Last August, the Financial Accounting Standards Board (FASB) issued an update that simplifies accounting rules around hedge accounting. The update is effective for public companies in 2019 and private companies in 2020, but early adoption is permitted. With several options available in the implementation, the full impact of the new guideline must be carefully determined before setting an adoption date.
FASB Rationale for the new guideline on hedge accounting
The amendment issued by the FASB on accounting rules around hedge accounting responds to the difficulties in applying the standard. The statement of Financial Accounting Standards No. 133 was issued in 1998 and became effective in 2000. The implementation was judged by many to be too hard and many hedging strategies did not qualify for hedge accounting.
New rules bring more exposures to be hedgeable, facilitate the calculations and, ultimately make it easier for more companies to adopt the standard. The amendment also addresses the limitations for hedging both financial and non-financial risks. Ultimately, it clarifies previous concerns over the manner of reporting.
Some of the central principles of ASC 815 are maintained. Hedge accounting is still divided into Fair Value, Cash Flow and Net Investment. Several definition remain the same: derivative; bifurcation of embedded derivatives; reporting requirements in case hedge accounting is not elected or sought; ability to discontinue hedge accounting on a voluntary basis; need for prospective and retrospective assessment; quantitative thresholds for effectiveness.
The most notable changes
More hedging strategies will be eligible for hedge accounting. These include cash flow hedges of a component of a non-financial item, such as the purchase or sale of a commodity. It will be possible to hedge a contractually specified component of the risk. For example, it will be possible to exclude transportation costs. This was the biggest hurdle to hedging commodities.
For financial contracts, any contractually specified component, usually an interest rate benchmark, can be included. These include the benchmark rate component of the contractual coupon, cash flows of fixed-rate assets or liabilities, hedges of the portion of a closed portfolio of prepayable assets not expected to prepay, and partial-term hedges of fixed-rate assets or liabilities (e.g., the first and second years of a five-year bond). The new rules give more latitude in the choice of the benchmark. For cash flow hedges, the amendment gives the ability to use any contractually specified benchmark for rates.
In the case of a fair value hedge of interest rate risk, the choice of benchmark is limited. The SIFMA index (municipal bonds) has been added but this is not very meaningful for corporates. It is now possible to designate only a portion of the cash flows in the hedging relation.
The new standard permits a qualitative assessment for certain hedges on an ongoing basis. Although an initial quantitative assessment such as a regression analysis is still required upfront to establish that the hedge relationship is highly effective, this avoids producing calculations at every period.
Change to the recognition of cash flow hedges
Under the new standard, if a cash flow hedge is highly effective, changes in fair value of the hedging instrument will be recorded in OCI. On the other hand, for fair value hedges, changes of the hedge item and the hedging instrument’s fair value will be recorded in current earnings.
Last but not least, there are changes to presentation. Before, there wasn’t any prescriptive guidance. Now there is. The change in fair value of a derivative is presented in the same income statement line item as the earnings effect of the hedged item.
- must use same line location for hedge and hedge item
- new tabular presentation
- new for fair value hedges – basis adjustment to be amortized
- benchmark component vs. total coupon and shortcut for late hedging
- eliminated reporting of ineffectiveness
- qualitative assessment of effectiveness
- more time to calculate
- shortcut method: quantitative fallback
- de minimis issue goes away
- commodity hedging greatly improved
- ability to switch between spot method and forward method for non-interest hedges
- partial term hedging for fixed rate debt