SEC asks FASB to review accounting for hedging derivatives when counterparties change

The SEC has asked FASB to review elements of accounting for derivatives contracts designated as hedging instruments as part of FASB’s existing project on financial instruments, according to a letter posted on the SEC’s website.

SEC Chief Accountant James Kroeker sent a letter dated May 11 to Dan Palomaki, chairman of the Accounting Policy Committee of the International Swaps and Derivatives Association, explaining the SEC’s position. Kroeker copied the letter to FASB Chairman Leslie Seidman and PCAOB Chairman James Doty.

FASB is revamping its financial instruments standards as part of an ongoing convergence project with the International Accounting Standards Board (IASB). The SEC asked FASB to consider in its financial instruments project the accounting for a change in counterparties when a derivative contract is designated as a hedging instrument in a hedge relationship, Kroeker’s letter explained.

According to the letter, Palomaki had asked for Kroeker’s view on the accounting impact under U.S. GAAP of a novation of a bilateral, over-the-counter (OTC) derivative contract to a central counterparty on the same financial terms. Palomaki asked whether the novation of a derivative contract designated as an accounting hedge to a central party would result in the termination of the original derivative contract and associated hedge relationship, such that the use of hedge accounting subsequent to novation would require the designation of a new hedging relationship, Kroeker wrote.

Kroeker wrote that his staff would not object to a conclusion that the original contract has not been terminated and replaced with a new derivative contract, nor would his staff object to continuing hedging relationships when there is novation of a derivative contract to effect a change in counterparties to the underlying contract, providing that other terms of the contract have not been changed, in any of the following circumstances:

• For an OTC derivative transaction entered into prior to application of the mandatory clearing requirements, an entity voluntarily clears the underlying OTC derivative contract through a central counterparty, even though the counterparties had not agreed when entering the transaction that the contract would be novated to effect central clearing.
• For an OTC derivative transaction entered into after the application of the mandatory clearing requirements, the counterparties to the underlying contract agree in advance that the contract will be cleared through a central counterparty in accordance with standard market terms and conventions and the hedging documentation describes the counterparties’ expectations that the contract will be novated to the central counterparty.
• A counterparty to an OTC derivative transaction who is prohibited or expected to be prohibited by Section 716 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, PL 111-203, from engaging in certain types of derivative transactions novates the underlying contract to a consolidated affiliate that is not insured by the FDIC and does not have access to Federal Reserve credit facilities.

—Ken Tysiac (ktysiac@aicpa.org) is a JofA senior editor.