The Financial Accounting Standards Board (FASB) recently issued Accounting Standards Update (ASU) No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. The updated standard makes the hedge accounting guidance easier to understand and apply to a wider range of transactions.
Businesses often use hedging strategies to protect earnings from unexpected price jumps in raw materials, changes in interest rates or fluctuations in foreign currencies. How do these strategies work? A business purchases futures, options or swaps and then designates these derivative instruments to a hedged item. Gains and losses from both items are then recognized in the same period.
Effective use of hedge accounting can help minimize volatility in a company’s earnings. But many businesses don’t apply the hedge accounting rules, even if they’re using hedging strategies.
One reason is the high barrier to qualify for hedge accounting: Developed in the aftermath of high-profile financial derivatives blowups in the 1990s, the existing rules require hedged transactions to be documented at inception and to be “highly effective.” Businesses must periodically assess the transactions for their effectiveness.
Another reason businesses refrain from applying the hedge accounting rules is that the potential for errors is too high. The guidance on hedging is one of the most complex areas of U.S. Generally Accepted Accounting Principles (GAAP). And hedge accounting problems are a significant reason companies have to restate their earnings.
In turn, investors complain that, when a business sidesteps the hedge accounting rules, it prevents them from truly understanding how the business operates. The new standard tries to address these potential shortcomings.
ASU 2017-12 expands the strategies that are eligible for hedge accounting to include: 1) hedges of the benchmark rate component of the contractual coupon cash flows of fixed-rate assets or liabilities, 2) hedges of the portion of a closed portfolio of prepayable assets not expected to prepay, and 3) partial-term hedges of fixed-rate assets or liabilities.
In addition, the updated standard allows for hedging of nonfinancial components, such as corrugated material in a cardboard box or rubber in a tire. With the update, companies will, for example, be able to isolate the risk associated with variability in cash flows attributable to a raw ingredient used to make a final product. There is a catch, however: To qualify for hedge accounting, the price of the component must be specifically carved out in a purchase (or sale) contract.
The FASB also eliminated what critics have called an onerous penalty in the “shortcut” method of hedge accounting. This is a simplified hedge accounting technique that can be used for certain interest rate swaps. Under the old rules, if a company applies the shortcut method to a transaction and management subsequently determines that using the shortcut method was inappropriate, the hedge accounting rules can’t be applied to the transaction. With ASU 2017-12, companies in this situation can use the long-haul method to assess effectiveness.
Other updates include:
- Eliminating the concept of recording hedge “ineffectiveness,”
- 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,
- Revising the presentation and disclosure requirements for hedging to be more user-friendly, and
- Providing practical expedients to make it easier for private businesses to apply the hedge accounting guidance.
“Companies and investors alike have expressed overwhelming support for this long-awaited standard,” FASB Chairman Russell Golden said in a statement. “Thanks to their input, the final ASU better aligns the accounting rules with a company’s risk management activities, better reflects the economic results of hedging in the financial statements, and simplifies hedge accounting treatment.”
The update will be effective for public companies for reporting periods starting after December 15, 2018. Private companies and other organizations will have an extra year to comply with the changes. The FASB is permitting early adoption. Companies that use hedging strategies universally welcome the changes to the hedging guidance, and many expect to implement the updated standard early.