Need to Know: The Upcoming Hedging Standard

During the third quarter of 2017, the FASB will issue a new standard that will improve and simplify accounting rules around hedge accounting. The standard will take effect for public companies in 2019 and private companies in 2020. Early adoption will be permitted. It will apply broadly to any institution that elects to apply hedge accounting in accordance with current GAAP (Topic 815).
Both companies and investors have expressed overwhelmingly positive feedback on the amended hedge accounting model.

Both companies and investors have expressed overwhelmingly positive feedback on the amended hedge accounting model. In developing the upcoming standard, the FASB:
  • Considered 60 comment letters
  • Held numerous conference calls with investors and other financial statement users
  • Hosted two roundtables including preparers, auditors, regulators and others, and
  • Met with the Private Company Council (PCC) to discuss private company hedge documentation issues

Why do we need a new standard?


Financial statement preparers have expressed concerns over the difficulties associated with applying hedge accounting and its limitations for hedging both nonfinancial and financial risks. Users of financial statements also expressed concerns over the way hedging activities are reported in the financial statements.

How will the new standard address these concerns?

The amendments in the new standard will permit more flexibility in hedging interest rate risk for both variable rate and fixed rate financial instruments, and introduce the ability to hedge risk components for nonfinancial hedges.

To address these concerns, the new standard will:
  • Expand hedge accounting for nonfinancial and financial risk components to allow institutions to qualify for hedge accounting for more of their risk management activities
  • Decrease the complexity of preparing and understanding hedge results by eliminating the separate measurement and reporting of hedge ineffectiveness
  • Enhance transparency, comparability, and understandability of hedge results through enhanced disclosures and changing the presentation of hedge results to align the effects of the hedging instrument and the hedged item, and
  • Reduce the cost and complexity of applying hedge accounting by simplifying the way assessments of hedge effectiveness may be performed.

How will the new standard achieve this?


The amendments in the new standard will permit more flexibility in hedging interest rate risk for both variable rate and fixed rate financial instruments, and introduce the ability to hedge risk components for nonfinancial hedges. The following indexes are eligible to be designated when hedging interest rate risk, and the following risks are eligible to be designated when hedging a nonfinancial item:

Indexes Eligible to be Designated in a Hedge of Interest Rate Risk



 

Eligible Hedged Risks for Non-Financial Items




Current GAAP contains limitations on how an institution can measure changes in fair value of the hedged item attributable to interest rate risk in certain fair value hedging relationships. The amendments in the new standard will permit certain strategies undertaken for risk management purposes to qualify for fair value hedge accounting and will make it easier for institutions to apply fair value hedge accounting to portfolios of prepayable financial assets.

The new standard also will enhance the presentation of hedge results in the financial statements and disclosures about hedging activities by:
  • Requiring changes in the value of the hedging instrument be presented in the same income statement line item as the earnings effect of the hedged item
  • Amending the current tabular disclosure of hedging activities to focus on the effect of hedge accounting on individual income statement line items
  • Requiring a new disclosure that will provide investors with more information about basis adjustments in fair value hedges of interest rate risk
The new standard also will enhance the presentation of hedge results in the financial statements and disclosures about hedging activities.
To simplify the reporting of hedge results for financial statement preparers and decrease the complexity of understanding hedge results for investors, the FASB has eliminated the separate measurement and reporting of hedge ineffectiveness. Mismatches between changes in value of the hedged item and hedging instrument may still occur but they will no longer be separately reported. For cash flow and net investment hedges, all changes in value of the hedging instrument included in the assessment of effectiveness will be deferred in other comprehensive income and released to earnings when the hedged item affects earnings.

The ASU also includes targeted improvements to simplify assessment of hedge effectiveness. Those simplifications will:
  • Allow an institution to perform subsequent assessments of hedge effectiveness qualitatively if certain conditions are met
  • Allow all institutions more time to perform the initial quantitative hedge effectiveness assessment, with additional relief provided to certain private companies and not-for-profit institutions
  • Allow an institution to apply the “long-haul” method for assessing hedge effectiveness when use of the shortcut method was not appropriate, or no longer is appropriate, if certain conditions are met
  • Clarify that an institution may apply the critical terms match method for a group of forecasted transactions if the transactions occur and the derivative matures within the same 31-day period or fiscal month, and the other requirements for applying the critical terms match method are satisfied.
The final hedging standard will be available at www.fasb.org.