technique is working, or hedge effectiveness. Proposed ASU No. 2016-310 called for quantifying the hedge technique’s effectiveness when it is first measured, although subsequent tests do not require a quantifiable assessment unless a change in market conditions results in the hedge no longer being effective. Once a business switches to the more precise quantitative testing, it cannot return to qualitative testing, according to the proposal.

Businesses panned this provision, saying there could be situations in which a company needs to perform a precise calculation on a one-time basis to see if a hedging relationship is effective but then would be barred from resuming the simple qualitative assessment in future reporting periods.

A unanimous FASB agreed that businesses should not be prohibited to return to the easier method to assess effectiveness.

“I didn’t want companies to be reluctant to try a quantitative test for fear that they would never be able to go back to qualitative testing,” FASB member Marc Siegel said.

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