Hedge accounting: Key aspects of the new FASB guidance
The Financial Accounting Standards Board (FASB) has issued new guidance on hedge accounting. Hedge accounting allows an entity to align its risk management strategies with the financial information reported to investors by reducing volatility in earnings. This is done by aligning the recognition of gains and losses from changes in the value of the hedged item with changes in value of the instrument used to hedge that risk.
For example, under current accounting guidance, the criteria to qualify for hedge accounting can be difficult to meet. This often results in entities entering into transactions to reduce their economic risks, such as interest rate risk on variable rate debt or foreign currency risk on receivables or payables denominated in a foreign currency, that do not qualify for hedge accounting.
The new FASB hedge accounting guidance simplifies the application of hedge accounting in select situations.
The new guidance is intended to better align the accounting for hedging relationships with economic results of the entity’s hedging strategies by expanding the number of hedging strategies that qualify for hedge accounting. In addition, the new guidance simplifies the application of hedge accounting in select situations.
Several aspects of the new guidance are important for companies to consider, including:
The new guidance expands the number of hedging strategies that will qualify for hedge accounting.
Hedging nonfinancial assets
Under the new standard, hedge accounting can be applied to a specific component of a contract for the purchase and sale of nonfinancial assets (for example, commodities contracts) as long as that component qualifies. Previously, the entire contract had to qualify for hedge accounting.
Interest rate risk hedges
The new standard allows additional strategies for hedging interest rate risk, for both fixed rate and variable rate financial instruments. The standard also addresses concerns that the way entities are required to measure the change in value of its hedges of interest rate risk under the current hedge accounting rules do not reflect the economics of the hedges. The new amendments now permit additional methodologies for measuring the change in fair value of the hedged item.
The new hedge standard requires entities to present the changes in fair value of the hedged item and the derivative being used to hedge that item in the same line item on the income statement. The new hedge standard also eliminates the requirement to separately measure and report hedge ineffectiveness.
Assessing hedge effectiveness has been a complex process. Under the current hedge accounting guidance, the assessment is to be completed at the inception of the hedged relationship and should continue on an ongoing basis. The new standard simplifies this process by allowing additional time to perform the initial assessment. The standard also allows entities to complete a qualitative assessment of hedge effectiveness, rather than the current quantitative assessment, as long as certain conditions are met.
Effective date and transition
The new hedge accounting standard will be effective for public business entities for periods beginning after Dec. 15, 2018 (2019 for calendar-year entities). All other entities will have one additional year to implement and are required to adopt the standard for periods beginning after Dec. 15, 2019 (2020 for calendar-year entities).
The standard permits early adoption for all entities and contains detailed transition guidance to be applied upon adoption.
As always, if you have any questions about the new hedge standard and hedge accounting guidelines, feel free to give us a call.