FASB Aims to Clarify Certain Aspects of Hedge Accounting Rules

The Financial Accounting Standards Board (FASB) released an exposure draft on Sept. 25 on a proposal that would clarify parts of its current guidance on hedge accounting and address several incremental hedge accounting issues arising from the global reference rate reform initiative.

In 2017, the FASB issued Accounting Standards Update No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, to “better portray the economic results of an entity’s risk management activities in its financial statements and to make certain targeted improvements to simplify the application of the hedge accounting guidance,” the board said.

During the FASB’s 2021 agenda consultation project and other outreach, stakeholders expressed concerns that, in certain circumstances, the current guidance increases the risk of not being able to apply hedge accounting for otherwise highly effective hedging relationships, which results in less decision-useful information for investors. Stakeholders also identified some areas of hedge accounting guidance requiring further updates to address the effects of reference rate reform on hedge accounting, the FASB said.

The amendments in the proposed Accounting Standards Update (ASU) would enable companies to apply hedge accounting to a greater number of highly effective economic hedges, thereby improving the decision-usefulness of information provided to investors.

The proposal addresses five issues in particular. The following is an excerpt from the exposure draft that explains each issue:

Issue 1: Similar Risk Assessment for Cash Flow Hedges

The amendments in this proposed Update would expand the hedged risks permitted to be aggregated in a group of individual forecasted transactions in a cash flow hedge by changing the requirement to designate a group of individual forecasted transactions from having a shared risk exposure to having a similar risk exposure. Entities would be required to assess risk similarity both at hedge inception and on an ongoing basis. The proposed amendments also would clarify that a group of individual forecasted transactions would be considered to have a similar risk exposure if the derivative used as the hedging instrument is highly effective against each risk in the group. In addition, in some cases, entities would be permitted to perform an ongoing qualitative assessment of whether a group of individual forecasted transactions has a similar risk exposure on a hedge-by-hedge basis.

The amendments in this proposed Update would improve GAAP by expanding the hedged risks permitted to be aggregated in a group of individual forecasted transactions, thereby enabling entities to apply hedge accounting to broader portfolios of forecasted transactions. Entities would be able to apply hedge accounting in a more efficient, cost-effective manner while reducing the risk of missed forecasts for highly effective economic hedges. Furthermore, clarifying the application of the similar risk assessment would improve operability and help entities apply the guidance more consistently. Therefore, investors would have more relevant information about entities’ risk management activities related to cash flow hedges of groups of forecasted transactions.

Issue 2: Hedging Forecasted Interest Payments on Choose-Your-Rate Debt Instruments

The amendments in this proposed Update would facilitate the application of the change in hedged risk guidance to cash flow hedges of forecasted interest payments on variable-rate debt instruments with contractual terms that permit the borrower to change the interest rate index and interest rate tenor (that is, reset frequency) upon which interest is accrued (commonly referred to as “choose-your-rate” debt instruments). The contractual terms of the debt agreement would determine the alternative interest rate indexes and interest rate tenors that an entity may select during the hedging relationship without needing to discontinue hedge accounting. In addition, the proposed amendments would permit entities to use simplified assumptions when assessing hedge effectiveness and the probability of forecasted transactions occurring. Entities would be prohibited from applying this simplified guidance by analogy to other circumstances.

The amendments in this proposed Update would improve GAAP by establishing an operable model to address a pervasive hedging strategy for which stakeholders highlighted that diversity in practice exists. Furthermore, the amendments would enable entities to reduce the risk of hedge de-designation events and missed forecasts, while broadening the application of hedge accounting. As a result, entities would be able to more consistently reflect risk management strategies in the financial information provided to investors.

Issue 3: Cash Flow Hedges of Nonfinancial Forecasted Transactions

The amendments in this proposed Update would expand hedge accounting for forecasted purchases and sales of nonfinancial assets. Entities would be permitted to designate variable price components of the forecasted purchase or sale of a nonfinancial asset that meet the clearly-and-closely-related criteria within the normal purchases and normal sales scope exception. Relative to current GAAP, which limits designation of nonfinancial components to those that are contractually specified, a model based on the clearly-and-closely-related criteria would permit hedge accounting for eligible components of forecasted spot-market transactions and subcomponents of explicitly referenced components in an agreement’s pricing formula.

The amendments in this proposed Update would improve GAAP because the application of hedge accounting would not necessarily be limited by whether the nonfinancial purchase or sale transaction is executed in the spot or forward market. Furthermore, the proposed amendments also may enable entities to reduce the risk of missed forecasts for highly effective economic hedges, more closely aligning entities’ risk management strategies with hedge accounting to better reflect those strategies in financial reporting.

The amendments in this proposed Update also would clarify that entities may designate a variable price component in a contract that is accounted for as a derivative as the hedged risk if the associated forecasted purchase or sale of the nonfinancial asset qualifies to be a hedged forecasted transaction. That clarification would improve GAAP because it would resolve diversity in practice about whether hedge accounting may be applied in those situations and would allow hedge accounting to be applied to highly effective economic hedges.

Issue 4: Net Written Options as Hedging Instruments

The amendments in this proposed Update would permit compound derivatives composed of a written option and a non-option derivative (for example, an interest rate swap with a written cap or floor) to qualify for designation as a hedging instrument in a cash flow hedge by adjusting the eligibility criteria for when a net written option may be designated as a hedging instrument. The proposed amendments would permit an entity to assume that certain terms of the hedged forecasted transactions match those of the hedging instrument for purposes of applying the net written option test.

The amendments in this proposed Update would improve GAAP by making the net written option test more operable for hedging relationships involving a variable-rate loan with an interest rate floor hedged by an interest rate swap that contains a mirror-image interest rate floor. The proposed amendments would accomplish that by allowing simplifying assumptions to be made that would accommodate differences in the loan and swap markets that exist after the cessation of the London Interbank Offered Rate (LIBOR). Making those simplifying assumptions would allow entities to continue to apply hedge accounting for strategies involving compound derivatives composed of a written option and a non-option derivative after LIBOR cessation.

Issue 5: Foreign-Currency-Denominated Debt Instrument as Hedging Instrument and Hedged Item (Dual Hedge)

The amendments in this proposed Update would eliminate the recognition and presentation mismatch related to a dual hedge strategy (that is, a hedge for which a foreign-currency-denominated debt instrument is both designated as the hedging instrument in a net investment hedge and designated as the hedged item in a fair value hedge of interest rate risk).

The proposed amendments would require that an entity exclude the debt instrument’s fair value hedge basis adjustment from the net investment hedge effectiveness assessment. As a result, an entity would immediately recognize in earnings the gains and losses from the remeasurement of the debt instrument’s fair value hedge basis adjustment at the spot exchange rate. Entities would be prohibited from applying this guidance by analogy to other circumstances.

The amendments in this proposed Update would improve GAAP by enabling entities that utilize dual hedging strategies to reflect the economic offset of changes attributable to both interest rate risk and foreign exchange risk.

Public comments on the proposed ASU should be submitted by Nov. 25.