Hedge Accounting Changes

Companies have indicated that the hedge accounting requirements in current guidance sometimes prevent companies from properly recognizing the economic results of their hedging strategies within their financial reporting.  As a result the Financial Accounting Standards Board (FASB) issued a new accounting Standards Update (ASU) 2017-12 “Improvements to Accounting for Hedging Activities.”  The stated objective of the ASU is to better align hedge accounting with an organization’s risk management activities in the financial statements and simplify the application where issues exist.

Discussed below are key changes to te amended guidance:

1. Risk Component Hedging
   1. The amendment allows defining the risk being hedged in commodity exposures as any commodity price component; however, this attribute must be a contractually specified component in the contract.  The original guidance required identifying the full price of any commodity exposure as the risk being hedged.
   2. The ASU eliminated the concept of benchmark interest rates for hedges and allow component hedging for interest rate exposures for any contractual interest rate component in a cash flow hedge.
   3. The amendment added the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate as a permissible benchmark rate.  It also allows Treasury rates, LIBOR Swap rates, and Fed Funds swap rates for fair value hedges.
2. Fair Value Hedges of Interest Rate Risk
   1. Under the new ASU, the same discount rate can be used as the one that applies to the hedging derivative when calculating the basis adjustment on the hedged item.
   2. The ASU allows an entity to calculate the change in the fair value of the hedged item assuming the same term as the derivative designated as the hedging instrument.  That is a portion of the term of a financial instrument may be designated as the hedged risk as opposed to the full maturity of the longer-maturity instrument that serves as the source of the exposure being hedged.
   3. Allowed to consider the effect of prepayment option only as it relates to the designated hedged risk.  This allows for more flexibility in calculating the carrying value adjustment for fair value hedges.
   4. The new ASU allows the “last of layer” approach in hedges of portfolios of prepayable financial assets or one or more beneficial interest secured by the portfolio.
3. Recognition and Presentation of the Effects of Hedging Instruments
   1. Hedge gains and losses must be posted to the income statement line that is used to present the earnings effect of the hedged item.
   2. For cash flow hedges, both effective and ineffective amounts will be recorded in Other Comprehensive Income and reclassified to the same income statement line item as the hedged item when the hedged item affects earnings.
4. Amounts Excluded from the Assessment of Hedge Effectiveness
   1. In assessing hedge effectiveness, the amendment allows an entity to exclude the portion of the change in fair value of the currency swap that is attributable to a cross-currency basis spread.
   2. The amendment allows excluded hedge gains and losses to be reflected in earnings on a systematic and rational method.  If an entity elects the method, any difference between the change in fair value of the excluded component and amounts recognized under the systematic and rational method is recognized in other comprehensive income.
5. Other Simplifications
   1. After an initial quantitative effectiveness assessment, an entity may perform subsequent assessments of hedge effectiveness qualitatively.  This qualitative testing should be assessed on a hedge by hedge basis.
   2. The critical terms match method would be met if the hedging derivative matures within 31 day period of the period in which the forecasted event occurs.
   3. If an entity that applies the shortcut method determines that use of that method was no longer appropriate, the entity may apply a long-haul method for assessing hedge effectiveness provided an alternative effectiveness assessment methodology had been specified in the hedge document.

ASU 2017-12 will become effective for Public business entities for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years.  The ASU will become effective for entities other than public business entities for fiscal years beginning after December 15, 2019 and interim periods within fiscal years beginning after December 15, 2020. 

Early adoption is permitted in any interim or annual period upon issuance of the final update.  A modified retrospective approach should be applied as of the adoption date, while the retrospective method will not be allowed.

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