The Financial Accounting Standards Board (FASB) on Oct. 25, 2018, published an update to U.S. generally accepted accounting principles (GAAP) to add a new interest rate from the market for U.S. Treasury repurchase contracts to the list of accepted benchmark rates for hedge accounting.
Accounting Standards Update (ASU) No. 2018-16, Derivatives and Hedging (Topic 815): Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes, adds the SOFR OIS as a benchmark rate that businesses can use to designate hedges of interest rate risk.
The update follows a decision by a panel sponsored by the Federal Reserve and the Treasury Department to introduce the SOFR OIS as an alternative to the London Interbank Offered Rate (LIBOR), which had historically been the most widely used benchmark interest rate in global capital markets until a price-fixing scandal was exposed in 2012. The SOFR is calculated by the Fed based on the interest rates banks charge one another in the overnight market for loans they make to one another, typically called repurchase agreements. In introducing the new rate, the Fed said that because it is based on transactions in the open market, it is more reflective of market conditions than LIBOR, which relies more on judgment.
Adding the SOFR OIS as an acceptable hedge accounting benchmark for U.S. GAAP is considered a critical step in helping it gain more acceptance in the market.
“In order for us to use it as hedging product, we need it to be liquid; it’s not there yet,” said Ruth Hardie, senior director of interest rates at an accounting consulting firm, in reference to the SOFR OIS. “So I think — or I hope, I should say — the FASB adding it as a benchmark rate will help.”
“It’s expected to get people to think about changes to LIBOR coming along,” said Gautam Goswami, partner at an international accounting firm.
Businesses “hedge” their exposure to changes in interest rates by buying derivatives. According to FASB ASC 815, Derivatives and Hedging, changes in the value of a derivative must be recorded at fair value on the income statement. In certain circumstances, businesses may qualify for 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. The favorable accounting keeps price swings in the underlying instrument out of reported earnings, avoiding volatility that can turn off investors and creditors.
FASB ASC 815 provides guidance on the risks associated with financial assets or liabilities that are allowed to be hedged. Among those risks is the risk of changes in fair values or cash flows of existing or forecasted issuances or purchases of fixed-rate financial assets or liabilities attributable to a designated benchmark interest rate.
U.S. GAAP considers a benchmark rate as a rate that is widely recognized, commonly referenced, and quoted in an active financial market. FASB ASC 815 lists three rates as benchmarks: the rate on direct Treasury obligations of the U.S. government, the Fed Funds Effective Swap Rate (Overnight Index Swap Rate) and the LIBOR swap rate. In 2017, the FASB added a fourth rate, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate when it published ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, which made several other changes to simplify hedge accounting and expand its use.
The FASB wants businesses and organizations to adopt the amendments in ASU No. 2018-16 at the same time they adopt the changes in ASU No. 2017-12.
For public companies that have adopted ASU No. 2017-12, the new amendments are effective for fiscal years beginning after Dec. 15, and interim periods within those fiscal years. For other companies and organizations that already have adopted ASU No. 2017-12, the new amendments are effective for fiscal years beginning after Dec. 15, 2019, and interim periods within those fiscal years. Early adoption is permitted in any interim period as long as the company or organization already has adopted the broader 2017 hedge accounting update.
In the development of the update to add the SOFR as a benchmark rate for hedging purposes, some groups called on the FASB to write a broad principle instead of identifying a rate by name. Coming up with a principle, however, proved difficult when the FASB was writing its separate 2017 update to hedge accounting, so the board said it would commit to working quickly in case regulators introduced new rates.
“I think they’ve proven they can move fast,” Hardie said.
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