Update aims to simplify, expand hedge accounting

More businesses guarding against price jumps in raw materials, changes in interest rates, or fluctuations in foreign currency will be able to avoid swings in earnings under an update to U.S. GAAP the FASB published on Aug. 28, 2017.

Accounting Standards Update (ASU) No. 2017-12 Derivatives and Hedging (Topic 815 — Targeted Improvements to Accounting for Hedging Activities), aims to make U.S. GAAP’s complex hedge accounting guidance easier to understand and applicable to a wider range of transactions. The update will be effective for public companies starting after Dec. 15, 2018. Private companies and other organizations will have another year to comply. Early adoption will be allowed.

Unlike many FASB endeavors, businesses, accountants and investors almost universally supported the changes.

“Watching a project where preparers, auditors and investors are uniformly applauding it really gives you a lot of comfort that we are doing something that’s going to be helpful,” FASB Vice Chairman James Kroeker said.

Businesses “hedge” their exposure to spikes in raw material prices, foreign exchange rates, and interest rates by buying derivatives such as futures, options, or swaps. Under Topic 815, Derivatives and Hedging, formerly SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, changes in the value of the derivatives must be recorded at fair value on the income statement. Under certain conditions, companies may employ hedge accounting, which involves designating a derivative instrument to a hedged item and then recognizing gains and losses from both items in the same period. When done right, the specialized accounting keeps the price swings out of reported earnings, avoiding volatility that can turn off investors and creditors.

Because hedge accounting allows deferral of gains and losses, there is a high barrier to qualify for it. Developed in the aftermath of high-profile financial derivatives blowups in the 1990s, the rules require hedged transactions to be documented at inception and to be “highly effective.” Businesses must periodically assess the transactions for their effectiveness.

Some businesses have criticized the rules as overly strict, however, saying bona-fide risk management techniques often do not qualify. Others told the FASB they avoid trying to use hedge accounting because the potential for errors is too high. Hedge accounting problems are a significant reason companies have to restate their earnings.

(ASU) No. 2017-12 attempts to address these criticisms. As hedging is a complicated area, it will not instantly make the accounting easier, but it will make it more accessible, said Rob Royall, Ernst & Young LLP’s derivatives and financial instruments solution leader.

“The effort to qualify for hedge accounting and to do the math is still there,” Royall said. “But once you qualify and you enter, the ongoing maintenance is definitely easier. You will benefit by robust work up front. And then your hedge that may go on for years and years, that’ll be easier to manage.”

Broadly, the update expands what hedging strategies are eligible for hedge accounting, such as for hedging contractually-specified price components of a commodity purchase or sale, hedges of 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, according to PricewaterhouseCoopers LLP.

For oil-and-gas, agriculture, and food-processing companies, the expansion of commodity risk hedging is expected to be welcome news. Under existing rules, companies have to hedge the entirety of a contract, arrangement, or expected purchase even if they were trying to only hedge the risk of a specific component. With the update, companies will be able to isolate the risk associated with variability in cash flows attributable to a raw ingredient to make a final product.

The catch: the component must be “contractually specified.” For some transactions, the component will not be spelled out in a contract, so these may not qualify for hedge accounting. Some close readers of the FASB’s draft plan asked the board to consider a looser requirement so companies would not have to worry about poring over old contracts and renegotiating terms just to qualify for an accounting method.

But the FASB wanted to put up appropriate barriers for what the board considers an accounting privilege, not right.

“It strikes the right balance of aligning risk management without opening up the opportunity for speculation in a hedge,” Kroeker said. “We struck a line: You have to be able to see it. You can’t just say, ‘Trust me, it’s in there’.”

Bankers also will see a major change with a provision that will let them hedge a portion of prepayable assets in a portfolio, a method called the “last-of-layer” approach. For a lender looking at a pool of 30-year mortgages, for example, and assessing the odds of prepayment, the lender could assume that a portion of customers will not pay off their mortgages early. The update allows banks to take this slice of the portfolio and manage it based on the risks associated with this group of assets versus the rest of the mortgages in the portfolio, which could be paid off earlier.

This is a “game changer,” said Michael Gullette, the American Bankers Association vice president for tax and accounting.

The newly allowed accounting matches bank risk management practices and further opens up new ways to mitigate the effect of interest rate fluctuations or capital buffer changes on earnings. Even small community banks will be able to follow this, Gullette said.

“We could see a big increase in the number of banks who try to apply this,” he said. “Everybody’s assuming interest rates are going up, so there’s this element of interest rate risk they need to adjust. This allows them a pretty easy way to do so.”

Other aspects of the update affect all kinds of businesses.

To simplify the reporting of hedge results, the FASB eliminated the separate measurement and reporting of hedge ineffectiveness. Mismatches between changes in value of the hedged item and hedging instrument may still occur but they will no longer be separately reported, the FASB said.

The board also offered some relief for some documentation requirements.

In addition, the FASB eliminated what critics have called an onerous penalty in the “shortcut” method of hedge accounting, a simplified hedge accounting technique that can be used for interest rate swaps that meet specific criteria. Under current GAAP, if the shortcut method is applied and then it is determined that using the shortcut method was not appropriate, hedge accounting cannot be applied to that transaction. With the update, the FASB is expected to let the so-called long-haul method for assessing hedge effectiveness apply to the transactions if the hedge if highly effective.

Other changes include adding the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate to a list of acceptable benchmark interest rates for hedges of fixed-interest-rate items.

“They kind of, in my opinion, bent over backward to get hedge accounting to what we all thought it should be,” Gullette said.

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