The Financial Accounting Standards Board (FASB) released its long-awaited improvements to ASC Topic 815, Derivatives and Hedging in late August. The hedging project began as a significant overhaul to hedge accounting as proposed in 2008 and 2010 Exposure Drafts. However, upon reactivating the hedging project, the FASB determined such broad-based changes were not necessary; rather, several targeted improvements could achieve the objectives.
These amendments, provided in Accounting Standards Update (ASU) 2017-12, are designed to address concerns expressed by preparers and users of financial statements regarding difficulties in applying hedge accounting as well as the clarity with which hedging activities are presented in the financial statements. Significant changes provided by the amendments of ASU 207-12 include:
- Expanded number of strategies that qualify for hedge accounting (financial and nonfinancial transactions)
- Changes to the measurement of the hedged item in a fair value hedge
- Provisions for qualitative testing of ongoing hedge effectiveness
- Elimination of the requirement to calculate hedge ineffectiveness for cash flow hedges
- Additional time to complete the initial hedge designation documentation (i.e. no longer required to be contemporaneous)
- Guidance on income statement presentation and additional disclosure requirements in the notes to the financial statements
Hedge Accounting Strategies
The amendments in ASU 2017-12 permit entities more options to hedge the interest rate risk for both variable rate and fixed rate financial instruments. Cash flows hedges have historically been limited to only qualifying benchmark interest rates, however, the amendments allow cash flow hedges of interest rate risk by designating as the hedged risk the variability in cash flows attributed to any contractually specified interest rate. Therefore, entities will no longer be required to designate only the overall variability in cash flows as the hedged risk in a cash flow hedge of a variable-rate instrument indexed to a non-benchmark interest rate.
This changes does not apply to fair value hedges of interest rate risk, but the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate has been added as an allowable benchmark interest rate for fair value hedges, which allows entities that invest in fixed-rate, tax-exempt financial instruments to hedge fair value changes attributable to interest rate risk related to the SIFMA Swap Rate.
The amendments will also allow entities to hedge risk components for nonfinancial assets. This will likely have the biggest impact on hedging strategies associated with components of a forecasted purchase or sale of a nonfinancial asset as entities will no longer be required to designate the overall variability in cash flows as the hedged cash flows, which often includes a basis difference for commodities. This allows an entity to designate the hedged risk as the variable in cash flows attributable to the changes in a contractually specified component in the contract.
Also, when assessing whether the qualifying criteria for the critical terms match method are met for a group of forecasted transactions, an entity may assume that the hedging derivative matures at the same time as the forecasted transaction if both the derivative maturity and the forecasted transactions occur within the same 31-day period or fiscal month.
Accounting for the Hedged Item in a Fair Value Hedge of Interest Rate Risk
To address concerns regarding limitations on the measurement of the fair value of the hedged items in a fair value hedge of interest rate risks, the amendments include certain accommodations for determining the fair value of the hedged item, including permitting:
- Entities to measure the change in fair value of the hedged item on the basis of the benchmark rate component of the contractual coupon cash flows determined at hedge inception, rather than the full contractual coupon cash flows as required by current U.S. GAAP;
- An entity to measure the hedged item in a partial-term fair value hedge of interest rate risk by assuming the hedge item has a term that reflects only the designated cash flows being hedged; and
- Entities to consider how changes in the benchmark interest rate affect the decision to settle a debt instrument before its scheduled maturity in the fair value determination.
Additionally, for a closed portfolio of prepayable financial assets, an entity can designate an amount that is not expected to be affected by prepayments, defaults, or other events affecting the timing and amount of cash flows. As a result, prepayment risk is not incorporated into the measurement of the fair value of the hedged item.
Initial quantitative testing remains required in most instances. Entities can elect to perform subsequent assessments of hedging effectiveness using qualitative measures. This eliminates the current requirement to perform a quantitative assessment in connection with each quarterly assessment. Entities that choose the qualitative assessment election must verify and document on a quarterly basis that the facts and circumstances related to the hedging relationship have not changed such that the entity can assert qualitatively that the hedging relationship continues to be highly effective. The election can be made on a hedge-by-hedge basis. Changes in the reporting of effectiveness include the following:
Cash Flow & Net Investment Hedges
Entities will record the entire change in the fair value of the hedging instrument included in the assessment of hedge effectiveness in other comprehensive income (cash flow hedges) or in the currency translation adjustment section of other comprehensive income (net investment hedges), eliminating the need to calculate and report ineffectiveness. Changes in the fair value of the hedging instrument reporting in other comprehensive income will be recognized in earnings at the same time that the hedged item impacts income.
