Maybe I’m in the minority, but I LOVE hedge accounting under ASC 815. Using derivatives, or even non-derivatives, to offset risk exposures within a company, in order to eliminate uncertainty or lock-in gains… that gets my nerdy accountant engines revving!
Sadly, over the past 10+ years I’ve been teaching, hedge accounting has become less and less popular of a topic for our clients. Why is this? Have companies stopped hedging their risk exposures? Certainly not. That’s a sure-fire way for management to lose its job!
Companies have continued, and will always, economically hedge their risks; however, hedge ACCOUNTING, i.e. the ability to alter normal accounting conventions so that a company’s income statement reflects the same reduction in volatility due to risk as was economically achieved by the hedging relationship, has become less popular over the years.
The decrease in popularity can be attributed to many factors, but I’ll just sum up the reasons to one general complaint… it’s too hard! It’s important to remind you that while all companies economically hedge their risks, hedge accounting is not a right handed down by the accounting gods; hedge accounting must be EARNED! And to “earn” hedge accounting, one must meet specific criteria set out in ASC 815, including:
Initial and ongoing quantitative effectiveness testing performed on both a retrospective and prospective basis to prove the hedging relationship is a successful one at risk offset
Limit the risk being hedged to specifically allowed hedgeable risks, which is further limited by whether the instrument being hedged is financial or non-financial
Put limits on what items could be hedged and what instruments could be used as hedging instruments
An accounting model that required separate recognition of ineffectiveness in a hedging relationship from the effective portions, while also not providing any definitive guidance on where these amounts should be booked, resulting in a combination of complexity and diversity in practice
These restrictions, among others, frustrated both those in charge of risk management, as well as the financial reporting groups in charge of the accounting. Over time, some felt the challenges of complying with ASC 815 were not worth the benefits of the accounting result nor the risk of noncompliance and SEC scrutiny which has been increasing in recent years.
Enough of the Doom and Gloom… Cue the Sunshine!
ASU 2017-12 was issued in August of 2017 and claims to be making “targeted improvements” to accounting for hedging activities. Although the standard is not mandatorily effective for public business entities until 2019 (2020 for private companies), many companies have, or are in the process of, early adopting the new guidance. Hedging is getting cool again!
What’s making everyone rethink hedge accounting under ASC 815? Under the amendments, hedge accounting is becoming even more aligned with typical strategies undertaken for risk management purposes, and they are making it easier to comply and account for these relationships.
Here is a summary of some of these targeted improvements:
- Say goodbye to “ineffectiveness” – ASU 2017-12 eliminates the concept of ineffectiveness (i.e. the imperfections in a hedging relationship despite an overall effective hedging relationship). As a result, any ineffectiveness under the previous guidance is now accounted for in the same way as effective aspects of the relationship are accounted for. This will impact cash flow hedges and hedges of net investments in foreign operations the most. Instead of recognizing ineffectiveness immediately in P&L (as was the requirement under the previous guidance), it is now recognized in OCI along with the effective movements in the hedging instrument.
- No more guessing about where to book hedge accounting through P&L – While ASC 815 provided considerable guidance related to hedge accounting, when it came to financial statement presentation, it was silent. As a result, there was diversity in practice as to what specific line-items were to be used in the P&L. Under ASU 2017-12, it is now clear that all changes in fair value associated with the hedging instrument shall be booked to the line item most closely associated with the hedged item. If you are hedging the interest-rate risk of your note payable, all P&L impacts associated with the hedging instrument are booked to “interest expense”. If you are hedging a firm commitment to acquire inventory, all P&L impacts associated with the hedging instrument are booked to “cost of sales”. While this change helps to simplify hedge accounting, the end result will likely be more volatility to these P&L line-items as now they are required to contain hedge ineffectiveness as well as aspects of the hedging instrument that have been omitted for effectiveness purposes (e.g. forward points, time value on options, etc.).
