The Financial Accounting Standards Board’s (FASB’s) guidance on reporting hedging transactions is complicated. In fact, hedge accounting is currently a leading cause of restatements — and some companies refrain from using hedge accounting to avoid the cost and hassle of compliance. But that could change, now that the FASB has issued Accounting Standards Update (ASU) No. 2017-12, Derivatives and Hedging (Topic 815) — Targeted Improvements to Accounting for Hedging Activities.
The much-anticipated standard expands the activities that qualify for hedge accounting and simplifies the rules for reporting hedging transactions. For example, hedging relationships are required to be “highly effective” in order to qualify for hedge accounting, however, the prior FASB rules required a complex qualitative analysis at the inception of the hedging transaction and then throughout the duration of the hedge. This new accounting guidance still requires an initial quantitative demonstration of hedge effectiveness, but allows for a qualitative assessment to support hedge effectiveness over the remaining life of the hedge.
A need for change
Some businesses buy derivatives — such as futures, options or swaps — to “hedge” their exposure to spikes in raw material prices, foreign exchange rates and interest rates. Under existing U.S. Generally Accepted Accounting Principles (GAAP), changes in the value of derivatives must be recorded at fair value in a company’s financial statements.
Under certain conditions, companies may employ hedge accounting, which involves designating a derivative instrument to a hedged item and then recognizing gains and losses from both items in the same period. When done right, hedge accounting keeps the price swings out of reported earnings, avoiding volatility that can be a source of concern for investors and lenders.
Stakeholders have criticized the current guidance, because it doesn’t allow companies to properly recognize the economics of hedging strategies. Often, the effects of hedging on a company’s financial statements are difficult for stakeholders to interpret. Some businesses also complain that the strict rules prevent some bona fide risk management techniques from qualifying for hedge accounting.
Hedge accounting generally allows deferral of gains and losses. To qualify for hedge accounting, the relationship between a hedging instrument and the hedged item has to be “highly effective” in achieving offsetting changes in fair value or cash flows attributable to the hedged risk.
The new standard retains the “highly effective” threshold, but it expands the strategies that qualify for hedge accounting to include:
- Hedging contractually specified price components of a commodity purchase or sale,
- Hedges of the benchmark rate component of contractual coupon cash flows of fixed-rate assets or liabilities,
- Hedges of the portion of a closed portfolio of prepayable assets not expected to be prepaid, and
- Partial-term hedges of fixed-rate assets or liabilities.
The update allows companies to isolate the risk associated with variability in cash flows attributable to a raw ingredient to make a final product. However, the component must be “contractually specified.” For some transactions, the component won’t be spelled out in a contract, so these still may not qualify for hedge accounting.
To simplify the application of the hedge accounting guidance, the FASB has made targeted improvements in the following areas:
Presentation. Businesses must periodically assess hedging transactions for effectiveness. Under the new standard, businesses will no longer have to record hedge ineffectiveness separately from the effective portion of the change in the value of the hedging instrument. For cash flow hedges, the entire change in value of the derivative will be recorded in other comprehensive income and reclassified to earnings in the same period in which the hedged item affects earnings. Mismatches between changes in value of the hedged item and hedging instrument may still occur under the new standard, but they won’t be separately reported.
Shortcut vs. long haul method. The update eliminates an onerous penalty in the “shortcut” method of hedge accounting that can be used for interest rate swaps that meet specific criteria. Under current GAAP, if the shortcut method is applied and then it’s determined later that using the shortcut method wasn’t appropriate, hedge accounting can’t be applied to that transaction. Under the updated standard, the so-called “long-haul” method for assessing hedge effectiveness will apply to those transactions as long as the hedge meets the “highly effective” threshold.
Financial hedging strategies. The Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate has been added to the list of acceptable benchmark interest rates for hedges of fixed-interest-rate items.
The new standard also gives private companies more time to compile their hedge accounting documentation, as well as allowing companies to assess hedge effectiveness qualitatively on a periodic basis as opposed to requiring quantification each quarter.
The update will be effective for public companies starting after December 15, 2018. Private companies and other organizations will have another year to comply. However, many businesses are expected to adopt the changes early.
Throughout the hedging project, the FASB worked closely with businesses, investors and financial statement preparers. Now, many companies in the banking, agribusiness, transportation, oil and gas, and industrial manufacturing sectors are anxious to implement the user-friendly changes. Contact us for more information about how the new standard will affect your financial statements and whether your company could benefit from early adoption.
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