FAQ on FASB Changes to Hedge Accounting Rules

Treasury and accounting professionals across the country are keenly anticipating the issuance of a FASB exposure draft that is expected to simplify hedge accounting—and eliminate much of the drag that stifles hedging among corporations with market risk.

The FASB has announced that the exposure draft will make "targeted improvements to the hedge accounting model." We believe the FASB intends for the impending changes to drive an increase in the number of hedging entities that take advantage of the benefits of special hedge accounting. These would be welcome changes. If the FASB succeeds in increasing the number of corporates using hedge accounting, that should, in turn, reduce non-GAAP reporting among U.S. multinationals and increase the usefulness of those companies' financial statements to end users of the statements.

The current rule set around hedge accounting and the diversity of interpretations by audit firms (which increases exponentially when multiplied by the number of audit partners in each firm) have combined to artificially reduce usage of hedge accounting. In fact, the hedge accounting rules have even discouraged some non-financial companies from using derivatives to manage their financial risks. The rules were designed to ensure appropriate controls and reporting on derivatives trades, but instead they've become a barrier to entry.

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FASB communication on the direction of the new rule set seems to be sending a message to companies and their auditors that all economically effective hedges—not speculative trades—should receive special hedge accounting treatment, and that this hedge accounting should be accessible and not unduly burdensome. The focus on controls will undoubtedly remain, but the new rules can be expected to lift some of the current requirements to capture, record, and disclose values that are not material to meeting the hedges' risk management objectives. Based on the FASB's tentative conclusions and meeting notes, here is what we expect the exposure draft to offer.

When are the changes coming?

Current expectations are that an exposure draft will be issued sometime before the end of the third quarter. We are cautiously optimistic, as it was originally anticipated in Q4/2015.

Who is affected?

The proposed changes to the GAAP rules are especially notable for organizations hedging, or considering hedging, commodity risk. However, all members of the corporate hedging community—those protecting against foreign currency risks, interest rate risks, commodity risks, etc.—will benefit to some degree from the proposed guidance changes.

Under the current regulatory regime, once a hedge relationship is created within a company's financial statements (between derivative and hedged line item), the company is required to regularly reassess quantitatively the degree of effectiveness of that hedge. This results in requirements to "measure," in every period, the amount of offset the derivative is not providing vis-a-vis the hedged item. This frequently results in complex calculations to measure the valuation difference between an anticipated transaction's recording date and the maturity date of the derivative—for example, the mathematical difference between the inception value and current value of the anticipated transaction, modeled as a derivative with a maturity at the start of the month, and the actual derivative with a maturity at the end of the month or in the following month.

This exercise is frustrating due to the difficulty in capturing what is inevitably an immaterial number. Even more frustrating is the high degree of precision required for smaller companies over larger companies due to materiality considerations.

In contrast, if all goes as planned, the rules presented in the upcoming exposure draft will lower the barriers to special hedge accounting qualification by narrowing the array of risks that a particular hedge needs to protect the company against. For example, current guidance would require a hedge of a fuel surcharge to protect the company not only against changes in the delivery costs, but also against changes in the prices of the widgets delivered. The new rules are expected to allow hedging of the contractually specified fuel surcharge only.

The new rules are also expected to simplify the accounting. With the elimination of effectiveness measurement and new requirements on the P&L geography for recording derivative gains/losses, companies will no longer be required to analyze how much of the gain or loss goes where, when. For all cash flow hedges, the entire gain/loss will eventually be recorded in the same line item as the hedged item. Even if hedgers "exclude time value," the time value—along with the rest of the derivative impact—will be recorded in the same line item as the hedged exposure. And the entire change in derivative (except any excluded time value) will go to Other Comprehensive Income when the hedged item impacts earnings. For fair value hedges, 100 percent of the derivative will go to the hedged item line. For net investments, all changes, except for any excluded time value, will go to Cumulative Translation Adjustment. The excluded time value on net investment hedges is the only P&L geography flexibility in the current proposals.

These changes should open the door to hedging financial exposures for companies that have been intimidated or shut out in the past. For those already hedging, the new FASB guidance seems likely to reduce the view of the hedge accounting process as a high-effort, low-value proposition, making it a more desirable option for a lot more corporate hedgers.

What's happening with commodity hedging?

Hedge accounting is currently cumbersome for companies hedging all kinds of financial risks, but it is most problematic for those hedging commodity risks. Many commodity hedges fail to qualify for special hedge accounting.

As I mentioned above, if the exposure being hedged is, for example, a fuel surcharge related to shipment of a widget, current GAAP guidance requires treasury to look at all changes in the widget price of the goods delivered when calculating the effectiveness of the hedge, because the guidance requires hedgers of a "purchase of non-financial assets" to hedge foreign exchange (FX) risk or "the risk of changes in cash flows relating to all changes in purchase price or sales price of the asset reflecting its actual location, not the risk of changes in the cash flows relating to a … similar asset in a different location or of a major ingredient." In the widget example, we would capture the change in a derivative on diesel fuel against the delivered price of widgets to a location. If the sales price of the widget changed during the period (in addition to its delivery costs, which might change due to fuel surcharge changes), that would create ineffectiveness. In this scenario, if widget prices change regularly based on anything but diesel prices, a hedger couldn't even qualify for special hedge accounting.

