Highly anticipated improvements to hedge accounting
FINANCIAL REPORTING INSIGHTS |
On August 28, 2017, the Financial Accounting Standards Board issued Accounting Standards Update (ASU) 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. This ASU can be early adopted and brings forth some long-awaited improvements to hedge accounting. A high-level overview of the most significant improvements, as well as effective date and transition considerations, follow.
Risk component hedging
Current guidance is restrictive in terms of the specific risks that can be hedged when applying hedge accounting. The ASU permits certain new risk components to be hedged, including:
- Variability in cash flows attributable to changes in a contractually specified component in a cash flow hedge of a forecasted purchase or sale of a nonfinancial asset, such as a commodity
- Variability in cash flows attributable to the contractually specified interest rate in a cash flow hedge of interest rate risk
- Changes in fair value attributable to interest rate risk related to the Securities Industry and Financial Markets Association Municipal Swap Rate in a fair value hedge of a tax-exempt financial instrument
Accounting for the hedged item in fair value hedges of interest rate risk
The ASU is more permissive in terms of how fair value hedges of interest rate risk can be designated and how the change in fair value of the hedged item can be measured by permitting:
- The change in fair value of the hedged item to be measured on the basis of the benchmark rate component rather than on the basis of full contractual coupon cash flows
- The hedged item in a partial-term hedge to be measured by assuming it has a term that reflects only the designated cash flows being hedged
- Entities to consider only how changes in the benchmark interest rate affect a decision to settle a prepayable debt instrument before its scheduled maturity when calculating the change in the fair value of the hedged item
- Use of a “last-of-layer” designation method when hedging a closed portfolio of prepayable financial assets whereby an entity can designate the hedged item as an amount that is not expected to be affected by prepayments, defaults and other events that could impact cash flows
Recognition and presentation of the effects of hedging instruments
To promote better financial statement alignment of the recognition and presentation of the effects of the hedging instrument and the hedged item, the ASU requires:
- The earnings effect of the hedging instrument to be presented in the same income statement line item with the earnings effect of the hedged item
- Hedge ineffectiveness to no longer be separately measured and reported
Amounts excluded from the assessment of hedge effectiveness
Current guidance allows an entity to exclude option premiums and forward points from the assessment of hedge effectiveness. The ASU also permits the portion of the change in fair value of a currency swap that is attributable to a cross-currency basis spread to be excluded from the assessment of effectiveness. In addition, the ASU permits recognizing the initial value of any excluded components in earnings over the life of the hedging instrument using a systematic and rational method, such as straight-line, rather than recognizing all fair value changes of excluded components currently in earnings as existing guidance requires.
Other simplifications of hedge accounting guidance
The ASU brings about certain other targeted improvements to ease the burden associated with assessing hedge effectiveness, including:
- Permitting an entity to elect on a hedge-by-hedge basis to assess effectiveness qualitatively (after an initial quantitative assessment is performed as necessary) by verifying and documenting on a quarterly basis that facts and circumstances have not changed, such that the entity can assert qualitatively that the relationship was, and continues to be, highly effective
- The ability to assume that the derivative and a hedged group of forecasted transactions mature at the same time if the derivative matures, and the hedged transactions occur, within the same 31-day period or fiscal month
- Allowing up until the first quarterly effectiveness testing date to perform the initial prospective quantitative assessment of effectiveness
- Allowing private companies (other than financial institutions and certain not-for-profit entities) up until the date on which the next interim (if applicable) or annual financial statements are available to be issued to (a) select the method that will be used to assess effectiveness and (b) perform any required initial and quarterly effectiveness assessments. (This relief is in addition to the simplified hedge accounting approach that can be elected by certain private companies for qualifying hedges of variable rate debt.)
- Allowing an entity that applies the shortcut method and subsequently determines that the use of the method was not, or no longer is, appropriate, to apply a long-haul method for assessing effectiveness, as long as the hedge is highly effective and the entity documents at hedge inception the long-haul methodology that will be used
Effective date and transition
The ASU is effective for public business entities in fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. It is effective for all other entities in fiscal years beginning after December 15, 2019, and interim periods beginning after December 15, 2020. Early application is permitted in any interim period after issuance of the ASU, with the impact of adoption reflected as of the beginning of the fiscal year of adoption. Certain advantageous transition elections can be made upon adoption of the ASU. These elections, as well as the transition requirements, will apply to hedging relationships that are in existence on the date of adoption.
We encourage you to refer to the ASU in its entirety for additional information and to reach out to your RSM representative with questions. In the weeks that follow, we will provide a more in-depth analysis of the ASU and the improvements it brings to hedge accounting.