FASB's ongoing efforts to simplify hedge accounting
INSIGHT ARTICLE |
Efforts to simplify hedge accounting began as part of a joint project with the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) to improve and simplify the reporting for financial instruments and work towards convergence between the two boards’ respective standards. In addition to hedge accounting, this project encompassed the recognition and measurement of financial instruments and credit impairment. Ultimately, the boards went down separate paths. The IASB completed its project in 2014 with the issuance of the final version of IFRS 9, Financial Instruments (July 2014). The FASB is nearing completion of its project as final Accounting Standards Updates (ASU) were issued in January and June 2016 to address the classification and measurement of financial instruments and the recognition of credit losses, respectively, and a proposed ASU on hedge accounting is expected to be issued in September 2016. We provide additional information about the final ASUs in the following white papers:
- Financial instruments: FASB issues standard on recognition and measurement
- Financial instruments: In-depth analysis of new standard on credit losses
Highlights of decisions made to date that are expected to be reflected in the proposed ASU on hedge accounting include:
- The highly effective threshold requirement inherent in current guidance would be retained for all hedging relationships.
- The initial requirement to quantitatively test the effectiveness of hedges would be retained (unless the hedges meet the requirements for the shortcut or other methods that permit the assumption of perfect effectiveness). While the required timing for the preparation of hedge elections would not change, entities could take as long as the first three-month effectiveness testing period to perform this initial quantitative testing.
- Subsequent quantitative effectiveness testing would be required only if facts and circumstances change such that the entity can no longer assert qualitatively that the hedging relationship was and continues to be highly effective.
- In those circumstances where the shortcut method was applied and was, or is, no longer appropriate, an entity could apply a long-haul method and continue to apply hedge accounting uninterrupted if the hedge remained highly effective from its inception. Initial hedge documentation would require selection of the long-haul methodology that would be applied in this circumstance. (Under current guidance, if the determination is made that the shortcut method was inappropriately applied, the hedge election generally would be deemed invalid from inception, and efforts to qualify for hedge accounting prospectively would be complicated by the derivative no longer being at market.)
- Entities would be permitted to use the critical terms match method and assume there is no ineffectiveness in a cash flow hedge of a group of forecasted transactions if the forecasted transactions occur and the derivative matures within the same 31-day period (assuming the entity meets all other requirements to use the critical terms match method).
- For those hedges that are highly effective, ineffectiveness would no longer be separately recognized. For fair value hedges, the entire change in the fair value of the derivative would be recorded in the same income statement line item as the earnings impact of the hedged item. Similarly, with the exception of changes in fair value that are excluded from the assessment of hedge effectiveness (which would be recognized immediately in the income statement), changes in the fair value of the derivative in a cash flow hedge would be recognized in other comprehensive income and reclassified to the income statement line item impacted (or to be impacted) by the item being hedged when the hedged item affects earnings or is probable of not occurring.
- Component hedging would be permitted for nonfinancial items. Hedged items could be a contractually specified component or an ingredient that is linked to an index or rate stated in the contract, including those that have caps, floors or negative basis associated with the contractual pricing provided the effectiveness criteria are met. (Under current guidance, hedge accounting is difficult to achieve for many commodities and other nonfinancial items given that only total changes in cash flows or fair value can be hedged and most derivatives only address the risk of a component of the total exposure.)
- The concept of benchmark interest rates would be eliminated for variable-rate financial instruments as an entity could designate as the hedged item the contractually specified index rate in cash flow hedges of interest rate risk. The existing definition of benchmark interest rates would be expanded for hedges of fixed-rate financial instruments to include the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index.
- Other decisions related to fair value hedges of financial instruments include:
- In a hedge of interest rate risk, an entity could designate the benchmark component of the total coupon cash flows as the hedged risk rather than all contractual cash flows (which necessitates considering credit spreads). If the effective interest rate of the financial instrument is less than the benchmark interest rate on the date of hedge designation, the entity would be required to use the total coupon cash flows.
- For callable debt, an entity could limit its consideration of the effect of a prepayment option to the risk designated as being hedged (e.g., interest rate risk), while excluding other risks (e.g., credit).
- A portion of the term of a financial instrument could be designated as the hedged risk rather than the entire term. An entity would be permitted to calculate the change in the fair value of the hedged item by assuming the same term as the derivative designated as the hedging instrument. Additionally, partial term hedges of interest rate risk would be eligible for the shortcut method.
- Current guidance that permits voluntarily de-designating hedges would be retained.
- Existing disclosure requirements would be expanded and modified.
- Transition for hedging relationships in existence at the date of adoption would be through a modified retrospective approach. In other words, the ASU (if finalized) would only be retrospectively applied to the current period in the period of adoption through a cumulative effect adjustment to the beginning balance of the appropriate component of equity.
- The effective date of any final ASU will be determined after the FASB redeliberates the decisions in the proposed ASU. However, early adoption of the ASU (if finalized) in its entirety is expected to be permitted as of the beginning of any fiscal period occurring subsequent to final issuance.
- Entities would be permitted to make the following one-time elections upon adoption of the ASU (if finalized), either by the end of the first fiscal year after adoption or on or before the first quarterly hedge effectiveness assessment date after the adoption date (as indicated below):
- Amend existing hedge documentation to indicate whether subsequent assessments of effectiveness would be performed qualitatively (by the end of the first fiscal year after adoption)
- Amend hedge documentation for existing shortcut method hedging relationships to indicate how quantitative assessments of effectiveness would be performed if it is determined at a later date that use of the shortcut method is no longer appropriate (by the end of the first fiscal year after adoption)
- Set the terms of the hypothetical derivative to have a fair value of zero as of the original hedge inception date for hedging relationships that meet the criteria to designate the variability in a contractually specified component as the hedged risk (on or before the first quarterly hedge effectiveness assessment date)
- In circumstances whereby upon adoption an entity elects to de-designate and immediately re-designate a fair value hedge of interest rate risk and change its method for measuring the hedged item, the basis adjustment of the hedged item from the de-designated hedging relationship would be incorporated into the new hedging relationship as though the revised methodology had been used all along.
- In circumstances whereby upon adoption an entity hedging a tax-exempt security for the risk of changes in the overall fair value elects to de-designate and simultaneously re-designate the hedging relationship with the hedged risk defined as fluctuations in SIFMA, the basis adjustment from the de-designated hedging relationship at the time of de-designation would be amortized over the remaining life of the hedged item on a level yield basis.
Once issued, the proposed ASU will be open for comment by constituents for a limited period of time. Based on the comments it receives, the FASB will redeliberate decisions included in the proposed ASU to determine if there is support to move forward with a final ASU as proposed or with modification. Given the time needed to complete these activities, we do not expect a final ASU to be issued before the end of 2016.