Easing the Complex World of Hedge Accounting

By Gina Omolon

The expected number of financial institutions that use derivatives and hedging to manage interest rate risk is expected to rise as a result of Accounting Standards Update (“ASU”) No. 2017-12, Derivatives and Hedging, issued by the Financial Accounting Standards Board (“FASB”) in August 2017. While the ASU made targeted improvements to current hedging practices, the two main objectives of the new guidance are: (1) to align an entity’s financial reporting of hedging relationships with its risk management activities and (2) to simplify the application of hedge accounting guidance. The ASU becomes effective for public business entities with fiscal years beginning after December 15, 2018 and interim periods within those fiscal years, and a year later for all other entities. Earlier application is permitted in any interim period after issuance of the ASU, with the effect of adoption reflected as of the beginning of the fiscal year of adoption.

The ASU is a product of a long overdue project that started in 2008. In November 2014, the project was moved from research status to active status, and in September 2016, the Board issued a proposed ASU.

The amendments in the recently issued ASU result in the following improvements:

  1. Expand types of transactions that qualify for hedge accounting, specifically component hedging for nonfinancial risks.Current GAAP permits hedging the overall change in price for a nonfinancial item as the hedged risk. It does not allow an entity to hedge risk arising from changes in cash flows of a component of a nonfinancial item, with the exception of cash flow hedges of foreign exchange risk. This is in contrast from hedges of financial items for which an entity may designate either the overall risk or changes in cash flows of one or more specific risks as the hedged risk.For example, instead of designating the total cost for the purchase of aluminum (includes aluminum price plus transportation and other costs) as the hedged risk, an entity can now designate a more specific component (in this case for example, just the price of aluminum rather than the total cost). This provides better matching of what enterprise risk managers really focus on in practice, and results in better hedging effectiveness.
  2. Replace the concept of benchmark interest rate to contractually specified interest rate under cash flow hedges, and specifically add the Securities Industry and Financial Markets Association (“SIFMA”) Municipal Swap Rate to the list of acceptable benchmark interest rates for fair value hedges of interest rate risk.Current GAAP defines interest rate risk uniformly for both fair value and cash flow hedges as the risk of changes in the hedged item’s fair value or cash flows attributable to changes in the designated benchmark interest rate and explicitly specifies three eligible benchmark interest rates in the United States: the US Treasury Rate, LIBOR Swap Rate, and the Fed Funds/Overnight Index Swap Rate (OIS). The ASU redefines the term “interest rate risk” for both fair value and cash flow hedges.Under the amended guidance, for variable-rate financial instruments, interest rate risk will be the risk of changes in the hedged item’s cash flows attributable to changes in the contractually specified interest rate in the agreement. This eliminates the concept of benchmark interest rates for hedges of variable-rate instruments in current GAAP and, as a result, expands the types of interest rate risk eligible to be hedged under cash flow hedges.For fixed-rate financial instruments, the new guidance defines interest rate risk as the risk of changes in the hedged item’s fair value attributable to changes in the designated benchmark interest rate. The ASU added the SIFMA Municipal Swap Rate to the list of allowable benchmark rates. SIFMA is the average rate at which high-credit-quality U.S. municipalities may obtain short-term financing, and is currently the predominant rate referenced in issuances of municipal bonds.
  3. Under fair value hedging, the new guidance permits an entity to measure the change in fair value of the hedged item on the basis of the benchmark rate component, rather than the full contractual coupon cash flows determined at inception.Current GAAP requires entities to include all contractual coupon cash flows in determining the change in the fair value of the hedged item attributable to interest rate risk. As such, current accounting incorporates credit risk into the calculation; however, stakeholders have emphasized that this generally does not form part of their risk management activities and only results in ineffectiveness. The new guidance will better align hedge accounting with an entity’s risk management function.For example, an entity that issues an 8% fixed-rate debt with a 3% embedded spread can enter into a fair value hedge utilizing a 5% swap rate. Under current GAAP, an entity would have to measure changes in the fair value of the hedged item using the 8% full coupon rate which will result in significant ineffectiveness in earnings. Under the new guidance, an entity can measure the change in the debt at 5% (without the credit risk component) against the 5% swap which will result in a higher degree of effectiveness.
  4. Under fair value hedging, the new guidance permits an entity to measure the hedged item in a partial-term fair value hedge of interest rate risk by assuming the hedged item has a term that reflects only the designated cash flows being hedged.While current GAAP does not specifically prohibit partial-term hedges, the mechanics of fair value hedging make it difficult to obtain a derivative that meets the highly effective offset requirement, thereby preventing an entity from applying hedge accounting. This could be the case, for example, as the principal repayment of the debt occurs at a different time than the maturity of the interest rate swap.Under the new guidance, an entity is permitted to measure the change in the fair value of the hedged item by using an assumed term that begins when the first hedged cash flow begins to accrue and ends when the last hedged cash flow is due and payable. Also, to qualify under the standard, such designated cash flows should be one or more consecutive cash flows. For example, if you have a 5 year callable bond and you entered into a 3 year swap, instead of including the entire contractual cash flow of the bond over 5 years, under the new guidance, you can assume maturity of the bond at the end of year 3.
