Risk Management

FASB Holds Christmas in June for Derivatives Users

The Financial Accounting Standards Board’s ruling on hedge accounting has something for every company that uses derivatives, an EY executive says.
David KatzJune 15, 2017

It may be hard to think of the serious-minded standard setters of the Financial Accounting Standards Board as Santa Clauses. But  Rob Royall, EY’s derivatives and financial instruments leader, suggests that might be an apt metaphor after FASB voted earlier this month to go ahead with its plan to make the first major change in hedge accounting in nearly 20 years.

“Anybody that uses derivatives will find something that they like in this. A few will find things that they don’t like,” he says. “But mostly it’s Christmas.”

Royall thinks that the board’s new accounting standard aimed at improving and simplifying hedge accounting could go a long way toward making things better for corporate derivatives users it in two ways: lowering the barriers for companies to qualify for hedge accounting and making it easier for companies that have already qualified to maintain their financial and non-financial derivatives programs. 

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The final accounting standards update, which is expected to be published in August 2017 with some changes from the approved public exposure draft, will take effect for public companies with fiscal years, and interim periods within them, starting after December 15, 2018. For private companies, the clock will start for fiscal years beginning after December 15, 2019 and interim periods for fiscal years beginning after December 15, 2020.

Companies can adopt the rules early, starting in any interim period or fiscal years before the effective date of the standard.  Amending a 1998 standard, FASB’s update aims to simplify the rules for qualifying for hedge accounting and for presenting hedging results on financial statements.

Calling the standard “a significant, meaningful attempt to make it easier for companies to qualify for hedge accounting,” Royall notes that most companies that use derivatives want to qualify. The reason is that hedge accounting enables the derivatives user to avoid the effect on earnings of having to report the hedge result on the income statement — a highly volatile proposition.

“A derivative always has to be on the balance sheet at fair value, and fair value is a number that moves unpredictably. The normal accounting for that is to take that unpredictable movement and put it right in P&L now, which is really not what a corporate CFO wants,” says Royall.

But if a derivative qualifies for the hedge accounting model, the company can “store” the effects of the unpredictable movements of a derivative on its balance sheet, rather than having to report them on the income statement, according to the accountant. In that way, the company can avoid earnings volatility.

The part of the balance sheet where the volatility can be recorded is the “other comprehensive income” part of the equity section of the balance sheet. In hedge accounting, “equity goes up and down, but profit and loss doesn’t go up and down until the transaction that the derivative is hedging eventually happens — which might be the following quarter [or] years later even,” explains Royall.

To qualify for such benefits represents a big lift, especially for smaller companies and those outside the financial services industries. The elimination of many requirements could lower the compliance costs for such companies and encourage them to attempt to qualify for hedge accounting, he suggests.

For instance, current GAAP provides special hedge accounting only for that part of the hedge that’s “highly effective,” meaning that the changes in the value of the hedged item and the hedging derivative significantly offset each other. The catch, however, is that companies must separately reflect the amount by which the hedging instrument doesn’t offset the hedged item, which is referred to as the “ineffective” amount.

The reporting of hedge ineffectiveness has “been difficult for financial statement users to understand and, at times, for preparers to explain,” according to the current draft of the standard. As a result, FASB eliminated the requirement that companies separately measure and report hedge ineffectiveness.

That’s a highly significant change. “The measuring of imperfection was, in many cases quite an exercise,” according to Royall.

For example, a company might have a hedge that was deemed ineffective if the risk moved $100 and the derivative moved in the opposite direction by $99. It’s no exaggeration, Royal says, to say that “the company would have to have systems in place to measure the $1 difference.”