The upcoming exposure draft is expected to include a provision allowing for bifurcation of risk, such that only contractually specified components of a transaction would need to be considered in calculating the hedge-able risk posed by the transaction. So, for example, a corporate treasurer who uses DOE-based diesel fuel contracts to manage the risk of fuel price volatility on delivering product could qualify for special hedge accounting. The derivatives could effectively protect the company against the changes that are contractually specified—the fuel surcharge based on DOE diesel—rather than all conceivable risks present in the sales price of widgets.

Initial quantitative testing of hedge effectiveness will need to be prepared by quarter-end rather than at designation date, as currently required. Assumptions of perfect effectiveness will have to be documented with a new backup test methodology in the event that an auditor or internal reviewer disagrees with the "perfectly effective" assertion. This provides an additional buffer between a hedge program and restatement.

Additionally, under the expected changes, once a commodity hedge qualifies for special hedge accounting, the company will no longer be required to calculate and record ineffective amounts. Currently, a corporate hedger has to perform retrospective and prospective effectiveness testing at least quarterly, and frequently monthly. Under the upcoming exposure draft, corporate hedgers will no longer need to perform this ongoing effectiveness testing, unless changes in the marketplace suggest the hedge relationship is no longer effective. This could occur when, for instance, a strong correlation between two commodities breaks after a significant period of stability. Thus, the change in hedging accounting rules will substantially simplify the debits and credits required to account for a derivative.

The tentative conclusion treats all changes in derivatives as effective. So all changes in cash flow hedges would be recorded in Other Comprehensive Income and reclassified to earnings when the hedged item is recorded. No longer would those tedious calculations identifying small amounts related to ineffectiveness need to be calculated, recorded, audited, and disclosed.

How will my existing cash flow FX and/or interest rate hedges be affected?

For initial effectiveness testing, the expected rule changes on risks that are contractually specified would benefit cash flow hedge accounting of interest rate risks in the same way it would benefit commodity hedging.

Currently, to qualify for hedge accounting, an entity paying prime on debt has to prove that its hedge protects it against all possible changes in its interest payments—including changes driven by improvement or deterioration in the borrower's credit, which has nothing to do with movement in the prime interest rate. The proposed rules would instead allow hedge accounting if the hedge protected against only the changes in prime as a contractual component. The result of this modification should be a significant increase in qualifying cash flow interest rate hedges.

For all hedgers, we expect the primary benefit of the exposure draft to be the elimination of ongoing effectiveness measurement—or, more appropriately, elimination of the requirement to continuously measure any amount of ineffectiveness, record it (sometimes), and disclose it (sometimes).

Time value—forward points, backwardation, or contango on forwards, and option value minus intrinsic value on options—can continue to be excluded from the hedge relationship, as it is today. The proposal does require that hedgers record all derivative gains and losses—including time value—in the same financial reporting line as the hedged exposure. This may appear to be a new constraint, but it really only codifies a decade-old SEC comment.

How will my fair value interest rate hedges be affected?

Fair value hedgers of fixed-rate debt will likely experience much less hedge ineffectiveness under the new rules, based on changes that allow companies to hedge only the benchmark component of the hedged item's cash flows. Previously, hedgers needed to capture changes other than the benchmark in hedged items (e.g., credit, market appetite). The hedged item will typically be a much better match for the hedging instrument based on applying the flexibility provided under the new rules. In addition, partial-term hedging will be more effective (e.g., hedging only the first five years of a 10-year note), as the measured changes in the hedged item can reflect the swap maturity rather than the hedged-item maturity.

What do I need to do to get ready?

Commodity hedgers (and potential hedgers) may have the most homework to do to take advantage of the changes when they go into effect. Since only contractually designated components can be bifurcated, the treasury professionals managing corporate hedging must check in with appropriate contracting departments—e.g., sales, procurement—to ensure that contracts (whether master agreements or purchase or sales orders) are written in such a way that the company will be able to take advantage of the relaxation in special hedge accounting qualification requirements. For instance, a purchase price might now need to be quoted as "June average CME copper +25 cents per pound" rather than "$3.00 per pound, subject to change with 30-day notice."

It is also a good time for all hedgers to examine their hedge programs holistically, either using internal resources or by tapping an external expert. In particular, they should examine the financial derivatives in use and evaluate whether those instruments are the right choice for eliminating the company's risk, or whether they have just been the most accounting-friendly instrument.

What should I do after the exposure draft is issued?

All affected parties should be preparing to write comment letters to the FASB highlighting the benefits (or lack thereof) for users of their financial statements, asking for clarification, and discussing costs/savings of the proposed guidance. Too often, comments deal only with negatives and dislikes, leaving overwhelmingly positive changes under the radar and potentially subject to accidental removal. Treasury professionals should not hesitate to comment on all aspects of the exposure draft—things they like and things they don't like—to help ensure the most positive change possible. The comment period is likely to be 75 days long.

As the guidance is likely to permit early adoption, companies that are currently using derivatives hedging for financial risk management might also start evaluating the pros and cons of early adoption and lay out their preferences in terms of timing of their adoption of the new hedge accounting rules.

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Helen Kane is a recognized leader in the application of ASC 815 (formerly FAS 133) "Accounting for Derivative Instruments and Hedging Activities" within corporate environments. She founded Hedge Trackers in 2000 as a FAS 133 consulting and outsourcing firm providing deeply technical yet practical software and service solutions to Fortune 1000 companies.