FASB issues standard bringing targeted improvements to hedge accounting
This Heads Up provides a summary of the FASB's Accounting Standards Update No. 2017-12, "Targeted Improvements to Accounting for Hedging Activities," which amends the hedge accounting recognition and presentation requirements in ASC 815, "Derivatives and Hedging."
On August 28, 2017, the FASB issued ASU 2017-12, which amends the hedge accounting recognition and presentation requirements in ASC 815. The Board’s objectives in issuing the ASU are to (1) improve the transparency and understandability of information conveyed to financial statement users about an entity’s risk management activities by better aligning the entity’s financial reporting for hedging relationships with those risk management activities and (2) reduce the complexity of and simplify the application of hedge accounting by preparers.
For public business entities, the ASU is effective for fiscal years beginning after December 15, 2018, and interim periods therein; however, early adoption by all entities is permitted upon its issuance.
This Heads Up summarizes the ASU’s key provisions. The appendix of this Heads Up highlights important differences among the ASU’s amendments, U.S. GAAP before the ASU’s adoption, and the IASB’s hedging model under IFRS 9. (See "The ASU at a Glance" chart in pdf.)
The ASU at a Glance
What Has Not Changed
- “Highly effective” threshold.
- Benchmark interest rate concept for fair value hedges (hedges of fixed-rate financial
- Voluntary hedge dedesignations.
- Required timing for preparation of all hedge documentation except that related to the initial quantitative prospective assessment (private companies that are not financial institutions and certain not-for-profit entities will receive additional relief).
What Has Changed
- Elimination of the concept of recognizing periodic hedge ineffectiveness for cash flow and net investment hedges.
- Recognition and presentation of changes in the fair value of the hedging instrument.
- Recognition and presentation of components excluded from an entity’s hedge effectiveness assessment.
- Addition of the ability to exclude cross-currency basis spreads for currency swaps from an entity’s hedge effectiveness assessment.
- Addition of the ability to elect to perform subsequent effectiveness assessments
- Elimination of the benchmark interest rate concept for variable-rate instruments in cash flow hedges. An entity can now designate the contractually specified interest rate as the hedged risk.
- Addition of the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate as a benchmark interest rate.
- Addition of the ability to designate a “fallback” long-haul method for the shortcut method.
- Addition of the ability to apply the shortcut method to partial-term fair value hedges of interest rate risk.
- Enhancement of the ability to use the critical-terms-match method for cash flow hedge of groups of forecasted transactions when the timing of the hedged transactions does not perfectly match the hedging instrument’s maturity date.
- Addition of new disclosure requirements and amendments to existing ones.
Additional Relief Provided by the ASU
- Certain fair value hedges of interest rate risk:
- Measurement of hedged item — Option to use either the benchmark interest rate
component of total contractual coupon cash flows or the total contractual coupon cash flows to calculate the change in the fair value of the hedged item attributable to changes in the benchmark interest rate.
- Prepayable financial instruments — Ability to consider only how changes in the benchmark interest rate affect the decision to settle the hedged item before its scheduled maturity.
- Partial-term hedges — Ability to measure the change in the fair value of the hedged item attributable to changes in the benchmark interest rate by “using an assumed term that begins when the first hedged cash flow begins to accrue and ends when the last hedged cash flow is due and payable.”
- Portfolio hedge of prepayable assets — Addition of a “last-of-layer” method that enables an entity to fair value hedge a portion of a closed portfolio of prepayable assets (or one or more beneficial interests secured by a portfolio of prepayable financial instruments) without having to consider prepayment risk or credit losses when measuring those assets.
- Measurement of hedged item — Option to use either the benchmark interest rate
- Ability to hedge contractually specified components of the price of forecasted purchases and sales of nonfinancial assets.
- Although private companies that are not financial institutions and certain not-for profit entities would have to document certain aspects of a hedging relationship at hedge inception, they would not have to perform and document hedge effectiveness assessments until their next set of financial statements is available to be issued.
Hedging Concepts Retained by the ASU
ASU 2017-12 significantly alters the hedge accounting model by making it easier for an entity to achieve hedge accounting and have that accounting better reflect its risk management activities. Although the changes are substantial, constituents should note the following key aspects of hedge accounting under preadoption guidance that the Board retained:
- The “highly effective” threshold for qualifying hedging relationships.
- The ability for an entity to:
- Voluntarily dedesignate a hedging relationship.
- Designate certain component risks of the hedged item as the hedged risk.
- Apply the critical-terms-match method or the shortcut method.
