The current economic environment of rising interest rates is hurting the financial performance of companies holding debt security investments as financial assets. Financial asset values decrease when interest rates rise because the future cash flows become discounted at a higher rate. As a result, many companies are hedging to reduce interest rate risk exposure (see the sidebar “Hedging Basics”). These companies can benefit from FASB’s new and more flexible hedge accounting guidance.
FASB improved its hedge accounting guidance in March 2022 when it issued Accounting Standards Update (ASU) No. 2022-01, Derivatives and Hedging (Topic 815): Fair Value Hedging — Portfolio Layer Method (see the sidebar “What ASU 2022-01 Improves”). This update provides a more flexible hedge accounting model that more closely aligns a company’s financial reporting with the results of its risk management strategy. The update also simplified fair-value hedge accounting for investments in debt securities. The income statement impact of improved risk management and hedge accuracy is difficult to quantify.
The effective date for ASU 2022-01 for public business entities is in 2023, including interim periods. All other companies have an additional year to comply. Companies may early adopt if they have already adopted ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.
ASU 2022-01 has both prospective and modified retrospective application for different aspects of the guidance. Prospective application applies to designating multiple hedged layers and hedging these layers in an existing closed portfolio. Modified retrospective application applies to fair-value basis adjustments in an existing closed portfolio. This means a company that had previously allocated fair-value basis adjustments to individual assets for a last-of-layer hedge in a closed portfolio would reverse this allocation amount through a cumulative-effect adjustment to the opening balance of retained earnings as of the ASU 2022-01 adoption date. For new disclosure guidance, companies may elect to adopt either prospectively or retrospectively.
PRIOR GUIDANCE FOLLOWING ASU 2017-12
In August 2017, FASB issued ASU 2017-12 to improve financial statement recognition of economic results from hedging activity. For a closed portfolio of prepayable debt securities, ASU 2017-12 introduced the “last-of-layer” method permitting fair-value hedging for the proportion of the debt securities expected to be outstanding for the designated hedge period. It also simplified this hedging by clarifying that prepayment risk would not impact hedged-item value measurement.
ASU 2017-12 expanded and refined accounting for hedging activities, but the improvements were limited. Firstly, allowing hedging for only a single layer of a closed portfolio did not align well with company risk management activities. Secondly, because cash flow and interest rate risks exist in both prepayable and nonprepayable debt securities, nonprepayable debt securities in a closed portfolio should also be eligible for hedging. Thirdly, the update did not provide accounting guidance for fair-value hedge basis adjustments associated with last-of-layer hedges.
HOW ASU 2022-01 HELPS WITH HEDGING
ASU 2022-01 addresses some of the questions resulting from ASU 2017-12. It improves hedging risk management in two ways: by increasing the number of portfolio hedges permitted and by expanding the types of financial assets that qualify for hedging.
Using the portfolio-layer method
The first step in implementing fair-value hedges for debt securities is establishing a closed portfolio of the financial assets. The portfolio is termed “closed” because new assets may not be added, although assets may be removed because of prepayments, defaults, or other factors. The company forms the closed portfolio with financial assets that are anticipated to remain outstanding for the designated hedge period and identifies this portfolio as the hedged item.
Also, the nature of debt (as a financial asset) is that it has prepayment risk, which results in different estimated maturities in a closed portfolio, creating more than one fair-value risk. Borrowers commonly settle debt before maturity as business needs and economic conditions change. In addition, debt instruments may contain put and call options.
Prior to ASU 2022-01, accounting guidance permitted only a single hedge (called the last-of-layer method) on a closed portfolio. This created risk management challenges because a single hedge could not match all portfolio value risks, resulting in many risks being unhedged.
ASU 2022-01 creates new flexibility for combining and hedging financial assets with different maturity profiles in a single closed portfolio. It permits hedging multiple stated amounts in different periods by designating multiple hedged layers, a process referred to as “layering.” This reduces the need to construct several separate closed portfolios.
Layering allows the total closed-portfolio hedged amount to change with anticipated changes in the amount of the closed portfolio still outstanding. Larger stated amounts are hedged in earlier periods, and smaller stated amounts are hedged in later periods. Amounts in later periods are typically smaller due to prepayments and defaults. The benefit is that a greater portion of the closed portfolio’s interest rate risk now qualifies for hedge accounting.
Financial assets with a longer maturity may support a shorter hedged-layer maturity, but not vice versa. For example, financial assets with five years remaining until maturity can support a hedged layer designated for years one to three but not a hedged layer designated for years one to 10. The reason is that a five-year asset hedged for changes in the designated benchmark interest rate does not exhibit the same interest rate risk profile as a 10-year asset hedged for changes in the same rate. On the other hand, a 10-year financial asset hedged for changes in the designated benchmark rate for a five-year partial term is considered to exhibit the interest rate risk profile of a five-year financial asset hedged for changes in the designated benchmark rate.
Expanding types of assets eligible for hedging
Prior to ASU 2022-01, accounting guidance permitted only prepayable financial assets to be included in the closed portfolio, which was less than ideal because it excluded nonprepayable financial assets. Although nonprepayable financial assets do not have prepayment cash flow risk, they may still incur uncertain cash flows due to default risk and interest rate changes.
Now, under ASU 2022-01, both prepayable and nonprepayable financial assets qualify for the same hedge accounting method. This better reflects the impact of company asset value risk management activities on the financial statement because it allows financial asset value risks managed in the same way to qualify for the same hedge accounting. This reduces complexity for both financial statement users and preparers.
