FASB Plans Further Hedge Accounting Adjustments

Reviews of the Financial Accounting Standards Board's recent hedge accounting changes have been highly favorable, and they're likely to become even more so should additional changes, soon to be proposed, come to fruition.

FASB directed its staff in a May meeting to issue an exposure draft of several changes to its accounting standards update (ASU), Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. Two of those changes could significantly facilitate obtaining and retaining hedge accounting treatment: one making it easier to change the indices that hedges are tied to; the other enabling more nonfinancial hedges, such as those on commodities, to qualify for the treatment.

Jon Howard, senior consultation partner at Deloitte & Touche, said that corporate clients have mostly been pleased with the new standard, for which FASB permitted early adoption in any interim period after the standard was issued in August 2017. All public companies had to begin applying the standard by the start of 2019. (See New FASB Guidance Facilitates Hedge Accounting)

“The new rules certainly make it easier for people to apply hedge accounting,” Howard said, pointing to a significant uptick anecdotally in corporates hedging foreign exchange risk across industries. “The first quarter 10Qs of many significant global organizations with subsidiaries in Europe or Japan show they are probably now doing net investment hedges and have entered into cross-currency swaps.”

That activity was driven in part by Wall Street banks pointing out that forward rates rested below spot rates, creating a favorable cross-currency basis spread that companies sought to lock in for the next three or four years. The changes FASB plans to propose in the exposure draft, expected by early third quarter, will provide longer-term benefits.

Change of Benchmark

One change would enable corporates to more easily change the benchmark over which they're pricing their cash flow hedges. For example, a company may forecast hedging debt priced over three-month Libor, but, depending on the shape of the yield curve, later determine that pricing it over one-month Libor is preferable.

“The rules on that are now very restrictive,” Howard said, adding that if the forecasted transaction ends up not happening, then the company has to remove all the previous impacts of hedge accounting and run those through P&L. “Now they're trying to ease the rules on that, basically saying that as long as the hedge remains in the ballpark and is similar, the company can retain hedge accounting.”

In fact, it is fairly common for companies' cash flow forecasts to change in accordance with commodity prices, interest rates or currency exposures. Now, such a change may require a company to de-designate the hedge and then re-designate a new hedge, a burdensome process that increases risk and could upset hedge accounting treatment, said Dan Gentzel, head of the global accounting advisory team at Chatham Financial. Under the anticipated draft, if the exposure being hedged is similar, then the swap and hedge accounting treatment can remain in place.

“FASB is saying that if the company can show the hedge relationship is still highly effective, it can continue to apply hedge accounting, and that should simplify things,” Gentzel said.

Documentation Questions

When it comes to enabling more nonfinancial hedges to qualify for hedge accounting treatment, FASB's guidance under the ASU requires the index on which a derivative is priced to be explicitly named in the contract or related documentation. But the standards board didn't provide examples to illustrate what that means.

Gentzel said that contracts often are not clearly articulated, and there may be side letters, side agreements and information agreements. Consequently, questions arose about just what kind of documentation could be looked to as contractual support, especially for commodity hedging.

“We've definitely seen an uptick in this type of hedging in the last few years, but we've also seen hedging programs not qualify that we had hoped would have, and they may end up qualifying under these proposed changes,” Gentzel said, adding that Chatham anticipates FASB clarifying the types of documents that provide contractual support.

One issue arises when companies forecast plans to hedge a certain commodity, but instead choose to buy it in the spot market from the supplier. While it is unclear whether those types of transactions qualify for hedge accounting, Gentzel said the answer is likely to be yes, as long as the contractual support identifies how the price was determined, including the specific index used in the calculation.

Receipt as Evidence

He added that FASB will probably have to permit the spot receipt as evidence, but that will still be challenging if it requires the receipt to indicate the specific index from which the price was determined. A trucking company may allow drivers to purchase fuel when needed, but fuel-station receipts are unlikely to include the specific index.

“They're probably going to allow spot transactions to be counted as the hedged transaction, and that will be positive and help clear up ambiguity that's existed over the last two years since ASU was issued,” Gentzel said. “However, it may still be a challenge for certain spot purchases where the index isn't specified on the receipt.”

The International Financial Reporting Standard (IFRS) for hedge accounting, issued by the International Accounting Standards Board (IASB) about five years ago, takes a slightly different approach. The hedged risk can be a risk component that is separately identifiable and reliably measurable based on an assessment within the context of the particular market structure for the item, Gentzel said. In that model, the specific index needn't be explicitly documented, as long as the party can demonstrate the pricing for the item being purchased or sold in a particular market is based on the hedged index.

“The FASB has decided to go down a different path and is trying to make the current model work,” Gentzel said. “It's come a long way since before ASU 2017-12 was issued, but it's finding some transactions don't qualify. If FASB wants to scope in those other types of hedging programs, it may have to consider a model more like the IFRS's.”