- Expanding “qualitative” effectiveness testing – The onerous quantitative effectiveness testing is one of the biggest challenges for hedge accounting. ASC 815 allowed a “qualitative” approach in certain situations, two of the more popular ones being the shortcut method for hedges using an interest rate swap and critical terms match approach for hedges using forwards. Under these effectiveness approaches, the hedging relationship was assumed to be perfect if all the critical terms of both the derivative and the hedged item were the same. ASU 2017-12 expands the ability to use these methods and also introduces a new “quantitative and qualitative” approach to effectiveness testing. Under this new approach, after an initial quantitative effectiveness test at hedge inception, subsequent effectiveness testing may be performed on a qualitative basis. Of course, with all these expanded qualitative options, there will be a need for additional and expanded hedge documentation to ensure it is clear how this qualitative effectiveness testing will be performed.
- More risks to be hedged – Hedgeable risks were generally limited to non-financial items to either total cash flows or total fair value of the non-financial item, or just the FX risk. Other risks were not allowed under ASC 815. Under the amendments in ASU 2017-12, risks that represent “contractually-specified components” may not be identified as hedgeable risks if certain criteria are met. This means that hedging specific commodity risks on non-financial contracts which were previously forbidden, may now be possible. For financial instruments such as variable debt, the amendments expand the interest rate risk that can be hedged from only benchmark interest rates to “contractually-specified interest rates”. This means that variable rate debt based on a bank’s prime rate may now be eligible for hedge accounting.
- More options to improve your hedging relationships – One of the more exciting changes involves ways that ASC 815 has been amended to align itself more with the risk management strategies a company might undertake. To do this, the amendment provides for ways to document and measure effectiveness to improve the likelihood of a highly effective relationship. Some of these new or improved hedging strategies include:
- Expanding “excluded portions” from a hedging relationship – in addition to forwarding points and the time value of options, ASU 2017-12 also allows FX currency basis spreads to be omitted from effectiveness testing
- Partial term hedges – although never forbidden in the standard, under the amended guidance, an entity may hedge a partial term of a hedged item (e.g. the first 5 years of a 10-yr note payable). Under the amendments, this type of hedging relationship can be assessed for effectiveness by giving the hedged item an “assumed term” and “assumed maturity” which coincides with the period of the hedging relationship. This will allow cash flows to line up and improve effectiveness.
- Fair value hedges of interest rate risk – ASU 2017-12 specifies two separate strategies for assessing effectiveness. The first approach allows an entity to identify only to measure the change in fair value of the benchmark component of cash flows to measure the fair value of the hedged item. By eliminating the “credit spread” from the fair value assessment, the change in fair value is likely to be more in-line (or perfectly in-line) with the change in fair value of the interest rate swap derivative. The second approach relates to the treatment of prepayment options embedded in fixed rate debt instruments. Assuming an entity has a “mirror option” to hedge this prepayment option, ASU 2017-12 allows the fair value of the prepayment option to be valued based solely on changes in interest rates (while ignoring other possible factors impacting fair value such as credit quality, and other risk factors that might impact the likelihood of the prepayment option to be exercised). By isolating the impact on fair value to only changes in interest rate risk, the mirror option is more likely to offset the risk of prepayment of the hedged item.
- Last-of-layer technique - this is a new hedging technique discussed in ASU 2017-12 for portfolios of pre-payable fixed rate assets such as residential mortgage loans or mortgage-backed securities. Under this approach, an entity can designate the portion of the portfolio that it expects will remain outstanding and NOT be prepaid. Since it will not know which assets will be prepaid and which will not, the hedge can be identified as a “layer” within the entire portfolio. This will enable the hedge of these portfolios (without becoming no longer effective) should a reasonable number within the portfolio be prepaid. Note that this approach is only eligible for fixed-rate assets, not liabilities.
Perhaps this was a lot to take in all at one time. At the end of the day, this new ASU is expected to make hedging easier to “earn”, as well as implement. Over the weeks and months that follow, I will try to add to the blog, getting into more of the details of the hedging strategies that will likely be aided by these new amendments. Stay tuned… hedge accounting is back, baby!
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