The third quarter was all about hedging and complex financial instruments. Two accounting standards updates will simplify accounting for entities and the users of their financial statements.
Accounting for Hedging Activities
Under ASU 2017-12, Derivatives and Hedging (Topic 815) Targeted Improvements to Hedging Activities is designed to align hedge accounting with risk management strategies, simplify the application of hedge accounting and increase transparency of hedging programs. Its changes include increasing the eligibility for hedge accounting, simplifying effectiveness testing and amending the presentation and disclosure requirements.
New Hedging Opportunities
Entities that are interested in hedging cash flow risks related to the purchase of goods that are heavily influenced by the price of commodities will be interested in the new ability to designate a cash flow hedge for a contractually specified price component of a nonfinancial item. For example, a company that purchases high fructose corn syrup under a contract that is dependent on the price of corn will now be able to designate only the component of the contract tied to corn prices as a hedge. Previously, such an entity could only designate the entire contract as a hedged item, which caused difficulties in trying to initially qualify, and subsequently apply, hedge accounting because of the ineffectiveness of hedging a contract for corn syrup to the prices of corn. In addition, entities may also hedge a specified component of a not-yet-existing contract that is expected to have a contractually specified component.
In another expansion of what is permitted in a cash flow hedge, the update expands guidance for hedges of interest rate risk by eliminating the concept of benchmark interest rate for a variable-rate financial instrument. An example relevant to many companies is borrowings based on the issuing bank’s prime rate. Previously, a company would not have been able to designate the hedge based on the bank’s prime rate, which increased the complexity of qualifying and applying hedge accounting. Now an entity can designate a hedged risk for the variability in the bank’s prime rate directly.
Opportunities may also be available for new fair value hedges. Entities can designate parts of an interest rate hedge including benchmark components, portions of the remaining term and the amount not affected by prepayments for pre-payable financial assets (eliminating the need to match prepayment risk). Also, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate was added as a benchmark rate.
In a change that will reduce the challenges in internal controls and preparing documentation to designate a hedge, the update eliminates the requirement for contemporaneous documentation with hedge designation. For public business entities, the initial assessment is required by the end of the first quarter in which a hedge is designated. All other companies will have until their financial statements are available to be issued to complete their documentation. Documentation once completed must include the initial effectiveness assessments and quarterly assessments that would have been required since hedge inception. Just as importantly, the update permits the use of a qualitative approach for the quarterly assessments of hedge effectiveness after the initial effectiveness testing. This change will reduce computational and data burdens on companies. As an added bonus, as discussed below, the change also means that the separate presentation and disclosure of the amount of hedge ineffectiveness will no longer be required resulting in financial statements that are easier to prepare and easier for financial statement users to understand. To qualify to use the qualitative approach, an entity will need to reasonably support that the hedge is highly effective and is expected to remain highly effective. Entities that use the qualitative effectiveness assessment must document quarterly whether facts and circumstances have changed.
Another simplification to the initial testing of effectiveness of a hedge and the subsequent accounting is the introduction of an election to exclude option premiums, forward points and cross-currency basis for a currency swap from the effectiveness assessment. The value of excluded components is recognizedratably into earnings. Fair value differences are recognized in other comprehensive income, and entities may elect to recognize them into current earnings.
The FASB has also expanded the ability to use the methods that are simpler then initial effectiveness testing to designate a hedge, potentially further reducing the cost of designating an accounting hedge. An entity will now be able to apply the critical terms match method to a group of forecasted transactions. Entities must assume that the hedging derivative matures at the same time as the forecasted transaction if both maturities occur within the same 31-day period or fiscal month.
In practice, the shortcut method for designating a hedge has fallen out of practice because of the risk that a restatement may be triggered if subsequent to hedge designation, it is discovered that the designated hedge no longer qualifies for hedge accounting. Those that would prefer to use the shortcut method will be interested to learn that under the update they may now designate a back-up long-haul method if the shortcut method is no longer appropriate and avoid restatement if the hedge is highly effective and documentation of the back-up long-haul methodology is done at hedge inception.
Presentation of Hedge Instrument Earnings
The update eliminates the separate measurement and reporting of hedge ineffectiveness. All changes in the fair value of the derivative hedging instrument for cash flow and net investment hedges will be recorded in other comprehensive income. Entities will reclassify the changes to earnings when the hedged item impacts earnings. For fair value hedges, changes in fair value of the hedged item and the derivative financial instrument are recorded in current earnings.
Disclosures will change under the new standard. Tabular disclosures related to the effect on the income statement of fair value and cash flow hedges are required. Fair value hedges will require tabular disclosures related to cumulative basis adjustments. The disclosure of the ineffective portion of the change in fair value of hedging instruments is eliminated.