Fair Value Hedges
Entities will present the entire change in the fair value of the hedging instrument included in the assessment of hedge effectiveness in the same income statement line as the earnings effect of the hedged item. The timing of recognition in the change in fair value of the hedging instrument is the same as under current U.S. GAAP.
To further simplify accounting for hedge effectiveness, the amendments allow entities to exclude option premiums and forward points as well as certain components of a hedging instrument's change in fair value from the hedge effectiveness assessment. Entities can also 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. If entities elect to exclude certain components of a hedging instrument's change in fair value from the assessment of hedge effectiveness, they can elect to either recognize the changes in the fair value of the excluded components of the hedging instrument in current period earnings or defer the amounts and recognize over the life of the hedge. If an entity elects deferral, any difference between the change in fair value of the excluded components and amounts deferred and recognized under a systematic and rational method is recognized in other comprehensive income (for net investment hedges, the difference is recognized in the cumulative translation adjustment section of other comprehensive income). As a result, entities may now report amounts in other comprehensive income related to fair value hedging strategies.
The changes are designed to assist entities in reporting the economic results of fair value and cash flow hedges. They are also expected to assist financial statement users in seeing the results of an entity's hedging program.
Existing GAAP requires entities to complete the hedge documentation contemporaneous with the date of designation, although certain relief has been granted to non-public entities applying the simplified approach. The amendments in ASU 2017-12 allow all entities a grace period in completing the hedge documentation, so long as it is completed no later than the first quarterly effectiveness testing date (i.e. completed during the completion of the interim period of designation).
Private entities that are not financial institutions may elect the method of assessing hedge effectiveness, perform the initial qualitative effectiveness assessment and perform all quarterly hedge effectiveness assessments before the next interim or annual financial statement is issued.
Inappropriate application of the short cut method of hedge accounting has resulted in a significant number of prior period errors and financial statement restatements. In order to address this perceived application issue, the FASB included provisions in ASU 2017-12 that allowan entity to apply short cut accounting. Entities can apply the long haulmethod of hedge accounting if it is later determined the hedging strategy does not qualify for the short cut method. The ability to apply the long haul method, and not consider the accounting in the prior period to be an error, is only available to a reporting entity if the hedge is highly effective and the details regarding the application of the long haul method are included in the original hedge designation documentation.
Presentation and Disclosure
As part of an effort to better portray the economic results of an entity's risk management activities, the amendments include certain changes to the presentation and disclosure requirements. Entities will present the earnings effect of the hedging instrument in the same income statement line item in which the earnings' effect of the hedged item is reported.
The amendments to the disclosures are designed to provide users with a more complete picture of the effect of hedge accounting on the income statement and balance sheet, which may provide more decision-useful information. The amendments include additional information in the tabular disclosure related to the effect of cash flow and fair value hedges on the income statement designed to focus on the effect of the hedging strategies on the individual income statement line items. Cumulative basis adjustments for fair value hedges will also have new tabular disclosures.
Public business entities will be required to adopt these amendments for fiscal years and interim periods beginning after Dec. 15, 2018. All other entities will be required to adopt for fiscal years beginning after Dec. 15, 2019, and interim fiscal periods beginning after Dec. 15, 2020.
Early adoption is permitted, and based on the changes, it is expected many entities will take advantage of the improvements by adopting early. Upon adoption, entities will apply the new guidance to existing hedging relationships. Cash flow and investment hedges will require a cumulative-effect adjustment that relates to the elimination of the separate measurement of ineffectiveness to accumulated income. Entities will also need to make a corresponding adjustment to the opening balance of retained earnings in the year of adoption for their cash flow and investment hedges. Presentation and disclosure guidance will be adopted prospectively.
For More Information
If you have specific comments, questions or concerns about the new guidance for financial instruments, please contact Mike Loritz or James Comito of MHM's Professional Standards Group. Mike can be reached at firstname.lastname@example.org or 816.945.5611. James can be reached at email@example.com or 858.795.2029.
Published on November 07, 2017