August 28, 2017
The Financial Accounting Standards Board has released its long-awaited hedging standard, the final component of its financial instruments convergence project with the International Accounting Standards Board.
The accounting standards update has been in the works since 1998, when FASB last issued a standard for hedge accounting activities. After it agreed in 2002 to begin working with the IASB on converging accounting standards, FASB issued two exposure drafts in 2008 and 2010 on hedge accounting. However, after the comment period ended for the 2010 proposals, the project to improve hedge accounting guidance was put on hold to give FASB time to pursue other financial instrument initiatives. After FASB and the IASB diverged on issues such as accounting for impaired loans, the IASB issued a single set of International Financial Reporting Standards for financial instruments in IFRS 9 in July 2014. FASB then issued its standards under U.S. GAAP for the recognition and measurement of financial instruments in January 2016 and for credit losses in June 2016.
In the hedging project, FASB decided not to overhaul the hedge accounting guidance but instead to focus on targeted improvements to address key practice areas.
The accounting standards update takes effect for public companies in 2019 and private companies in 2020. But FASB is also allowing early adoption for companies if they want to begin using it right away.
“I’d categorize the changes as a few,” FASB vice chairman James Kroeker told Accounting Today. “One is changes to the hedge accounting model that allow for greater alignment between risk management strategies in the financial reporting or the accounting. Those are in a few areas, one as it relates to really putting on equal footing the financial product hedge accounting model with the nonfinancial. It’s opening up nonfinancial hedging to components, so if there’s a contractually specified component, you’re able to more closely align the accounting with the risk management strategies there.”
On the financial side, he added, the new standard opens up hedge accounting strategies to a greater array of strategies that are employed in risk management. “We thought the accounting didn’t accurately allow entities to portray that,” Kroeker explained. “Partial-term hedging was challenging under the old accounting model, as well as certain other strategies like hedging the SIFMA interest rate. We also added in the final standard the ability to do portfolio hedging associated with pre-payable financial assets. I think that’s referred to as the 'last of layer' approach.”
The new standard also simplifies the hedge accounting documentation requirements to allow more time for entities to get all the documentation in place, as well as permit the use of a qualitative assessment on a periodic basis as opposed to a required quantification each quarter, he noted.
Another change is in the area of presentation and disclosure. “It’s a more effective presentation of the impact of hedge accounting both in the P&L or the income statement itself by taking the hedged risk and the results of hedge accounting, and matching them up with the hedged item,” said Kroeker. “That’s the derivative matched up with the hedged item, and then the disclosures in the footnote. You’re taking what was already there by and large, but putting it in what many investors we’ve talked to have viewed as a more effective format. It allows them to see the impact of hedging in the income statement more clearly in the results both pre- and post-, the results with and without hedging, so you can see the impact of the hedge programs.”
The earlier drafts of the standard have generally met with widespread approval, according to FASB officials. “Companies and investors alike have expressed overwhelming support for this long-awaited standard,” FASB chairman Russell G. Golden said in a statement. “Thanks to their input, the final ASU better aligns the accounting rules with a company’s risk management activities, better reflects the economic results of hedging in the financial statements, and simplifies hedge accounting treatment.”
The new hedging standard will take effect for fiscal years, and interim periods within those fiscal years, beginning after Dec. 15, 2018, for public companies and for fiscal years beginning after Dec. 15, 2019 (and interim periods for fiscal years beginning after Dec. 15, 2020), for private companies. FASB is allowing early adoption in any interim period or fiscal years before the effective date.
The effective date of the new standard lands roughly in the middle between the effective dates of the classification and measurement standard and the credit losses standard, but early adoption is allowed.
On Monday, Sept. 25, FASB plans to host a one-hour webinar on the new hedging standard from 1:00 to 2:00 p.m. ET, featuring Kroeker, along with FASB board member R. Harold Schroeder, and other members of the FASB project team. Attendees of the live webcast will be eligible to receive up to 1.2 continuing professional education credits. See the FASB website at fasb.org for registration details. The website also has the final accounting standards update, along with a FASB in Focus overview summary, an educational video, and an Understanding Costs and Benefits document.
