Easier Hedge Rules on the Horizon

In September, the Standards Board (FASB) released an exposure draft seeking comments on proposed changes to guidance. Hedging is a reduction technique used to offset future changes in or flows of an or liability. Hedge accounting involves designating a instrument to a hedged item and then recognizing gains and losses from both items in the same period. Industries that most actively hedge risk include agricultural producers, beverages, food manufacturing, industrials, oil and gas, , and banking. This is FASB’s third attempt in eight years to refresh guidance that preparers see as overly complicated and difficult for financial statement users in analyzing an entity’s activities. Both derivative markets and firms’ risk management practices have substantially evolved since the 1998 issuance of FAS 133 containing the first hedging accounting guidance. One aim of this proposal is to have hedge accounting rules better align with ’ risk management practices. The proposed amendments make targeted changes to reduce the and complexity of applying hedge accounting and enhance financial statement understandability through new disclosure and presentation changes. Comments are due by November 22, 2016.

Risk Component Hedging Generally accepted accounting principles (GAAP) limit how an entity can designate the hedged risk in hedging relationships. The proposal expands hedge accounting for financial and nonfinancial risk components, e.g., purchases of ingredients and materials for production and operations. . For a hedge of a nonfinancial asset, an entity could designate as the hedged risk the variability in cash flows attributable to changes in a contractually specified component stated in the . Currently, only foreign risk can be designated as the hedged risk for a nonfinancial item. This change would allow entities to benefit from hedge accounting for derivatives to offset risk from changes in ingredients or items, e.g., a tire ’s hedging against changes in rubber . . For a of risk of a variable-rate , an entity could designate as the hedged risk the variability in cash flows attributable to the contractually specified interest rate. This would eliminate current GAAP guidance on “benchmark” interest rates for hedges of variable-rate instruments; currently, only variability in cash flows related to one of three defined benchmark interest rates are permitted to be the hedged risk.

Fair Value Hedges of GAAP limits how an entity measures changes in fair value of the hedged item attributable to interest rate risk in certain fair value hedging relationships. The proposal would: . Allow an entity to measure the hedged item in a partial-term fair value hedge of interest rate risk by assuming the hedged item has a term that only reflects the designated cash flows being hedged. Current GAAP does not allow this methodology when calculating the change in the fair value of the hedged item attributable to interest rate risk. . For prepayable financial instruments, permit an entity to consider only how changes in the benchmark interest rate affect a decision to settle a debt instrument before its scheduled in calculating the change in fair value of the hedged item attributable to interest rate risk. . Permit an entity to measure the change in fair value of the hedged item on the basis of the benchmark rate component of the contractual coupon cash flows determined at hedge inception, rather than on the full contractual coupon cash flows as currently required.

Easier Hedge Accounting Rules on the Horizon

New Benchmark Rate For hedges of fixed rate financial instruments, the proposal would add the Securities Industry and Financial Markets Association (SIFMA) Municipal Rate as an eligible benchmark interest rate in addition to those already permitted (the U.S. Treasury Rate, the London Interbank Offered Rate (LIBOR) Swap Rate and the Fed Funds Effective Swap Rate). This would benefit -exempt issuers and .

Hedge Effectiveness Hedge effectiveness is the extent to which changes in the fair value or cash flows of the hedging instrument offset changes in the fair value or cash flows of the hedged item for the hedged risk. Today’s guidance contains specific requirements for initial and ongoing quantitative hedge effectiveness testing as well as strict requirements related to the specialized accounting methods, i.e., “shortcut” method and “critical terms match” method, that allow an entity to forgo quantitative hedge effectiveness assessments. This proposal would ease the assessment of hedge effectiveness. Entities would have to make at least a qualitative effectiveness assessment at the inception of a hedging relationship. A reassessment only would be required if changes in circumstances suggest that the hedging relationship may no longer be reasonably effective. This is a significant change from the current requirement for a quarterly reassessment. Other changes include: . An entity would have more time to perform the initial prospective quantitative assessment of hedge effectiveness. An entity could perform that assessment at any time after hedge designation, but no later than the quarterly effectiveness testing date, using data applicable as of the hedge inception date. . When initial quantitative testing is required, an entity would have the to perform subsequent assessments of hedge effectiveness qualitatively unless facts and circumstances related to the hedging relationship change to an extent that the entity no longer may qualitatively assert the hedging relationship was and continues to be highly effective. An entity would continue to assess effectiveness for similar hedges in a similar manner. . In assessing whether the qualifying criteria for the critical terms match method are met for a group of forecasted transactions, an entity may assume the hedging derivative matures at the same time as the forecasted transactions if both the derivative maturity and the forecasted transactions occur within the same 31-day period. . If the shortcut method is no longer appropriate, an entity could apply a -haul method for assessing hedge effectiveness as long as the hedge is highly effective and the entity documents at inception which long-haul methodology it would use. A failed use of the shortcut method wouldn’t necessarily disqualify a company from the benefits of hedge accounting, as it would under current rules.

Recognition & Presentation FASB proposes updates to measurement and presentation guidance to better align the recognition and reporting of the hedging instrument’s effects with the hedged item. GAAP provides special hedge accounting only for the hedge portion deemed “highly effective” and requires an entity to separately reflect the amount by which the hedging instrument does not offset the hedged item, which is referred to as the “ineffective” amount. This is difficult for financial statement users to understand and preparers to explain. FASB proposes an approach that would no longer separately measure and report hedge ineffectiveness. In addition, an entity would report the hedging instrument’s entire effect in the same line item in which the hedged item’s earnings effect is reported.

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Disclosures The amendments would modify some current disclosures, most notably revising the tabular disclosure for fair value and cash flow hedges to focus on hedge accounting’s effect on income statement line items and eliminating the requirement to disclose ineffectiveness. New disclosures would include the cumulative basis adjustments for fair value hedges and a description of quantitative hedging goals, if any, set to achieve hedge accounting objectives.

Effective Date & Transition If adopted, the amendments would be applied on a modified retrospective basis. Entities would apply the guidance to all hedging relationships existing on the adoption date, with a cumulative effective adjustment to the opening balance of retained earnings. FASB will determine the effective date after considering feedback on the proposal. However, early adoption would be permitted at the start of any fiscal period before the standard’s effective date. BKD will continue to monitor updates. For more information, contact your BKD advisor.

Contributor Anne Coughlan Director 317.383.4000 [email protected]

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