Changes to accounting for hedge activities are on the horizon, and for companies that engage in these activities, the simplifications in the new accounting standard couldn’t come soon enough. Hedge accounting errors have long been a trouble spot for financial reporting, in some cases leading to financial restatements.
The Financial Accounting Standards Board (FASB)’s Accounting Standards Update 2017-12, Derivatives and Hedging (Topic 815) Targeted Improvements to Hedging Activities (ASU 2017-12) is designed to alleviate some of the complexity in hedge accounting. It aligns hedge accounting with risk management strategies, simplifies the application of hedge accounting, and increases transparency of hedging programs. Topic 815 changes also include increasing the eligibility for hedge accounting, simplifying effectiveness testing, and amending the presentation and disclosure requirements.
New Hedging Opportunities
Entities that are interested in hedging cash flow risks related to the purchase of goods that are heavily influenced by the price of commodities will be interested in the new ability to designate a cash flow hedge for a contractually specified price component of a nonfinancial item. For example, a company that purchases high fructose corn syrup under a contract that is dependent on the price of corn will now be able to designate only the component of the contract tied to corn prices as a hedge. Previously, such an entity could only designate the entire contract as a hedged item. This would have caused difficulties in trying to initially qualify, and subsequently apply, hedge accounting because of the ineffectiveness of hedging a contract for corn syrup to the prices of corn. In addition, under the changes to Topic 815, entities may hedge a specified component of a not-yet-existing contract that is expected to have a contractually specified component.
In another expansion of what is permitted in a cash flow hedge, the update expands guidance for hedges of interest rate risk by eliminating the concept of benchmark interest rate for a variable-rate financial instrument. An example relevant to many companies is borrowings based on the issuing bank’s prime rate. Previously, a company would not have been able to designate the hedge based on the bank’s prime rate, which increased the complexity of qualifying and applying hedge accounting. The changes to Topic 815 permit an entity to designate a hedged risk for the variability in the bank’s prime rate.
Opportunities may also be available for new fair value hedges. Entities can designate parts of an interest rate hedge, including benchmark components, portions of the remaining term and the amount not affected by prepayments for pre-payable financial assets (eliminating the need to match prepayment risk). The accounting standards update adds the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate as a benchmark rate because it is expected that the London Inter-Bank Offered Rate (LIBOR) is going to be discontinued.
Another change in ASU 2017-12 is expected to reduce the challenges in internal controls and preparing documentation to designate a hedge. The update eliminates the requirement for contemporaneous documentation with hedge designation. For public business entities, the initial assessment is required by the end of the first quarter in which a hedge is designated. All other companies will have until their financial statements are available to be issued to complete their documentation. Documentation once completed must include the initial effectiveness assessments and the quarterly assessments since hedge inception.
Just as importantly, the update permits the use of a qualitative approach for the quarterly assessments of hedge effectiveness after the initial effectiveness testing. This change will reduce computational and data burdens on companies. As an added bonus, the change also means that the separate presentation and disclosure of the amount of hedge ineffectiveness will no longer be required, resulting in financial statements that are easier to prepare and easier for financial statement users to understand. To qualify to use the qualitative approach, an entity will need to reasonably support that the hedge is highly effective and is expected to remain highly effective. Entities that use the qualitative effectiveness assessment must document quarterly whether facts and circumstances have changed.
Another simplification to the initial testing of effectiveness of a hedge and the subsequent accounting is the introduction of an election to exclude option premiums, forward points, and cross-currency basis for a currency swap from the effectiveness assessment. The value of excluded components is recognized ratably into earnings. Fair value differences are recognized in other comprehensive income, and entities may elect to recognize them into current earnings.
The FASB has also expanded the ability to use the methods that are simpler then initial effectiveness testing to designate a hedge, potentially further reducing the cost of designating an accounting hedge. An entity will be able to apply the critical terms match method to a group of forecasted transactions. Entities must assume that the hedging derivative matures at the same time as the forecasted transaction if both maturities occur within the same 31-day period or fiscal month.
In practice, the shortcut method for designating a hedge has fallen out of practice because of the risk that a restatement be triggered if subsequent to hedge designation it is discovered that the designated hedge no longer qualifies for hedge accounting. Entities that would prefer to use the shortcut method will be interested to learn that under ASU 2017-12, they may now designate a back-up long-haul method if the shortcut method is no longer appropriate. The back-up long-haul method will help the entity avoid financial restatement if the hedge is highly effective and documentation of the back-up long-haul methodology is done at hedge inception.
Presentation of Hedge Instrument Earnings
The update eliminates the separate measurement and reporting of hedge ineffectiveness. All changes in the fair value of the derivative hedging instrument for cash flow and net investment hedges will be recorded in other comprehensive income. Entities will reclassify the changes to earnings when the hedged item affects earnings. For fair value hedges, changes in fair value of the hedged item and the derivative financial instrument are recorded in current earnings in the same income statement line item.
Disclosures will change under the new standard. Tabular disclosures related to the effect on the income statement of fair value and cash flow hedges are required. Fair value hedges will require tabular disclosures related to cumulative basis adjustments. The disclosure of the ineffective portion of the change in fair value of hedging instruments is eliminated.
Effective Date & Transition
For public business entities, the standard takes effect for calendar year Dec.31, 2019. All others will adopt for calendar year Dec. 31, 2020. Early application is available in any interim period.
To transition to the standard, entities will use a cumulative-effect adjustment at the beginning of the adoption year. There are several elections to consider, including designating the back-up long-haul method for hedge accounting performed under the shortcut method.
Hedge accounting will now be better able reflect the way business are run and how information is communicated to financial statement users. Even though the complexity of the guidance is not eliminated, the changes do make it easier to apply hedge accounting and more forgiving when under audit. As a result, many who have not utilized hedge accounting in the past may now find giving hedge accounting a second look will be a worthwhile.
For more information about how the change to hedge accounting may affect your business, please contact us.
Joyce is a Managing Director in the Accounting and Auditing Group in New England. She can be reached at 401.626.3224 or email@example.com.
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