FASB proposes targeted improvements to hedge accounting
On September 8, 2016, the FASB issued a proposed ASU that would amend the hedge accounting recognition and presentation requirements of ASC 815 to (1) reduce their complexity and simplify their application by preparers and (2) improve the transparency and understandability of information conveyed to financial statement users about an entity’s risk management activities by better aligning those activities with the entity’s financial reporting for hedging relationships.
Key Proposed Changes to the Hedge Accounting Model
Elimination of the Concept of Separately Recognizing Periodic Hedge Ineffectiveness
The proposed amendments would eliminate the concept of separately recognizing periodic hedge ineffectiveness (although under the mechanics of fair value hedging, economic ineffectiveness would still be reflected in current earnings for those hedges). The Board’s rationale for this decision is that the entire change in the fair value of the hedging instrument represents a cost of hedging; accordingly, presenting that whole change in the same income statement line as the earnings effect of the hedged item provides “a more faithful representation of an entity’s risk management activities.” 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 a cost of hedging that should be recognized in the same income statement line as the earnings effect of the hedged item (other than amounts excluded from the assessment of effectiveness of net investment hedges). Furthermore, this rationale extends to “missed forecasts” as well. Thus, an entity that ultimately determines that it is probable that a hedged forecasted transaction will not occur would record the amounts reclassified out of accumulated other comprehensive income (AOCI) for that hedging relationship into earnings in the same income statement line that would have been affected by the forecasted transaction.
The Board acknowledges that, unlike the existing hedge accounting model, its proposed model will defer the timing of recognition of any economic ineffectiveness arising from cash flow or net investment overhedges (and eliminate recognition of ineffectiveness arising from net investment underhedges); however, it 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.
Recognition and Presentation of Changes in the Fair Value of Hedging Instruments
The following table summarizes key aspects of the amended hedge accounting and presentation model described in the proposal:
Hedge Effectiveness Assessments and Documentation Requirements
Quantitative Versus Qualitative Assessments of Hedge Effectiveness
The proposal would require an entity to perform an initial prospective quantitative hedge effectiveness assessment (by using either a dollar-offset test or a statistical method such as regression) unless the hedging relationship qualifies for application of one of the expedients that permits an assumption of perfect hedge effectiveness (e.g., the shortcut or critical-terms-match methods).
An entity would be permitted to perform the initial prospective quantitative hedge effectiveness assessment after hedge designation by using information available at hedge inception; however, the entity would have to complete that assessment by the earlier of:
- “The first quarterly hedge effectiveness assessment date.”
- “The date that financial statements that include the hedged transaction are available to be issued.”
- “The date that [any required hedging criterion] no longer is met.”
- “The date of expiration, sale, termination, or exercise of the hedging instrument.”
- “The date of de-designation of the hedging relationship.”
- “For a cash flow hedge of a forecasted transaction . . . the date that the forecasted transaction occurs.”
If (1) an entity’s initial prospective quantitative hedge effectiveness assessment of a hedging relationship demonstrates there is a highly effective offset, and (2) the entity can, at hedge inception, “reasonably support an expectation of high effectiveness on a qualitative basis in subsequent periods,” the entity may elect to perform subsequent retrospective and prospective effectiveness assessments qualitatively. To do so, in the hedge documentation it prepares at hedge inception, it must (1) specify how it will perform the qualitative assessments and (2) document the alternative quantitative assessment method that it would use if it later concludes, on the basis of a change in the hedging relationship’s facts and circumstances, that subsequent quantitative assessments will be necessary.
The proposal notes that an entity’s determination of whether it can reasonably support an expectation of high effectiveness will require the use of judgment and that the entity should consider (1) the results of the initial prospective quantitative hedge effectiveness assessment, (2) the extent to which the critical terms of the hedging instrument and the hedged item are aligned, and (3) the degree and consistency of correlation between changes in the underlyings of the hedging instrument and the hedged item.
The proposal also states that “[a]n entity must document that it will perform the same quantitative assessment method for both initial and subsequent prospective hedge effectiveness assessments.” Moreover, the proposal indicates that an entity that elects to perform subsequent qualitative effectiveness assessments should do so for all similar hedging relationships.
The proposal states that after an entity makes its initial election, “whenever financial statements or earnings are reported and at least every three months, [it must] verify and document that the facts and circumstances related to the hedging relationship have not changed to an extent that it no longer can assert qualitatively that the hedging relationship was and continues to be highly effective.” Indicators that may (individually or in the aggregate) allow an entity to continue to assert qualitatively that a hedging relationship continues to be highly effective include:
- “The factors that were assessed at the inception of the hedging relationship that enabled the entity to reasonably support an expectation of high effectiveness on a qualitative basis have not changed to an extent that the entity no longer can assert qualitatively that the hedging relationship was and continues to be highly effective.”