- The benchmark interest rate definition and concept for hedges of fixed-rate financial instruments (i.e., fair value hedges of financial instruments).
- The required timing for the preparation of all hedge documentation for public companies and private companies that are financial institutions, except for the documentation related to the initial prospective quantitative hedge effectiveness assessment (discussed below).
- A number of disclosure requirements.
Key Changes to the Hedge Accounting Model
The ASU makes a number of improvements to the hedge accounting model, including those outlined below.
Elimination of the Concept of Separately Recognizing Periodic Hedge Ineffectiveness
ASU 2017-12 eliminates the concept of separately recognizing periodic hedge ineffectiveness for cash flow and net investment hedges (however, under the mechanics of fair value hedging, economic ineffectiveness will still be reflected in current earnings for those hedges). The Board believes that requiring an entity to record the impact of both the effective and ineffective components of a hedging relationship in the same financial reporting period and in the same income statement line item will make that entity’s risk management activities and their effect on the financial statements more transparent to financial statement users.
Under this rationale, even a portion of the change in a hedging instrument’s fair value that is excluded from a hedging relationship’s effectiveness assessment is considered part of the hedging relationship and should be recognized in the same income statement line item as the earnings effect of the hedged item (other than amounts excluded from the assessment of effectiveness of net investment hedges). However, in a departure from the proposed ASU, the Board determined that presentation should not be prescribed for “missed forecasts” in cash flow hedges. Thus, an entity that ultimately determines that it is probable that a hedged forecasted transaction will not occur will not be required to record the amounts reclassified out of accumulated other comprehensive income (AOCI) for that hedging relationship into earnings in the same income statement line item that would have been affected by the forecasted transaction.
Connecting the Dots
In paragraphs BC145 and BC146 of the ASU, the Board acknowledges that, unlike the preadoption hedge accounting model, the new model under ASU 2017-12 will defer the timing of recognition of any economic ineffectiveness arising from cash flow or net investment overhedges (and amounts recognized as net investment underhedges under the preadoption hedge accounting model will no longer be recognized). However, the Board believes that the new model will benefit constituents by (1) reducing the costs of administering a hedging program and (2) allowing users to more clearly identify how an entity’s hedging program has affected its financial statements, thereby resulting in more decision-useful information.
In addition, in paragraphs BC135 and BC136 of the ASU, the Board acknowledged concerns expressed by certain financial institutions that the ASU’s requirement to record all changes in the fair value of the hedging instrument in interest income and expense for hedges of interest rate risk would generate increased volatility in those institutions’ key interest rate margin metrics. These institutions have historically recorded the interest accruals for such hedges in a different income statement line item than the one for other changes in the fair value of the hedging instrument. However, the Board ultimately reiterated its belief that its requirement for an entity to include all effects of a hedging relationship in the same income statement line item increases the transparency of the entity’s hedging strategy and provides more decision-useful information to investors.
Recognition and Presentation — Components Excluded From the Hedge Effectiveness Assessment
ASU 2017-12 continues to allow an entity to exclude the time value of options, or portions thereof, and forward points from the assessment of hedge effectiveness. The ASU also permits an entity to exclude the change in the fair value of cross-currency basis spreads in currency swaps from the assessment of hedge effectiveness.
For excluded components in fair value, cash flow, and net investment hedges, the base recognition model under the ASU is an amortization approach. An entity still may elect to record changes in the fair value of the excluded component currently in earnings; however, such an election will need to be applied consistently to similar hedges.
Under the ASU’s amortization approach, an entity recognizes the initial value of the component that was excluded from the assessment of hedge effectiveness as an adjustment to earnings over the life of the hedging instrument by using a “systematic and rational method.” In each accounting period, the entity recognizes in other comprehensive income (OCI) (or, for net investment hedges, the currency translation adjustment (CTA) portion of OCI) any difference between (1) the change in fair value of the excluded component and (2) the amount recognized in earnings under that systematic and rational method.
If an entity derecognizes the hedged item in a fair value hedge or determines that it is probable that a hedged forecasted transaction in a cash flow hedge will not occur, the entity will recognize any amounts previously accumulated in AOCI under the amortization approach for those hedged exposures in current earnings. Otherwise, upon discontinuation of a hedging relationship that is accounted for under the amortization approach, amounts recorded in AOCI related to the changes in the fair value of the excluded components will be released to earnings either (1) when the hedged forecasted transaction affects earnings (for a cash flow or net investment hedge) or (2) in the same manner that the other components of the hedged item’s carrying amount are ultimately recognized in earnings (for a fair value hedge).
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