Market participants waiting for years for comprehensive hedge accounting guidance may soon get their wish. The Financial Accounting Standards Board included “Risk Management and Hedge Accounting” in its January Agenda Consultation document with an invitation to comment.
Hedge accounting in financial statements describes the use of derivatives to hedge interest-rate and foreign-exchange risk.
The accounting standards body summarized past stakeholder feedback: “that the current hedge accounting model is complex, rules-based, and may no longer be suitable for its intended purpose. Stakeholders indicated that the guidance may not provide investors with decision-useful information, as many economic hedging activities do not qualify for hedge accounting because the hedge accounting guidance was not developed to broadly apply to risk management strategies that are developed and executed on an entity-wide basis.
“Therefore, stakeholders said that the guidance can result in financial statements that do not reflect the underlying economics of risk management transactions and the continued use of non-GAAP measures.”
Kern Roberts of Chatham Financial
The FASB also said that feedback was mixed on whether to continue to pursue the narrow, issue-by-issue approach that it has taken since a major hedge accounting update in 2017. An exposure draft last year addressed five different issues, an example of what Kern Roberts, global accounting practice lead at Chatham Financial, described as “whack-a-mole,” and leading some to call for more holistic consideration.
“We may need to step back and, instead of addressing individual items that aren’t working, think about how to make the overall infrastructure of the accounting standard more flexible and able to deal with the fact patterns we see in practice,” Roberts said.
After reaching tentative decisions in late March, the standards board directed staff to create a draft in preparation for a formal vote.
In a November comment letter on the exposure draft, the American Bankers Association supported most of the proposed changes. But ABA also favors a more comprehensive and flexible approach to hedge accounting, according to spokesperson Jeff Sigmund, and it “plans to include that and other elements in its comments regarding issues FASB should prioritize.”
The International Swaps and Derivatives Association, in a paper last July, used the term “holistic review” in reiterating a prior request for a second major hedge accounting update, to provide “new opportunities” to apply hedge accounting to risk management practices.
Without a holistic review, according to ISDA, “there will continue to be tension in how the accounting guidance influences decisions regarding whether or not to transact risk-reducing derivatives.”
Roberts said Chatham Financial, which works with corporates and financial institutions to hedge financial risk, agrees with ISDA’s overall analysis and would make a similar request of FASB. He asserted that under current U.S. generally accepted accounting principles (GAAP), a number of strategies don’t qualify for hedge accounting that probably should, or the result is difficult to explain to investors.
“This is particularly true for long-term hedges where the facts and circumstances perhaps inevitably will change over time, and the current model struggles to deal with those changes,” the Chatham managing director explained.
Take, for example, a company hedging a five-year loan with an interest-rate swap. It may want to refinance the debt after three years and move the reference rate to three-month from one-month SOFR. Although the two Secured Overnight Financing Rate benchmarks are highly correlated, and the swap remains an efficient hedge, current hedge accounting could require releasing gains or losses accumulated in “other comprehensive income” directly into P&L (profit and loss).
“The company may have a good hedge before and after the modification, but it actually ends up having to release a large amount in one period,” Roberts said, and that volatility is hard to explain to investors.
A key issue to reconsider, Roberts continued, is the lack of flexibility in hedge documentation. That is apparent in FASB’s 2024 exposure draft (ED). It proposes new language that would make it easier to retain hedge accounting when borrowers change the maturity and/or interest-rate index on a so-called choose-your-rate debt instrument.
“As a result, entities would be able to more consistently reflect risk management strategies in the financial information provided to investors,” the ED says.
To do so, however, would require contracts to stipulate from the get-go the specific alternative interest-rate indexes and loan maturities that an entity can select during the hedging relationship to retain hedge accounting. More flexible rules, Roberts said, would allow companies to update the nature of their hedged items over time, as facts and circumstances change.
“That would be a radical change, and it’s never easy for FASB to make radical changes,” he allowed. “But we think at this stage that there are so many challenges within specific parts of the guidance that it’s worth considering.”
FASB’s rigidity stems from concerns about organizations “managing earnings” for speculative purposes or to obscure a poorly designed hedge. Defining the hedged item at the outset reduces that risk by setting guardrails around the application of hedge accounting, although it clashes with the desire for more flexibility.
Roberts said tools to apply the hedge accounting model currently, including quantitative testing and recording derivatives on the balance sheet at fair value, remain useful to establish a hedge’s ability to offset the risk of losses. In the example of choose-your-rate debt instruments, he said, more dynamic effectiveness testing could increase flexibility while retaining hedge integrity.
“That could ensure there’s still a good economic offset between the hedged risk and the hedging derivative,” Roberts said.