Proposed Statement: Accounting for Hedging Activities, an amendment of FASB 133
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By: Linda Cavanaugh, CPA This proposed Statement would amend FAS 133 to a) simplify accounting for hedging activities, b) make the accounting model and disclosures more useful and easier to understand, c) resolve practice issues related to current hedging rules, and d) address differences between recognition and measurement of the derivative instrument and the hedged item.
The scope of the proposed Statement is the same as FAS 133 and it does not change the types of items or transactions that are eligible for hedge accounting.
Hedge Effectiveness Requirements
At the beginning of the hedging relationship, an entity should document that the hedging relationship is reasonably effective by performing a qualitative assessment that demonstrates “1) an economic relationship exists between the hedging instrument and the hedged item or hedged forecasted transaction and 2) changes in the fair value of the hedging instrument would be reasonably effective in offsetting changes in the hedged item’s fair value or the variability in the hedged cash flows.” A quantitative assessment may be necessary under certain situations. (Examples are given in the appendix to the proposed Standard.) This assessment will need to be re-evaluated if circumstances suggest that the hedging relationship may no longer be reasonably effective. This is different from current practice that requires a quantitative assessment that the relationship is highly effective and requires the assessment to be re-evaluated each reporting period.
The documentation of the qualitative assessment should include “the risk management objective expected to be achieved by the hedging relationship and how the hedging instrument is expected to manage the risk or risks inherent in the hedged item or forecasted transaction”. Also the basis for expecting that the hedging instrument would be reasonably effective in offsetting changes in the hedged item’s fair value and the sources of volatility for the hedged risk should be documented. The counter-parties’ credit risk should be taken under consideration. These documentation requirements are basically the same under FAS 133.
If the risk being hedged is the variability in cash flows related to a group of forecasted transactions within a specific time period, an entity may assess effectiveness using a method that would include a derivative that settles within a reasonable period of time related to the forecasted transaction. This is different than current practice, which requires the timing of the hedged instrument and hedged item to match exactly.
De-designation of Hedging Relationship
A hedging relationship can not be de-designated unless the criterion in paragraphs 20 and 21 (for fair value hedges) and paragraphs 28 and 29 (for cash flow hedges) is no longer met or the hedging instrument expires, is sold, terminated or exercised. Entering into an offsetting derivative instrument would effectively terminate a hedging relationship if the appropriate and concurrent documentation is prepared. These hedging instruments can not be designated as part of a hedging relationship in a future transaction. This is different from current practice where the entity can de-designate and re-designate hedging relationships at any time.
If a cash flow hedge is terminated by entering into an offsetting transaction, any gains or losses in Other Comprehensive Income (OCI) would remain in OCI until the original forecasted transaction affects earnings or is no longer probable of occurring.
Hedged Risk – Fair Value Hedge
The designated risk in a fair value hedge must be the risk of changes in the overall fair value of the hedged item or changes in the fair value attributable to only foreign currency exchange rates. This differs from current practice, in that an entity could choose which risks were being hedged. (For example, interest rate risk, price risk, or credit risk.)
An exception is the designation of an entity’s own debt (at the inception of the debt) as the hedged item. In this case, the interest rate risk or the foreign exchange rate risk or a combination of both can be designated as the hedged risk.
If the hedged item is a held-to-maturity debt instrument then only the foreign exchange risk may be designated as the hedged risk.
When measuring fair value, the measurement of the hedged item is to be independent of the measurement of the hedging instrument.
Hedged Risk – Cash Flow Hedge
The designated risk in a cash flow hedge must be the risk of overall changes in the hedged cash flows or the risk of changes in functional-currency-equivalent cash flows attributable to foreign currency exchange rates. As above, this is different than current practice where the individual risks could be designated as the hedged risk.
Hedge ineffectiveness is to be measured as the difference between the change in fair value of the hedging instrument and the present value of the cumulative change in expected future cash flows on the hedged forecasted transaction. The amount of the gain or loss recognized in Accumulated Other Comprehensive Income (AOCI) is to equal the present value of the cumulative change in expected future cash flows less any amount previously reclassified to earnings. The credit risk used to estimate the fair value of the hedging instrument can be used in the estimation of the fair value of the forecasted transaction. The measurement of hedge ineffectiveness under the proposed Statement differs from current practice in that the change in the cumulative fair value of the hedging instrument is compared to the change of the cumulative fair value of the hedged item.
For annual and interim reporting periods a disclosure for assets and liabilities reported within a single line item in the balance sheet that includes fair value adjustments, the following items should be disclosed:
1.The carrying amount of the assets or liabilities included within the line item
2.Cumulative fair value adjustments related to FAS 133 fair value hedging relationships
3.Cumulate fair value adjustments other than those related to FAS 133 fair value hedging relationships
4.The carrying amount of the assets or liability excluding any fair value adjustments.
If an entity designates interest rate risk in a hedging relationship of its own issued debt or other borrowings, the entity needs to add to its debt disclosure the following items:
1.Its use of derivative contracts to convert a portion of its fixed-rate debts to variable-rate debt or vice-versa
2.The relationship of the maturity structure of the derivatives to the maturity structure of the debt being hedged
3.The overall weighted-average interest rate both including and excluding the effects of derivatives designated as a hedge of its debt or the related interest payments.
If adopted this proposed Statement would be effective for fiscal years beginning after June 15, 2009 or for the first quarter 10Q in 2010.
At the date of initial application, all hedging relationships are to be de-designated, unless the hedged risk is permitted under both FAS 133 and the proposed Statement. The hedging relationships are to then be re-designated using the hedging criteria in the proposed Statement.
For cash flow hedges, the gains or losses in AOCI need to be adjusted to equal the difference, if any, between the fair values of a derivative that would provide cash flows that would exactly offset the hedged cash flows and the amount in AOCI related to the hedge just prior to initial application. Any adjustment is made to retained earnings.
At the date of initial application, an entity may transfer any held-to-maturity security for which it intends to manage certain risks inherent in the instrument into the available-for-sale category or the trading category. The securities transferred to available-for-sale can then be designated as the hedged item in a fair value hedge. The carrying value of the securities transferred is to be adjusted to fair value with the adjustment being recognized in retained earnings.
At the date of initial application, an entity may elect to account for any servicing assets or servicing liabilities that were designed as a hedged item immediately preceding initial application at fair value under FAS 156 – Accounting for Servicing of Financial Assets. The adjustment to fair value should be recognized in retained earnings.
At the date of initial application, an entity may elect to account for any financial instrument designated as a hedged item on the date immediately preceding initial application at fair value under FAS 159 – The Fair Value Option for Financial Assets and Financial Liabilities. The adjustment to fair value should be recognized in retained earnings.
Convergence with IFRS:
This proposed Statement would diverge from the guidance currently provided by IAS 39 – Financial Instruments: Recognition and Measurement. However, the IASB is considering two proposed amendments to IAS 39, one of which would bring it in line with this proposed Statement.
We probably won’t hear about this one until after the first of the year. As always, stay tuned.
Linda is a CPA living in Southwestern Ohio, working as a research accountant for an investor-owned publicly traded utility company. She specializes in implementing new FASB and SEC requirements and FAS 133 derivative issues. In her role at the utility she has encountered many issues and written many memos, so send in your implementation and derivative issues and Linda will help figure out an answer.