- “There have been no adverse developments regarding the risk of counterparty default.”
- “In a cash flow hedge of a variable-rate financial instrument with an interest rate cap or interest rate floor in which effectiveness is assessed in accordance with paragraph 815-20-25-100, the variable rate does not approach or move above or below the rate associated with the cap or floor.”
- “In a cash flow hedge of the variability in cash flows attributable to changes in a contractually specified component in a forecasted purchase or sale of a nonfinancial asset with a cap or floor in which effectiveness is assessed in accordance with paragraph 815-20-25-100, the price associated with the contractually specified component does not approach or move above or below the price associated with the cap or floor.”
An entity that initially elects to perform subsequent qualitative effectiveness assessments but later determines that the hedging relationship’s facts and circumstances have changed to the extent that qualitative assessments are no longer sufficient, would be required to quantitatively assess effectiveness at the time of the change and for the duration of the hedging relationship. The entity would not be able to revert to making qualitative effectiveness assessments at any time after such a change.
Amendments to Benchmark Interest Rates and the Definition of Interest Rate Risk
The proposed amendments would redefine the term “interest rate risk” as follows to describe hedgeable risks:
- “For recognized variable-rate financial instruments and forecasted issuances or purchases of variable rate financial instruments, interest rate risk is the risk of changes in the hedged item’s cash flows attributable to changes in the contractually specified interest rate in the agreement.”
- “For recognized fixed-rate financial instruments, interest rate risk is the risk of changes in the hedged item’s fair value attributable to changes in the designated benchmark interest rate. For forecasted issuances or purchases of fixed-rate financial instruments, interest rate risk is the risk of changes in the hedged item’s cash flows attributable to changes in the designated benchmark interest rate.”
Thus, the benchmark interest rate concept would be eliminated for variable-rate financial instruments under the proposed amendments but retained for fixed-rate financial instruments.
As indicated in the definition of interest rate risk, in cash flow hedges of interest rate risk associated with forecasted issuances or purchases of debt, the nature of the hedgeable risk will depend on the characteristics of the forecasted transaction. An entity that knows it will issue or purchase fixed-rate debt would hedge the variability in cash flows associated with changes in the benchmark interest rate; for a forecasted issuance or purchase of variable-rate debt, the entity would hedge the variability in cash flows associated with changes in the contractually specified rate. If the entity is unsure about the nature of its forecasted transaction, it would designate as the hedged risk the variability in cash flows attributable to a change in a rate that would qualify both as a benchmark interest rate (if the forecasted transaction ultimately was fixed rate) and as a contractually specified rate (if the forecasted transaction ultimately was variable rate).
Under the proposal, the Securities Industry and Financial Markets Association Municipal Swap Index (SIFMA) swap rate would also be added to those benchmark interest rates already permitted in the United States under U.S. GAAP to make it easier for entities to hedge interest rate risk for fixed-rate tax-exempt financial instruments.
Shortcut Method and Critical-Terms-Match Method
The proposal retains both the shortcut and critical-terms-match methods and provides additional relief for entities applying those methods. As a response to concerns about the number of restatements that have resulted from attempted application of the shortcut method, the proposal would amend the shortcut accounting requirements to allow an entity to specify, at the inception of the hedging relationship, the quantitative (long-haul) method it will use to assess hedge effectiveness and measure hedge results if it later determines that application of the shortcut method was not or no longer is appropriate. Before being able to use this alternative quantitative method (and avoid having to de-designate the original hedging relationship), the entity would have to have demonstrated that:
a. [It] documented at hedge inception . . . which quantitative method it would use to assess hedge effectiveness and measure hedge results if the shortcut method was not or no longer is appropriate during the life of the hedging relationship[; and]
b. The hedging relationship was highly effective on a prospective and retrospective basis in achieving offsetting changes in fair value or cash flows attributable to the hedged risk for the periods in which the shortcut method criteria were not met.
If criterion (a) is not satisfied, the hedging relationship would be invalid in the period in which the shortcut method criteria were not satisfied and all subsequent periods; otherwise (if criterion (a) is met), the hedging relationship would be invalid in all periods in which criterion (b) was not satisfied.
Even if an entity can continue the hedging relationship by using a quantitative effectiveness assessment and measurement method because both criteria are met, the entity still must apply the ASC 2509 error correction guidance “to the difference, if any, between the results recorded from applying the shortcut method and the quantitative method documented [at hedge inception].” Doing so ensures that any material differences would still be treated as errors in the financial statements, although presumably the size of the error would not be significant if the hedging relationship was highly effective. If either criterion is not met, an entity must apply the error correction guidance to the difference between the results recognized through application of the shortcut method and the results of not applying hedge accounting. These types of errors are more likely to be material, although that ultimate determination will depend on the specific characteristics of the hedging relationship.
