Bitcoin futures, hedge accounting, and ASC 815

But first, what’s bitcoin?

Bitcoin is a cryptocurrency, or an open-sourced software-based payment system, that was introduced in 2009. Bitcoin is based on a peer-to-peer payment system. Unlike physical currencies, such as the US dollar (USD), it's not a fiat currency that derives its value from government regulation or law. The value of bitcoin in relation to fiat currencies has historically been subject to significant volatility, with a high of $19,205.11 USD and a low of $801.98 USD in 2017.¹ As more entities accept bitcoin as a form of payment for goods and services provided and hold bitcoin, either for their proprietary accounts or for their customers, those entities face an increasing risk due to price fluctuations in the value of the bitcoin compared to fiat currencies. Bitcoin futures may help mitigate certain risk exposures related to bitcoin.

¹ Historical data from https://www.coinbase.com/charts

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Hedge accounting under ASC 815

Provided bitcoin futures meet the definition of a derivative under ASC 815, they would be recognized at fair value, with subsequent changes in fair value through earnings. ASC 815 allows for all or a portion of a derivative to be used as a hedging instrument, and how an entity may apply the hedge accounting rules to a hedging relationship involving bitcoin futures generally depends on the nature of the risk being hedged.

For example, if an entity has an exposure to market price fluctuations related to a holding of bitcoin recorded as an asset on the balance sheet, then a fair value hedge may be appropriate. Alternatively, if an entity has an exposure to market price fluctuations as a result of future forecasted purchases or sales of bitcoin, the entity may enter into a cash flow hedge. Clearly understanding the risk exposure an entity desires to hedge is the critical first step in applying hedge accounting treatment.

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Fair value hedge accounting

A fair value exposure exists when changes in market prices can change the fair value of an existing asset, liability, firm commitment or a homogenous group of each of these and that change in fair value could potentially impact earnings. Examples include a fixed interest rate asset or liability, inventory on hand, or a fixed price firm commitment that meets the definition in ASC 815-10-20.

The risks that can be hedged for a financial asset, liability or firm commitment are benchmark interest rates, creditworthiness, foreign currency or a combination thereof, including the overall change in fair value. If an entity is hedging a nonfinancial asset, liability, or firm commitment, the risk being hedged should be the overall change in fair value. As a result, entities' determination of the nature of bitcoin may impact the risk exposures eligible for hedge accounting treatment.

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Cash flow hedge accounting

A cash flow exposure exists when an entity may be exposed to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk. Examples include forecasted cash flows related to revenue denominated in a foreign currency, forecasted cash outflows related to the payments made on variable rate debt issued by an entity, or forecasted variable cash flows on the purchase of goods or services whose value is derived from an observable market (e.g., the purchase or sale of a commodity).

An entity may designate a derivative instrument as a cash flow hedge of an exposure to the variability in the expected cash flows of a recognized asset or liability or of a forecasted transaction. When a cash flow hedge is highly effective and meets all of the hedge accounting criteria of ASC 815, changes in the fair value of the hedging instrument are recorded in other comprehensive income and released into earnings in the period in which the variability from the forecasted transaction is also recorded in earnings.

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Hedge effectiveness

Hedge accounting treatment is limited to relationships that are expected to be "highly effective" in achieving offset in either the changes in fair value (for a fair value hedge) or variability in cash flows attributable to a hedged risk (for a cash flow hedge) during the hedging period.

While entities must assess hedge effectiveness prospectively at hedge inception and both retrospectively and prospectively on an ongoing basis, there's no prescribed method in how entities must do so. Instead, ASC 815 indicates that the assessment should be based on the objective of an entity's risk management strategy. Entities typically use one of two approaches depending on the nature of the hedging relationship:

• The "long-haul" method (if an entity in performing its assessment determines the critical terms of the hedging instrument and the hedged item match)
• The critical-terms-match method

The results of an entity's effectiveness assessment will indicate whether or not ineffectiveness will be recorded in any given period, and how ineffectiveness is recorded differs depending on whether an entity has a fair value hedge or a cash flow hedge.

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Consideration of ASU 2017-12

On August 28, 2017, the Financial Accounting Standards Board (FASB) issued ASU 2017-12,4 which amends the hedge accounting recognition and presentation requirements in ASC 815. The Board’s objectives in issuing the ASU are to:

• 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
• Reduce the complexity of and simplify the application of hedge accounting by preparers

The requirement that an entity determines at the inception of the hedging relationship that a hedging relationship will be highly effective hasn’t changed with the adoption of ASU 2017-12. Similar to ASC 815, ASU 2017-12 requires an entity to perform an initial prospective quantitative assessment unless the hedging relationship qualifies for the application of one of the expedients that permits an assumption of perfect hedge inception (e.g., the shortcut method or the critical-terms-match method). However, if an entity can, at 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 under ASU 2017-12. This change may lessen the operational burden for entities that apply hedge accounting using bitcoin futures for reporting periods subsequent to hedge inception.

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Beyond bitcoin

With the increasing number of cryptocurrencies and tokens available, entities may look to use bitcoin futures to hedge exposure to other cryptocurrencies. Known as a “proxy hedge,” this practice is most common on exposures to foreign currency risks, but may also be found in commodity markets. Similar to using bitcoin futures to hedge bitcoin exposures, entities will need to demonstrate prospective effectiveness between the bitcoin future and the exposure being hedged to qualify for hedge accounting treatment.

Want to learn more? Download the full report, “Risk management in the digital age: Bitcoin futures and hedge accounting.”

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