  5.  Another improvement under fair value hedging is for prepayable financial instruments. For financial instruments with a prepayment option, the new guidance permits an entity to consider only how changes in benchmark interest rates affect a decision to settle a debt instrument before its scheduled maturity date in calculating the change in the fair value of the hedged item attributable to interest rate risk, rather than to consider all other factors (i.e. changes in interest rates, credit spreads, other factors) in estimating the fair value of the prepayment option.Current GAAP does not clearly articulate how an entity would consider the effect of an embedded prepayment option in a hedge of interest rate risk, i.e. in practice, an entity would consider all factors that might lead it to settle the financial instrument before its scheduled maturity even if it has only designated interest rate risk as the risk being hedged. Allowing prepayment options to be modeled based only on changes in the benchmark interest rate more closely aligns the accounting for those hedges with an entity’s risk management activities (i.e. designate only interest rate risk).
  6. In a fair value hedging for a closed portfolio of prepayable financial assets (or one or more beneficial interests secured by a portfolio of prepayable financial instruments), the new guidance permits an entity to designate an amount that is not expected to be impacted by prepayments, defaults, and other events affecting the timing and amount of cash flows (the “last-of-layer” concept). Under this new concept, prepayment risk is not incorporated into the measurement of the hedged item. The main objective is to provide entities with the ability to obtain hedge accounting for portfolios of prepayable financial assets without having to incorporate any prepayment risks, defaults and other factors affecting the timing and amount of cash flows into the measurement of the hedged item.Under current GAAP, hedging portfolios of prepayable financial assets is operationally burdensome, requiring frequent de-designations and re-designations as current GAAP reflects a premise that hedge accounting should be applied to individual assets or liabilities or portions of individual assets or liabilities with consideration of prepayment risk. The current standard requires that the assets are viewed as being similar for hedge accounting purposes.Under the new guidance, it is not necessary to hedge specific or individual assets in a closed pool. Rather, one can forecast an amount which can be calculated as a percentage of the total portfolio. The amount is deemed an estimate and any changes in the estimate should be adjusted on a prospective basis. This last-of-layer concept leverages the benchmark component and partial term hedging guidance in the ASU, and includes a number of implementation questions that are discussed in the ASU. This specific guidance only applies to closed portfolios of prepayable financial assets, and does not extend to financial liabilities.
  7. For all types of hedges, the new guidance also prescribes a change in the recognition and presentation of the effects of the hedging relationships, as follows:
    • For fair value hedges, the entire change in the fair value of the hedging instrument (both effective and ineffective portions) included in the assessment of the hedge effectiveness is presented in the same P&L line item that is used to present the P&L effect of the hedged item. Current GAAP does not specify a required presentation of the change in the fair value of the hedging instrument and in practice makes it difficult for users to understand.For cash flow and net investment hedges, the entire change in the fair value of the hedging instrument included in the assessment of the hedge effectiveness is recorded in other comprehensive income (for cash flow hedges) or in the currency translation adjustment section of other comprehensive income (for net investment hedges). Those amounts are reclassified to earnings in the same P&L line item that is used to present the P&L effect of the hedged item when the hedged item affects earnings. Current GAAP requires an entity to separately reflect the amount by which the hedging instrument does not offset the hedged item (referred to as the “ineffective” amount) in earnings for the period. The new guidance eliminates the concept of splitting between effective and ineffective portions of the hedging instrument, rather, to include and record the entire change in the fair value of the hedging instrument when the hedged item affects earnings.Including all effects of a hedging instrument in the same income statement line item used to present the earnings effect of the hedged item makes the effect of entering into the hedging strategy more transparent and easier to understand.
  8. Under all types of hedging relationships, “excluded components,” which are defined as those portions of a hedging instrument’s change in fair value which are excluded from the assessment of hedge effectiveness, the ASU permits an entity to either:
    • Recognize in earnings the initial value of an excluded component using a systematic and rational method over the life of the hedging instrument (also referred to as amortization method). Under this method, any difference between the amounts recognized in earnings and the change in fair value of the excluded component is recognized in other comprehensive income; OR
    • Elect to recognize all changes in fair value of an excluded component currently in earnings (also referred to as mark-to-market method) consistent with current GAAP.