In addition, the proposal amends certain shortcut-method criteria to allow partial-term fair value hedges to qualify for the shortcut method.
The proposal also expedites an entity’s ability to apply the critical-terms-match method to cash flow hedges of groups of forecasted transactions. If all other critical-terms-match criteria are satisfied, such hedges will qualify for the critical-terms-match method if all the forecasted transactions occur within 31 days of the hedging derivative’s maturity.
Fair Value Hedges of Interest Rate Risk
Measurement of Changes in the Hedged Item’s Fair Value
Under the proposal, for a fair value hedge of interest rate risk, an entity may choose to use either (1) total contractual coupon cash flows or (2) the benchmark rate component of those contractual coupon cash flows to calculate the change in the hedged item’s fair value that is attributable to changes in the benchmark interest rate. However, if the current market yield of the hedged item is less than the benchmark interest rate at hedge inception (i.e., a “sub-benchmark” hedge), the entity would be required to use the total contractual coupon cash flows for its calculation.
Measuring the Fair Value of a Prepayable Instrument
For prepayable instruments such as callable debt, an entity would continue to consider the changes in the embedded prepayment option’s fair value when determining the change in the fair value of the hedged instrument in a fair value hedge of interest rate risk. However, under the proposal, “the factors incorporated for the purpose of adjusting the carrying amount of the hedged item shall be the same factors that the entity incorporated for the purpose of assessing hedge effectiveness.”
Therefore, when, for example, an entity (1) assessed hedge effectiveness in a fair value hedge of interest rate risk of callable debt and (2) measured the change in the fair value of callable debt attributable to changes in the benchmark interest rate, it could consider only how changes in the benchmark interest rate (and not changes in credit risk or other factors) would affect the obligor’s decision to call the debt.
Partial-Term Hedges of Interest Rate Risk
The proposal also provides relief to entities that wish to enter into fair value hedges of interest rate risk for only a portion of the term of a financial instrument, which is typically unachievable under current U.S. GAAP. Under the proposed guidance, such partial-term hedges would be permissible, and an entity would measure the change in the fair value of the hedged item attributable to changes in the benchmark interest rate “using an assumed term that begins with the first hedged cash flow and ends with the last hedged cash flow.” Also, the hedged item’s assumed maturity would be the date on which the last hedged cash flow is due and payable.
Ability to Designate Components of Nonfinancial Assets as Hedged Items
The proposed guidance permits an entity to hedge the “risk of 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 if the hedge meets the following criteria:
- “The purchase or sale contract for the nonfinancial asset creates an exposure related to the variability in cash flows attributable to changes in the contractually specified component throughout the life of the hedging relationship.”
- “The stated components of the price of the nonfinancial contract all relate to the cost of purchasing or selling the nonfinancial asset in the normal course of business in a particular market.”
- “All of the stated components of the price of the nonfinancial contract reflect market conditions at contract inception.”
Furthermore, an entity would be permitted to designate a hedge of a contractually specified component for a period that extends beyond the contractual term or when a contract does not yet exist to sell or purchase the nonfinancial asset if the criteria specified above will be met in a future contract and all the other cash flow hedging requirements are met.
Also, the proposal notes that an entity’s ability to make a hedge designation would not be precluded if the variability in a hedged item’s cash flows that is attributable to changes in the contractually specified component is limited by a cap or floor in the contract; however, the entity would need to consider such features in its assessment of hedge effectiveness.
The Board believes that enabling entities to component hedge better reflects risk management activities in those entities’ financial reporting. This decision also creates greater symmetry in the hedging models for financial and nonfinancial items because it will allow component hedging for both types of items.
The proposed ASU would add new disclosure requirements and amend existing ones. Also, to align the disclosure requirements with the proposed changes to the hedge accounting model, the proposal would remove the requirement for entities to disclose amounts of hedge ineffectiveness. In addition, entities would be required to provide:
- Tabular disclosure of (1) the total amounts reported in the statement of financial performance for each income and expense line item that is affected by hedging and (2) the effects of hedging on those line items.
- Disclosures about the carrying amounts and cumulative basis adjustments of items designated and qualifying as hedged items in fair value hedges.
- Qualitative disclosures describing (1) quantitative hedging goals, if any, established by an entity when developing its hedging objectives and strategies and (2) whether those goals were met.
These disclosures would be required for every annual and interim reporting period for which a statement of financial position and statement of financial performance are presented.
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