Standards Board wraps up proposal to facilitate hedge accounting treatment.
In its last meeting addressing issues that will shape the new hedge accounting standard, the Financial Accounting Standards Board (FASB) expanded its definition of time value and time-value exclusions, furthering its objective of simplifying and facilitating the use of hedge accounting.
“The FASB has been very responsive to feedback it has gotten from constituents,” said Robert Baer, market specialist, derivatives and hedge accounting, at Bloomberg. “It has tried to accommodate a lot of these complex issues, and if you look at the whole project, it’s been about what can the FASB do to simplify the accounting and make more hedging relationships potentially qualify for hedge accounting.”
Speaking at the NeuGroup’s FX Managers’ Peer Group (FXMPG) in early march, Mr. Baer provided a long list of key decisions shaping the proposed rule, anticipated to be approved in a final draft in a May meeting, that will give corporates much more flexibility in achieving hedge accounting treatment and less burdensome requirements. At its March 22 meeting, the board furthered that effort by expanding the definition of time-value exclusions beyond the time value of a purchased option and that of FX forward points to include also the time value of cross currency swaps.
Mr. Baer said the inclusion of cross-currency basis is particularly important when a company is looking at fair value hedge, such as a company issuing fixed-rate debt in a foreign currency that uses a cross currency swap to convert it back to floating functional currency debt.
“And what they also did is put in an elective alternative method for recognizing time value,” Mr. Baer said.
Like the proposed exposure draft rules, these rules allow financial statement providers to put any time value exclusion through the same line item as the hedge exposure. However, instead of requiring the fair market value recognition of time value, which can add volatility, it will add an election to amortize time value.
“This will apply only to cash flow and fair value hedging, but it will give the ability to smooth out earnings a bit,” said Baer, in a phone interview following FASB’s meeting.
Among the changes from current rules that will make hedge accounting more accessible and less burdensome for corporates will be the requirements to determine hedge effectiveness. Today, hedge accounting treatment requires meeting a high effectiveness threshold between 80% and 125% and routinely performing quantitative tests of that relationship until the maturity date of the hedge. As originally drafted in the proposed rule, hedgers would be allowed to assess the ongoing effectiveness of the hedge on a less burdensome qualitative basis. However, a change in the facts and circumstances of the hedging relationship would require a return to routine quantitative testing to verify qualification under the high effectiveness threshold.
Revising that language, FASB will now allow qualitative testing in the future if performing a quantitative test confirms a high degree of effectiveness was maintained and is expected in the future.
“This will encourage companies to test and confirm high effectiveness when facts and circumstances of a hedge relationship change, without the fear of losing the ability to test qualitatively in the future,” Mr. Baer said.
Another significant change for corporates seeking to hedge fluctuations in commodity prices is the introduction of component hedging for nonfinancial items. Today, companies must hedge the entire purchase price of the commodity, and the proposed rules would enable them to hedge a component of risk, as long as it is specified in the contract.
“So, if you have an invoice and can reference where the risk is specified in the contract, then you can hedge that,” Mr. Baer said at the Neu Group meeting, “Hedging all of the price risk adds a lot of ineffectiveness, and it’s often more risk than a company is looking to hedge.”
Exposures beyond a contract period can also be hedged, Mr. Baer noted, if they are expecting to eventually be contractually specified and are likely to occur. He added that FASB did consider the International Accounting Standards Board’s (IASB) provision in its new hedge accounting guidance that enables hedging components if they are separately identifiable and reliably measurable. However, the board concluded that such “market convention” components were too obscure and might be subject to abuse, although it will monitor the practice and potentially reconsider it.
FASB’s new hedge accounting rules will also permit partial-term fair value hedges. Today, a company issuing a 10-year bond must hedge the entire 10 years, introducing more credit risk, because hedging the entire term of the term bond requires considering all the cash flows of the financial instrument. A partial term hedge when compared to the entire bond will most likely result in an ineffective hedge. Under the proposed rule, there will be an assumption that only the hedged cash flows are the hedged item.
“It opens up the door for a lot more interest-rate risk management; it’s a really nice change in accounting rules,” Mr. Baer said, noting that FASB will also permit the short-cut accounting method in this instance, instead of just the long-haul approach.
Mr. Baer noted that a final statement arriving in the second or third quarter of this year might allow calendar-year companies to adopt the new rules as early as 2018.
“Adopting early will provide less time for companies to transition into the new rules, which will entail implementing new risk management procedures that aren’t necessarily easy to do company-wide,” Mr. Baer said, adding that early adoption would also enable companies to take advantage of the friendlier requirements.
Some of the other numerous benefits to the new rules that Mr. Baer outlined for FXMPG members included:
Hedging Pre-Payable Instruments – In assessing hedge effectiveness due to prepayment risk, entities will only need to consider changes in the benchmark interest rate, not other non-interest rate prepayment provisions.
Changes in the Fair Value of the Hedged Item – When not applying the shortcut method in a hedge of interest rate risk—a late hedge—the hedged item can be measured for changes in fair value by considering only the benchmark rate changes, and not all contractual cash flows. If the benchmark rate is greater than the total debt coupon, either the total fair value change of all cash flows or the change in the benchmark rate can be used to calculate the change in fair value of the hedged financial instrument.
Cash Flow Hedge of Interest Rate Risk – Like the component hedging for
commodities, if the variability in cash flows is based on a contractually specified index, that interest rate can be considered the hedged risk irrespective of it being a defined benchmark rate, such as the Prime rate.
Critical Terms Match Method – Of specific importance to hedging FX or commodities, the critical terms match method will allow for the hedging of a group of forecasted exposures by assuming a match in maturity dates if exposure and hedge mature within the same 31-day period.
Time to Perform Initial Effectiveness Assessment Extended – If a quantitative assessment of effectiveness is required—that is, the hedge relationship doesn’t qualify for shortcut or critical terms match—the test can be deferred to the quarter end reporting date.