For both fair value and cash flow hedges, excluded components recognized in earnings should be presented in the same income statement line item used to present the earnings effect of the hedged item. In addition, other than option premiums and forward points which are allowed under current GAAP to be excluded from the assessment of hedge effectiveness, the new guidance permits an entity to exclude the portion of the change in fair value of a currency swap that is attributable to a cross-currency basis spread from the assessment of hedge effectiveness.

9. In terms of hedge documentation and effectiveness assessment, the ASU provides the following relief:

  • Extending the time to complete initial quantitative prospective effectiveness assessment from the hedge inception date to any time after hedge designation but no later than the first quarterly effectiveness-testing period. Note that this only applies to hedge effectiveness assessment, but the hedge designation must still be documented at inception using data applicable as of the hedge inception date. There is further relief for private companies that are not financial instruments and certain not-for-profit entities to perform the initial quantitative and all quarterly effectiveness tests as well as designating the hedge effectiveness method until the next interim (if applicable) or annual financial statements available to be issued.
  • Instead of requiring quantitative effectiveness testing both for the initial and ongoing basis, the new guidance permits an entity to perform the subsequent hedge effectiveness testing on a qualitative basis. An entity that makes this election must be able to verify and document on a quarterly basis that the facts and circumstances have not changed and can continue to assert that the hedging relationship continues to be highly effective.
  • If the shortcut method used by an entity is deemed to be not appropriate, the entity can revert back to using the long-haul method for assessing hedge effectiveness as long as the hedge is highly effective and the entity documents at inception which long-haul method it will use. This was not allowed under current GAAP which resulted in significant restatements to financial statements when the hedge effectiveness testing under the shortcut method revealed that the hedging relationship was not highly effective, even if it were under the long-haul method.
  • To ease the application of the critical terms match method to hedges of groups of forecasted transactions, the new guidance allows an entity to assume that the hedging derivative occurs at the same time as the forecasted sales or purchases if those forecasted transactions occur and the derivative matures within the same 31-day period or fiscal month.

10. Disclosures. It is expected that a number of changes to the disclosure requirements will come about as a result of the above changes. Most notably, the new guidance includes a tabular disclosure related to the effect on the income statement of fair value and cash flow hedges, new tabular disclosures related to cumulative basis adjustments for fair value hedges, and eliminates the requirement to disclose the ineffective portion of the change in fair value of the hedging instrument.

As the changes discussed above impact a vast area of hedge accounting, we expect to see a number of practical implementation questions as the Board continues to monitor this project. As to transition requirements, the modified retrospective approach is required for cash flow and net investment hedges existing at the date of adoption, while a prospective approach is required for the amended presentation and disclosure guidance.