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Accounting for derivatives under ASC815, and specifically applying hedge accounting, has always been a complex undertaking for financial statement preparers. The difficulty associated with its application and the limitations imposed for hedging both non-financial and financial risks have finally been addressed by the Financial Accounting Standards Board (FASB), in its latest Accounting Standards Update (ASU 2017-12), issued on August 28, 2017.
This ASU, taking effect after December 2018, is a significant improvement designed to help companies better align their hedging activities with the reflection in their accounts and in a simpler and less onerous way.
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To simplify the reporting of hedges, the ASU now allows:
• for Cash Flow and Net Investment Hedges all changes of fair value included in the effectiveness assessment will be deferred into OCI (Other Comprehensive Income) and recognized in earnings at the same time as the hedged item affects earnings. Therefore, companies will no longer be required to perform a separate measurement and report of hedge ineffectiveness.
• the easing of hedge effectiveness requirements, by allowing a company to perform subsequent assessments of hedge effectiveness qualitatively if certain conditions are met.
• companies more time to perform the initial quantitative hedge effectiveness assessment (and for non-financial private companies, up until the date of the issuance of interim of annual financial statements).
• companies to apply the ‘long-haul’ method for assessing hedge effectiveness when use of the shortcut method was not or no longer is appropriate, when certain conditions are met.
• clarification that a company can apply the ‘critical terms match’ method for a group of forecast transactions if the transactions occur and the derivative matures within the same 31 day period or fiscal month as the hedged transactions.
• companies to exclude cross-currency basis spreads in cross-currency swaps from the assessment of hedge effectiveness.
• companies to consider how changes in the benchmark interest rate affect the exercise of a call or put option when assessing hedge effectiveness due to prepayment risk (i.e. ignoring credit, liquidity, and other non-interest rate prepayment provisions).
• companies to elect to perform the ongoing retrospective and prospective effectiveness assessments qualitatively, once the initial quantitative effectiveness test is satisfied,. Should facts and circumstances change, then quantitative testing would be required from that point onwards.
To better align hedge accounting with risk management activities, the FASB has changed the following:
• For interest rate hedging, the new ASU allows any contractually specified rate and expands the index eligibility to the SIFMA rate.
• For nonfinancial items, their contractually specified components will now be eligible as a hedged risk, and not only the total cash flows or overall changes in fair value.
• The change in value of the hedge will have to be presented on the same income statement line item(s) as the earnings effect of the hedged item.
Effective Date and Transition
For public business entities, the new changes take effect for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. For private entities, they will take effect for fiscal years beginning after December 15, 2019, and interim periods beginning after December 15, 2020. However, entities are permitted to early adopt in any interim or annual period after issuance of the ASU.
As with any change, there are several points to be considered in relation to the transition. For cash flow and net investment hedges existing at the date of adoption, a company must apply a cumulative-effect adjustment related to the separate measurement of ineffectiveness to accumulate other comprehensive income. The amended presentation and disclosure guidance is required only prospectively, and certain elections may be made by an entity upon adoption to allow for existing hedging relationships to transition to the newly allowable alternatives within the ASU.
How JCRA can assist
JCRA helps companies across multiple sectors with their derivatives reporting processes by supporting derivative fair value calculations, and complying with the requirements of hedge accounting. When a company is approaching an accounting change such as ASU 2017-12, JCRA can help by leading the internal analysis and external discussions with the relevant stakeholders (such as external auditors). This ensures that the company and its publics understand exactly what has changed and what the impact in their current workload and processes might be.
Although the ASU changes are a simplification of hedge accounting, topics like the cross currency swap basis or the new benchmark and hedging of specified components in non-financial items are new concepts under US GAAP. As such, they may require significant work to implement and could be subject to different interpretations by different audit and accountancy firms.
Have you got a question about how you hedge your financial risks, or structure and arrange your debt?
Find out how we can help you by contacting us today.