United States

Effect of novations on existing hedge accounting relationships

FINANCIAL REPORTING INSIGHTS  | 

As it relates to derivative contracts, the term novation refers to replacing one of the parties to a derivative contract with a new party. This may occur, for example, when a company decides or is forced to move its open derivative contracts from one counterparty to another. The guidance in Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 815, Derivatives and Hedging, requires that hedge accounting be discontinued if any of certain conditions occur, including if the derivative instrument involved in a hedging relationship is terminated. A derivative is considered to be terminated and hedge accounting discontinued if a critical term of the derivative is modified. Existing guidance in Topic 815 is not explicitly clear about whether a change in the counterparty to a derivative instrument constitutes a change in a critical term and would be deemed to terminate the derivative instrument. As a result, the existing guidance is applied inconsistently in practice.

The FASB recently issued Accounting Standards Update 2016-05, Derivatives and Hedging (Topic 815): Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships (a consensus of the Emerging issues Task Force). The ASU clarifies that a change in the counterparty to a derivative instrument that has been designated as the hedging instrument under Topic 815 does not, in and of itself, require dedesignation of that hedge accounting relationship provided all other hedge accounting criteria (including those in paragraphs 815-20-35-14 through 35-18) continue to be met. Specifically, the ASU clarifies that when applying the guidance in paragraphs 815-25-40-1 for fair value hedges and 815-30-40-1 for cash flow hedges, a change in the counterparty to a derivative instrument, would not, in and of itself, be considered a “termination” of the original derivative. Similarly, the ASU clarifies that when applying the guidance in paragraph 815-20-55-56, a change in the counterparty to a derivative instrument would not, in and of itself, be considered a change in a “critical term” of the hedging relationship. Consideration must still be given to whether any critical terms of the derivative were modified in conjunction with the novation or otherwise that would constitute a termination of the derivative.

For public business entities, the ASU is effective for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. For all other entities, the ASU is effective for financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within fiscal years beginning after December 15, 2018. Early adoption and modified retrospective application are permitted.