FASB’s Changes to Hedge Accounting Standards Seen as Most Significant Since 1998
In August 2017, the Financial Accounting Standards Board (FASB) issued a final Accounting Standards Update (ASU) designed to improve and simplify accounting rules around hedge accounting. One tax pro views the latest change on hedge accounting to be the most significant since 1998.
“Companies and investors alike have expressed overwhelming support for this long-awaited standard,” stated FASB Chairman Russell G. Golden. “Thanks to their input, the final ASU better aligns the accounting rule with a company’s risk management activities, better reflects the economic results of hedging in the financial statements, and simplifies hedge accounting treatment.”
According to the FASB, the new standard, ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, “refines and expands hedge accounting for both financial (e.g., interest rate) and commodity risks. Its provisions create more transparency around how economic results are presented, both on the face of the financial statements and in the footnotes, for investors and analysts.”
The new standard takes effect for fiscal years (and interim periods within those fiscal years) beginning after December 15, 2018, for public companies and for fiscal years beginning after December 15, 2019 (and interim periods for fiscal years beginning after December 15, 2020) for private companies, according to FASB. Early adoption is permitted in any interim period or fiscal years before the effective date of the standard.
Jon Howard, senior consultation partner in the Financial Instruments Group of Accounting Services in the Deloitte & Touche LLP (DTTL) national office, says the issuance of this new standard marks the most significant revision of the hedge accounting standard the accounting profession has seen since the issuance of FASB Statement No. 133 in 1998.
The new standard, Howard says, will make it simpler than ever for companies to achieve hedge accounting. More importantly, it’s easier to reduce volatility and enable steadier financial results. Public companies have already begun utilizing the new standard, Howard says, and now private companies are taking notice and want to understand what’s now entailed in applying hedge accounting.
AccountingWEB recently conducted a Q&A with Howard and Chris Monteilh, partner in the banking & securities practice at DTTL, to better understand the implications of this new standard and the impact it may have on small businesses and the CPAs who serve them.
AW: Can you please break down, in general, how this new standard revamps hedge accounting over the prior standards and practices?
Howard: The targeted improvements to hedge accounting eliminate the notion of measuring ineffectiveness. As long as your hedging relationship is highly effective, the impact of the derivative will be recognized in the same period as the hedged item. In addition, the improvements added several new ways to hedge components of items, instead of all of the changes in fair value or cash flows. Entities may now hedge contractually specified components of nonfinancial assets, and there are many new components of fixed-rate financial assets that may be hedged.
The targeted improvements also provide some relief with the ongoing compliance aspects of hedge accounting. In order to achieve hedge accounting, entities must show why they expect a hedging relationship to be highly effective at inception and then show that is has been highly effective on an ongoing basis. With the addition of the new components that may be hedged, many of the sources of ineffectiveness in common hedging relationships have been either significantly reduced or eliminated. If the hedge is deemed “perfect,” then the analysis is purely qualitative. If the hedge is not perfect, this analysis must be quantitative at inception, but the ongoing assessments may be qualitative in certain circumstances.
AW: Why does it matter? Will this new standard truly make hedge accounting easier and simpler for all to achieve? And how might the changes reduce volatility and enable steadier financial results?
Howard: Hedge accounting will be easier to achieve. The addition of new risk components reduces sources of ineffectiveness in many hedging relationships. This means that more hedging relationships will qualify for hedge accounting. In addition, the whole notion of separately measuring and recognizing ineffectiveness has been eliminated. For cash flow and net investment hedges, all changes in fair value of the derivative are recorded in other comprehensive income, and released into earnings when the hedged item impacts earnings. Prior to the changes, ineffectiveness would have been recognized in earnings during the life of the hedge. For fair value hedges, the recognition model didn’t really change — changes in fair value of the derivative are recognized in earnings, but the hedged item is also remeasured for changes in its fair value due to changes in the hedged risk and those changes are also recognized in earnings. However, with the new risk components that have been added in interest rate hedging, there should be much better offset in those amounts.
AW: How can this new standard help small business owners and the CPA firms who work with them? Will it fulfill its promise of simplification and accounting rules that “better reflect the economic results of hedging in the financial statements?”
Howard: While the targeted improvements are helpful to all entities that want to apply hedge accounting, there are some additional simplifications that are only applicable to private companies that are not financial institutions, and to most not-for-profit entities. Qualifying entities get relief on the timing of the hedge designation documentation. At the inception of the hedge, these entities can prepare an abbreviated form of hedge designation documentation, and complete all of the other required components of the hedge documentation (including the hedge effectiveness assessment) by the time their next interim or annual financial statements are available to be issued. When you combine this relief with all of the other changes, we believe this will fulfill its promise.
AW: What, in particular, do the CPA firms who work with small business clients need to know about this new standard?
Monteilh: CPA firms will need to understand the changes in the standard to be able to help their clients identify and assess current and future hedging strategies and advise on changes to hedge accounting policies and documentation. CPA firms should consider clients’ governance and hedging strategy development, process redesign and control mapping, and changes that might occur to valuation and modeling of derivative positions.
AW: What are the top “lessons learned” from early adopters who have already implemented the new standard as they relate to small businesses?
Howard: The effort to adopt the new standard really depends on how significant an entity’s current use of hedge accounting is, and that can cut both ways. Upon transition, an entity is required to apply the new standard to all of its existing hedging relationships, as if it had been applying the mechanics of the new standard to those hedges since the inception of the hedging relationship. This will result in a cumulative effect adjustment to retained earnings as of the beginning of the fiscal year of adoption. There are also one-time elections that can be made for those existing hedges, including modifying the designated risk and potentially formally changing to qualitative ongoing effectiveness assessments. When you consider all of that, the larger your hedging book, the more effort it takes to make sure you have a thoughtful and thorough adoption.
Now if you consider the other side of the spectrum, if an entity has not been applying hedge accounting at all, while there is no transition effect to calculate, the entity needs to think about how to ensure it has proper internal controls over financial reporting for something it has not done before. Hedge accounting requires contemporaneous designation documentation (with some of the timing relief we discussed before), that also requires a discussion of how the hedging relationship is consistent with an entity’s risk management objective and strategy for undertaking the hedge. The entity will also need to assess whether it qualifies to do qualitative hedge effectiveness assessments, or if not, how it will perform the quantitative assessment. These are certainly not insurmountable obstacles, and they are easier than before, but there is a level of effort required when you are doing something you have not done before. Small businesses will more often fall into this category.
AW: Can you please give us some examples of the types of small businesses this new standard will impact, and how CPAs can employ the new standard to significantly reduce long-term risk and volatility within financial statements for small business owners?
Howard: We think one of the common misperceptions of this standard is that it is really just for financial services companies. While they may be heavy users of hedge accounting, the standard does provide financial reporting that can match the timing of the effect of proper risk mitigation activities with the actual exposures that entities are managing. This is not industry specific. Entities that issue variable rate debt often decide to hedge some of the exposure to increasing interest rates through the use of interest rate swaps or interest rate caps. Businesses that use commodities in their operations often use derivatives to hedge against the risk of changes in the price of that commodity to protect their margins. The use of hedge accounting can significantly reduce the volatility in earnings for those activities.
Deanna Arteaga is a professional freelance writer and public relations specialist who for the past six years has covered CPA industry trends for AccountingWEB. She also writes about CPA firm marketing, higher education and professional development for CPAs, and workplace trends in the accounting profession. She has more than 20 years...