COMPARING THE EXISTING AND NEW GUIDANCE
The following example illustrates the difference between the existing guidance following the last-layer method under ASU 2017-12 and the portfolio-layer method under ASU 2022-01:
A company forms a $10 million closed portfolio of financial assets and hedges interest rate risk following its risk management strategy. In this closed portfolio, the company expects $7.5 million to remain outstanding for five years and $2.5 million to remain outstanding for 10 years. The company expects that the financial assets in the closed portfolio will not be affected by prepayments, defaults, or other factors affecting the timing or amount of cash flows for the hedge periods.
Under the last-layer method in ASU 2017-12, the company could only hedge either $7.5 million for five years or $2.5 million for 10 years, as long as the company expected the portfolio assets would remain outstanding for these periods.
After adopting ASU 2022-01 using the new portfolio-layer method, the company gains significant flexibility in how it manages risk. The company is no longer restricted to only one hedge layer because ASU 2022-01 allows the creation of multiple hedged layers in a single closed portfolio. Thus, the company could create more than one hedged layer. For example, the company could:
- Designate two layers and enter into:
- One hedge for a $5 million layer ($7.5 million − $2.5 million) with five years expected until maturity, and
- A second hedge for a $2.5 million layer expected to remain outstanding for 10 years; or
- Designate two layers and enter into:
- One hedge for a $7.5 million layer with five years expected until maturity, and
- A second hedge for a $2.5 million layer with expected maturity during years six through 10.
As part of the initial hedge documentation and at each subsequent hedge effectiveness assessment date, document the analysis supporting the expectation that the hedged layers and aggregated closed portfolio is anticipated to be outstanding for the designated layer period and for the designated hedge periods. The analysis incorporates expectations about prepayments, defaults, and other factors impacting the cash flow amounts and timing of the financial assets in the closed-portfolio layers.
NEW GUIDANCE FOR BASIS ADJUSTMENTS
Additionally, ASU 2022-01 provides accounting guidance for closed-portfolio basis adjustments or for dedesignating a portfolio layer. The update prohibits including closed-portfolio asset basis adjustments when measuring expected credit losses or when determining available-for-sale (AFS) security impairment. The hedged-item fair-value change attributed to the hedge risk remains within the closed portfolio and does not adjust the individual asset carrying value in (or removed from) the closed portfolio.
A company that makes closed-portfolio basis adjustments in its hedge accounting should allocate these adjustments to different balance sheet line items when presenting closed-portfolio assets in different balance sheet line items. For example, if a hedged item (a debt security in a portfolio layer) is normally measured at fair value with changes in fair value reported in other comprehensive income, such as for an available-for-sale debt security, the hedged item should be recognized for fair-value adjustment in earnings (instead of other comprehensive income) to offset the hedge fair-value adjustment that is recognized in earnings.
Individual available-for-sale and amortized-cost debt security carrying amounts included in the closed portfolio are not adjusted. The adjustment amount is maintained on each portfolio layer. If other GAAP requires closed-portfolio amortized cost basis disaggregated disclosure, the company should exclude the basis adjustment from its asset cost basis and, instead, disclose the total portfolio-layer basis adjustment amount excluded.
A company that fully or partially discontinues a hedging relationship voluntarily or due to an anticipated breach in the closed portfolio should allocate the dedesignation basis adjustment amount to the remaining individual assets in the dedesignated layer. A company is required to amortize this amount over a period consistent with other discount or premium amortization periods for these assets following other GAAP topics. For an actual breach, the company should recognize the breach basis adjustment amount in the current-period interest income or expense.
CONCLUSION
ASU 2022-01 improves hedge accounting flexibility for companies holding debt securities. This more closely aligns hedge accounting and financial reporting with risk management activity in this increasing interest rate economy. This flexibility includes managing financial asset value risks by using portfolio layering techniques matched with different derivative types tailored to a company’s individual risks.
In addition, companies holding financial asset investments can now designate new hedging relationships and dedesignate existing hedging relationships.
What ASU 2022-01 improves
The most significant improvements over prior GAAP guidance are that it:
- Expanded the number of hedged layers from only one layer to multiple layers in a single closed portfolio. Accordingly, it uses the term portfolio layer method rather than last-of-layer method.
- Expanded the hedged-item scope from only including prepayable financial assets to including nonprepayable financial assets.
- Provided additional guidance for fair-value hedge basis adjustments, including determining a credit loss impact.
Hedging basics
FASB ASC Topic 815, Derivatives and Hedging, provides hedge accounting guidance. At hedge inception, companies must determine and document:
- The hedging relationship;
- The risk management objective and strategy for undertaking the hedge;
- The hedged item, hedging instrument, and the nature of the risk being hedged; and
- The method used to assess hedge effectiveness.
For derivatives designated and qualifying as a fair-value hedge, the gain or loss on the derivative and the offsetting loss or gain on the hedged item are both recognized in current income in the same income statement line item. (See example 20 in ASC Paragraph 815-10-55-181 and ASC Paragraphs 815-10-50-4EE through 815-10-50-4EEE.)
Additional fair-value hedge documentation includes:
- The method for recognizing in earnings the gain or loss; and
- The method of calculating fair-value changes due to the hedged risk and the recognition accounting policy.
For a portfolio-layer method hedging relationship containing multiple hedged layers, document that the hedged layers are supported by assets anticipated to be outstanding during the designated hedge period and as of the hedged item’s assumed maturity date.
About the author
Mark D. Mishler, CPA, CMA, MBA, is a principal at CFO Resource Management in Morristown, N.J., and an adjunct professor of accounting, finance, and management at Seton Hall University in South Orange, N.J., and Rutgers University in New Brunswick, N.J. To comment on this article or to suggest an idea for another article, contact Courtney Vien at Courtney.Vien@aicpa-cima.com.
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