Recent changes to FASB's standard for hedge accounting deliver to company finance teams new alternatives to account for their risk management activities that organizations may wish to explore.
"Companies were afraid to apply hedge accounting because it was too challenging to implement, too onerous in the amount of work required, and too punitive in terms of the implications of getting it wrong," said Brian Goetsch, CPA, director, Accounting Advisory Services for KPMG.
That may no longer be the case. Accounting Standards Update (ASU) No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, is designed to make hedge accounting easier to apply in addition to making it more reflective of hedging activities.
However, be sure not to confuse "easier" with "easy." Gautam Goswami, CPA, national assurance partner at BDO, said hedge accounting can be complex even after the changes, and some companies may continue to shy away from it because it is still perceived as more onerous to apply than many other accounting topics. It also remains optional. "Per the FASB's thinking, hedge accounting is a privilege for which the requisite criteria have to be met and, even if met, then hedge accounting is not mandatory but is an election," Goswami said.
Still, the hedge accounting changes may be a game-changer for some companies. Public companies have already gone through the process of evaluating whether they could apply the changes in ASU 2017-12, issued in August 2017, and will continue to do so. But for private companies, the timing is right for them to consider whether hedge accounting can be applied for the first time or to manage existing business risks.
Here is some background on hedge accounting, what is changing, and how it has emerged as a more viable approach. For guidance on how the uncertainty created by the coronvirus pandemic is affecting hedging strategies, see the sidebar, "COVID-19 May Affect Hedge Activities."
THE PROBLEM TO SOLVE
The legacy accounting framework for derivatives and hedging is FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, issued in 1998 (now contained in FASB ASC Topic 815, Derivatives and Hedging). Before Statement 133, there was little detailed guidance in this area, but Statement 133 provided a complex and prescriptive framework. It was amended many times and resulted in a Derivatives Implementation Group that reviewed more than 170 practice issues later incorporated into amendments.
FASB received much feedback over the years that additional improvements were needed to the hedge accounting model. Considering the number of other significant new accounting changes, FASB decided to try to make hedge accounting easier to apply.
FASB's objective was to improve financial reporting of hedging relationships to better portray the economic results of risk management activities in financial statements. This resulted in changes to guidance for designating and measuring qualifying hedges and presenting hedge results. In addition, the amendments intend to simplify the guidance in current GAAP, including the timing of required documentation and the assessment of hedge effectiveness. Along with this new standard come some new disclosure requirements.
The ASU applies to all entities that elect hedge accounting. It became effective for public business entities for fiscal years and interim periods beginning after Dec. 15, 2018. For all other entities, a delayed effective date was announced in November 2019, and it is now effective for them for fiscal years beginning after Dec. 15, 2020, and interim periods within fiscal years beginning after Dec. 15, 2021. Early adoption is permitted.
ECONOMIC HEDGES ARE DIFFERENT FROM ACCOUNTING HEDGES
"Most derivatives are economic hedges, which entities enter into for risk management rather than speculative purposes," Goswami said. "There is a distinction between an economic hedge and an accounting hedge, and ASC Topic 815 has specific and complex guidance on when an economic hedge can be treated as an accounting hedge."
Companies first must identify whether they have a business risk that the use of a derivative can help to solve. This will vary by company and by industry. "CFOs and controllers may have a good sense of this, but the board of directors may not, and there may be apprehension about using derivatives incorrectly or inappropriately. But not using derivatives may leave companies exposed to more risk than if they were to use them," said Chris Moore, CPA, a partner at Crowe LLP.
Under Topic 815, all derivatives are marked to market each reporting period, and absent a hedging designation all changes to fair value are accounted for through earnings. Reflecting unrealized gains and losses in the income statement creates earnings volatility that is challenging for companies that use derivatives for risk management.
"Hedge accounting at the most basic level is the use of derivative instruments to mitigate various risk exposures and to try to achieve an accounting result that aligns the accounting for the derivative with the economics achieved through the use of the derivative," Goetsch said.
Companies may enter into cash flow hedges to manage operational cash flows and fair value hedges to manage future values of assets. A common hedge example is an entity's hedging variable interest payments (the hedged item) by entering into an interest rate swap (a derivative) with a counter party that economically converts the variable interest rate to a fixed rate. The entity now knows upfront what its interest payments on the debt and derivative together are going to be over the term of the debt, and it has economically managed and mitigated interest rate variability by fixing the rate.
If eligible, the entity may elect to designate its interest rate swap as a hedge for accounting purposes. As a cash flow hedge, changes in fair value of the derivative are initially recorded in accumulated other comprehensive income and reclassified to earnings when the related interest payments on the debt affect earnings each reporting period. This accounting mitigates the income statement volatility that could otherwise occur each period through the recognition in earnings of the unrealized gains and losses on the derivative.