Convergence in a Way
FASB's hedging standard goes beyond the financial instruments convergence project with the IASB in some ways and wraps it up in others. “I think originally it was put in that category, in part because some viewed finalizing hedging as at least related to classification and measurement and impairment,” said Kroeker. “Those are sort of the risks you are trying to hedge. If you change the base accounting accounting model for classification and measurement, so at one end of the spectrum if you went to all fair value for classification and measurement, that could have a big impact on how you would do hedge accounting. I guess it's related in that way, but much of hedge accounting is really separate from that as well. A lot of it relates to nonfinancial products, such as commodities and expected future transactions. I think it was under that broad category, but I would really describe it as discrete from the other aspects. I don't think we have anything left on what we would call the financial instruments project.”
The language used in the new standard under U.S. GAAP differs in some ways from IFRS 9, but the outcomes would be similar in general for many common hedge accounting strategies. But there are still some differences. IFRS 9 retained separate measurement and reporting of hedge ineffectiveness and, unlike FASB's new standard, doesn't have broad guidance on presentation.
“To me the good news on this is that it actually brings into closer convergence IFRS guidance and U.S. GAAP,” said Kroeker. “This was not done jointly with the IASB, but it does bring the results of many hedge accounting strategies closer to IFRS.”
The new rules promise to make it easier for financial statement preparers to apply hedge accounting. There will be more strategies available to them on the nonfinancial and financial sides. The way that hedge results are measured is going to eliminate some of the ineffectiveness that's been reported in the past, getting rid of some of the separate reporting previously required.
Presentation will also be more closely aligned. All changes in the value of the hedging instrument have to be presented with the income statement effect of the hedge guidance. The disclosures will focus more on the effect of hedge accounting on those statement line items more clearly than today, taking the existing disclosures and rearranging them a bit.
The new standard also eases the application of hedge accounting by giving people more time to prepare certain aspects of their hedge documentation, such as quantitative testing. It also eases some of the methods typically applied in hedge accounting, such as the shortcut method and critical terms match, to make them easier to apply in practice.
“I think it reduces the cost and complexity associated with applying hedge accounting,” said Kroeker. “It's a win-win because it does that in a way that I think also improves the transparency in the results reported to investors by allowing greater alignment between the economics and the accounting. The presentation and the disclosure also are very helpful in that. A lot of people are talking about either adopting it early or as soon as they can. But if people are excited about early adoption, they have to early adopt the whole standard. They need to have a well controlled environment, with disclosure controls around the new presentation, making sure they're doing that in a well controlled way when they're trying to do that as quickly as possible.”
In developing the new standard, FASB received important input from the Private Company Council, which like FASB is overseen by the Financial Accounting Foundation. The PCC advised FASB about the constraints faced by private companies that are not financial institutions and certain not-for-profit organizations in completing hedge documentation in a timely manner. FASB decided to provide relief by aligning the timing of performance and documentation of initial and subsequent effectiveness testing with the timing of the issuance of interim (if applicable) or annual financial statements.
“The input that we got from the PCC along the way, particularly as it relates to documentation and reasonable expectations of private companies' application of hedge accounting, has been very helpful,” said Kroeker.
For auditors, there might be some new controls they will need to put in place as well, particularly around the qualitative assessments of effectiveness that will be allowed, or around any new strategies.
“To the extent, for example, the 'last of layer' hedge approach requires companies to be more disciplined about the amount that they are asserting at sort of the last layer, there is some judgment there for auditors to get comfortable with, but that's no different than with any new standard that has differential judgments or accounting in it,” said Kroeker.
Financial professionals will have some work to do in acquainting themselves with the new standard. A recent survey by Chatham Financial found that only 18 percent of the financial risk professionals it surveyed during a recent webcast considered themselves to be well versed in the proposed guidance. Only 11 percent said they have assessed the rules' impact on their programs and plan to early adopt the guidance. Risk professionals believe the greatest impact of the new standards will be enhancements to fair value hedge accounting (38 percent), followed by no longer separately measuring and presenting ineffectiveness (33 percent) and changes to the shortcut method and other effectiveness assessment approaches (15 percent).
With the major convergence projects such as revenue recognition, leasing and financial instruments now finalized, FASB is continuing to work on some major projects of its own, including long-duration insurance contracts and not-for-profit accounting for revenue from grants and contracts. "Stay tuned to our agenda consultation which is coming up in early fall," said Kroeker.