Effective Date & Transition
For public business entities, the standard takes effect for calendar year Dec. 31, 2019. All others will adopt for calendar year Dec. 31, 2020. Early application is available inany interim period.
To transition to the standard, entities will use a cumulative-effect adjustment at the beginning of the adoption year. There are several elections to consider, including designating the back-up long-haul method for hedge accounting performed under the shortcut method.
Hedge accounting will now be better able reflect the way business are run and communicate information to financial statement users. Even though the complexity of the guidance is not eliminated, the changes do make it easier to apply hedge accounting and more forgiving when under audit. As a result, many who have not utilized hedge accounting in the past may now find giving hedge accounting second a look will be a worthwhile.
Financial Instruments with Down Round Features
Another major accounting change in the third quarter also related to financial instruments. As previously discussed, ASU 2107-11 simplifies accounting for certain equity-linked financial instruments and embedded features with down round features. The down round features result in the strike price being reduced based on the pricing of a future equity offering. The standard also converts the nonpublic entity indefinite deferral of mandatorily redeemable financial instruments to a scope exception.
In current U.S. GAAP, a freestanding instrument is required to be classified as a liability solely due to its down round feature. The update eliminates that provision, and clarifies that the existence of a down round feature does not preclude the instrument from being classified as equity, which may change the accounting for certain instruments.
Entities will instead recognize the effect of a down round feature in an equity-classified freestanding financial instrument when the down round feature is triggered. The effect is treated as a dividend and a reduction of income available to common stockholder in basic earnings-per-share.
The standard takes effect for public business entities in the Dec. 31, 2019 calendar year and the following year for all other entities. Early application is permitted in any interim period. The standard can be applied either retrospectively with a cumulative-effect adjustment to outstanding financial instruments with a down round feature or retrospectively to outstanding financial instruments with a down round feature for each prior reporting period presented.
SEC Staff Accounting Bulletin 116
Codified through ASU 2017-13, the SEC staff modified their guidance on revenue recognition in its release of SAB 116. After adoption, it clarifies the previous SEC recognition guidance will be eliminated.
Significantly for joint ventures or others that are partially owned by public business entities, the SEC staff also stated that they would not object to an entity that is only a public business entity because its financial statements or financial information is included in another entity’s filing with the SEC from using the effective date for entities that are not public business entities for ASC Topic 606 Revenue from Contracts with Customers (Topic 606) and ASC Topic 842 Leases (Topic 842). This means that entities whose financial statements are included in the 10-K or other filings of one of their investors may not be required to adopt ASC Topic 606 and ASC Topic 842 for annual periods, including interim periods within, beginning after Dec. 15, 2017, and Dec. 15, 2018, respectively. Instead, they can utilize the later dates for nonpublic business entities under ASC Topic 606 and ASC Topic 842 of annual periods beginning after Dec. 15, 2018, and Dec. 15, 2019, respectively, and interim periods in the subsequent annual period. This effectively defers their implementation for a period for up to two years, for instance in the case of ASC Topic 606 a calendar year entity that is a public business entity solely because of its financial statements inclusion in the public filings of another entity would have been required to adopt the standard Jan. 1, 2018 and will now be able to adopt on Dec. 31, 2019 instead.
Pay Ratio Rules
The SEC also issued guidance clarifying and providing relief to public companies as they prepare their disclosures over pay ratios, which include CEO pay compared to the median of annual total compensation for all employees, excluding the CEO. The clarifications permit entities to state that these disclosures are estimates, clarify who qualifies as an employee, when foreign workers may be excluded, and provide guidance on the use of sampling and reliance on data to develop the estimate. Although the pay ratio rule will not be deferred as some had hoped, the clarifications will make the disclosures easier to develop as entities prepare them for their proxy and information statements, registration statements, and annual reports. Smaller reporting companies, foreign private issuers, emerging growth companies and registered investment companies are excluded from the rule.
The FASB is considering replacing ASC Topic 810, Consolidation with ASC Topic 812, Consolidation, which would reorganize existing guidance related to variable interest entities (VIEs) and voting interest entities. It would also eliminate guidance for control by contract and research and development arrangements.
An exposure draft of changes would have land easements be evaluated under the new lease guidance. As a first step for accounting for land easements they would be required to be evaluated to determine if they meet the definition of a lease. Under the proposal, entities would be able to elect to scope out easements that exist or expire upon the adoption of the new lease guidance.
An update would make revenue recognition easier for not-for-profits by clarifying whether a transaction is nonreciprocal transaction. It would also include guidance to help organizations distinguish between conditional and unconditional contributions.
For More Information
We will continue to monitor accounting updates as they become available. For specific comments, questions or concerns about any of the third quarter updates, please contact Mark Winiarski of MHM’s Professional Standards Group. Mark can be reached at firstname.lastname@example.org or 816.945.5614.
Published on October 17, 2017