"Hedge accounting doesn't change any of the cash flows or the total income statement impact, but it changes the timing of the impact to avoid earnings volatility that would ordinarily result under normal derivative accounting," Goetsch said.
APPLYING HEDGE ACCOUNTING
Achieving the benefits of hedge accounting instead of recognizing fair value changes through earnings does take some effort. "FASB views hedge accounting as something you've earned, because users of financial statements need clear and transparent information about the risk of using derivatives," Goetsch said.
One of the first steps is to identify whether the cash flow or fair value hedging model is appropriate, because each model has different approaches.
To qualify for hedge accounting under the guidance, there needs to be an eligible hedge relationship, including what derivative instruments are eligible to be used and what hedged items and forecasted transactions are eligible. The ASU provides such a list. Also, the hedging relationship must be highly effective in offsetting changes in fair value or cash flows of the derivative, which in practice is at a level of 80% to 125%. "The entity applying hedge accounting must demonstrate this highly effective relationship, and the amount of effort to do this will be dictated by the underlying item and transaction," Goetsch said.
There are also significant contemporaneous documentation requirements at the inception of the hedge relationship about the nature of the risk, the economic objectives, the hedged item and hedging instrument used, the timing, the effectiveness, and more. Other documentation for nonpublic entities can be prepared by the end of the reporting period.
Assessing and demonstrating that the hedge relationship has been highly effective and is expected to be over the remainder of the hedge is an ongoing requirement. Extensive disclosure requirements could require significant effort as well.
Third-party service providers can assist in preparing the required documentation and provide software tools and other assistance for companies considering the use of hedge accounting, including valuing derivatives and ongoing hedge accounting and reporting, which may be especially helpful to companies that use a significant number of derivatives.
WHY WAS ASU 2017-12 ISSUED?
The targeted improvements are intended to increase the scope of what can be hedged and to provide certain relief for measuring hedge effectiveness and in the timing of documentation. Although relief for certain documentation timing has been provided, the documentation requirements remain voluminous.
"ASU 2017-12 removes several roadblocks and opens up the door to new opportunities," Moore said. "That is, the standard makes certain aspects easier and increases overall flexibility, such as which strategies qualify for hedge accounting. But even with these changes, applying hedge accounting will still require effort."
WHAT CHANGED WITH ASU 2017-12?
There are many areas of change, and accountants should review the ASU for a thorough understanding. Some of the more significant areas include the following:
Simplified and expanded eligible hedging strategies for financial and nonfinancial risks
For cash flow hedges, designated hedged risk can be based on interest rates that are contractually specified in addition to benchmark interest rates (LIBOR, U.S. Treasury, Federal Funds Effective rate), including prime, with appropriate documentation.
Designated hedged risk of a forecasted purchase or sale of nonfinancial assets can be a contractually specified component within the transaction rather than hedging the total change in cash flows of the contract (for example, the rubber component of a tire purchase if the contract includes the rubber price in the buildup of the overall tire price).
In a fair value hedge, assumptions about the term of the hedged item may now reflect the term of the derivative instead of the entirety of the cash flows of the hedged item (for example, hedge the first five years of a 10-year note with a five-year interest rate swap).
Enhanced transparency in presentation and disclosure of hedging results
The earnings impact of the designated derivative instrument must be presented in the same income statement line as the hedged item.
Additional disclosures have been added, including amended tabular disclosures for the income statement effects of fair value and cash flow hedges, and new tabular disclosures for cumulative basis adjustments of fair value hedges.
Simplified assessment of hedge effectiveness and amended methods to be used
An initial quantitative assessment of effectiveness often is required at initial hedge designation, but the ongoing required quarterly assessments may be performed qualitatively if it is expected the hedge will be highly effective over the hedge's life.
The use of the shortcut method to assess effectiveness still applies, but a backup method can be specified at inception to apply if it is determined that the shortcut method is no longer appropriate or should not have been applied. Misapplication of the shortcut method should result in fewer material misstatements going forward because of the ability to apply a backup method and to continue to apply hedge accounting.
Relief on timing of certain hedge documentation
The initial qualitative documentation is still required at hedge inception. The initial required quantitative hedge effectiveness analysis is extended from the inception date to the first quarterly effectiveness assessment date. Certain nonpublic entities may be able to defer both the initial quantitative test and each subsequent quarterly hedge effectiveness assessment until before the date on which the financial statements are available to be issued when completing the documentation on a deferred basis.
Eliminated requirement to separately measure and record hedge ineffectiveness
For cash flow and net investment hedges, all changes in the hedge's fair value, both the effective and ineffective portions, are deferred in other comprehensive income and recognized in earnings at the time the hedged item affects earnings. The separate measurement and recording of ineffectiveness directly into earnings was eliminated because FASB believes all aspects of the risk management relationship should be accounted for in the same manner whether or not it is perfectly effective.
For fair value hedges, the hedge's entire fair value change is presented in the same income statement line as the hedged item is recorded.
OTHER ASUs THAT RELATED TO THE NEW HEDGING STANDARD
Since ASU 2017-12 was issued, other ASUs have been issued that accountants should be aware of, including:
- Proposed ASU, Derivatives and Hedging (Topic 815): Codification Improvements to Hedge Accounting (comments were due Jan. 13, 2020).
- 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.
- ASU No. 2019-04, Codification Improvements to Topic 326, Financial Instruments — Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments.
- Proposed ASU, Codification Improvements (comments were due Dec. 26, 2019).
WHAT SHOULD CPAs DO NOW?
Many resources are available on how to apply the standard in a number of situations, including detailed guidance from accounting firms and third-party service providers. Member firms of the AICPA's Center for Plain English Accounting have access to several reports on this topic.
Management should also look to their auditors for education about hedge accounting and assess whether their organizations have the necessary capabilities to manage hedge accounting relationships under the new standard. They may also want to talk to other companies that have already adopted the standard. "I try to break it down into bite-sized pieces for clients, because it is too much to digest the entirety of the standard at once," Moore said.
Although ASU 2017-12 is intended to alleviate some complexities and make hedge accounting easier to apply, significant work remains. "It is still one of the more challenging areas of accounting, and anyone looking to get into the world of hedge accounting definitely needs to do their diligence to apply the standard in an informed manner," Goetsch said.
COVID-19 may affect hedge activities
In just a few months, the coronavirus pandemic has led to significant and far-reaching changes in the economy. The resulting uncertainty and regulatory responses have impacted global capital markets, and the interest rate environment is very sensitive. The usual business activities of companies and their customers are changing and may not be able to be predicted at this point in time, and expected hedge relationships may be going away.
"Every company hedging its forecasted transactions needs to think hard about whether or not what is happening is going to impact them," said Brian Goetsch, CPA, director, Accounting Advisory Services for KPMG. Companies contemplating hedging face the inability to anticipate what will happen in the future and will have more of a struggle to provide required evidence about probability of occurrence than in the past.
There are many specific areas of FASB ASC Topic 815, Derivatives and Hedging, that should be reviewed by companies using or contemplating hedge accounting. These include, among others, changes in hedge effectiveness and changes in probability of occurrence of forecasted transactions and performance under firm commitments. FASB's staff addressed hedge accounting issues related to the pandemic in Q&As published April 28 on the board's website. The Q&As are available at fasb.org.
The big-ticket items Goetsch is already seeing in practice include the impact on current accounting of having to immediately reclassify gain and loss amounts from accumulated other comprehensive income to earnings if forecasted transactions are probable of not occurring, and the impact on future accounting of having mark-to-market volatility in P&L from the inability to achieve hedge accounting on derivatives. Some companies may need to consider getting out of derivatives because they find themselves economically in an over-hedged position.
However, the significant changes in economic environments could also provide favorable opportunities for hedging. Examples include the ability to lock in low costs of using derivatives for future transactions based on where the current spot rate and forward rate/curves are for particular commodity products and to take advantage of the lowest interest rates in years on current and forward debt issuances.
"There are concerns about the economic implications of COVID-19 and how they will impact activities you were hedging, but there also may be potential opportunities to strike when prices or rates are lower," Goetsch said. "Interest rates, commodity prices, and foreign currency exchange rates have all been significantly impacted, and companies may be able to achieve lower costs of borrowing, purchasing, and interacting in foreign markets."
About the author
Maria L. Murphy, CPA, is a North Carolina-based freelance writer. She has extensive experience in accounting, auditing, and finance.
To comment on this article or to suggest an idea for another article, contact Ellen Goldstein, the Association's director—Communications & Special Projects, at Ellen.Goldstein@aicpa-cima.com.
- "Checklist: Making Use of FASB Delays," JofA, Dec. 2019
- "FASB Proposes Clarifying Hedge Accounting Standard," JofA, Nov. 12, 2019
- "FASB Permits New Benchmark Rate for Hedge Accounting," JofA, Jan. 2019
- Audit Guide: Special Considerations in Auditing Financial Instruments (#AAGAFI16E, ebook; #AAGAFIO, online access)
- Annual Update for Accountants and Auditors (#730795, text; #153680, online access)
For more information or to make a purchase, go to aicpastore.com or call the Institute at 888-777-7077.