Corporate Finance

Sizing Up the New Hedge Accounting Rules

Companies should start preparing soon for the changes slated to take effect in late 2018.
Chandu ChilakapatiNovember 10, 2017

It’s just over a year until the scheduled effective date for Accounting Standards Update 2017-12, the long-awaited update to the Financial Accounting Standards Board’s derivatives and hedge accounting standard.

Chandu Chilakapati

Chandu Chilakapati

The goal of the update, issued in August of this year, is to align financial statements with the hedging and risk-management programs of financial-statement issuers. To accomplish the goal, FASB made targeted improvements to the standard for electing, performing, and maintaining hedge accounting.

This article offers implementation guidance, shedding light on the pitfalls of procrastination and providing direction on early adoption, internal decision-making, and key items to consider for hedgers of non-financial assets.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

Hedge accounting has always been a special form of accounting for qualifying hedges, designed to match the timing of the exposure with the income-statement impact. But the associated administrative burden, coupled with the risk of restatement from improper application, had proven to be a deterrent to companies using hedge accounting.

The update reduces the burden and risk, in most cases, by:

  1. Simplifying the “short-cut method” (for benchmark interest-rate hedges) and the “critical terms match” (for hedging financial or nonfinancial assets and liabilities). Both allow accounting for “perfectly effective hedges” — those that eliminate all risk in a position or portfolio – with limited documentation and analysis. The simplification is a shorter approach that was previously available but rarely utilized due to the risk of misapplication. The update clarifies the criteria for using the short-cut method and critical terms match, which should enable more instruments to qualify for hedge accounting with less risk.
  1. Allowing for contractually specified risk-component hedging (i.e., hedging a portion of the market risk associated with a market exposure). This will also allow more instruments to qualify for hedge accounting, because many companies hedge only certain components of their market risk.
  1. Allowing for qualitative ongoing testing for “highly effective” hedges — which meet certain criteria based on results of a regression analysis — in order to decrease the burden of performing tests for which the results are already known.
  1. Completely removing the concept of hedge ineffectiveness, such that if a hedge relationship meets the criteria of “highly effective,” companies no longer have to be concerned about separately measuring ineffectiveness.

Putting the Update into Context

While the update is a great step toward accomplishing FASB’s objective, the revised disclosure requirements will affect all issuers.

Companies might think that because they don’t use hedge accounting, the update doesn’t affect them. That’s a misperception that could send them scrambling once their external audit firm points out that disclosure tables and income-statement geography has changed. Internal processes around financial-statement reporting for derivatives will have to change to create the necessary new tables, XBRL tags, and updated descriptions of risk-management objectives.

The FASB update is designed to reduce or remove companies’ excuses for not adopting hedge accounting. The carrot-and-stick principle applies here: the update provides benefits for companies that use hedge accounting and requires a separate presentation from those that don’t.

The key paragraph from the standard states: “815-10-50-4CC — An entity shall present separately by type of contract (as discussed in paragraph 815-10-50-4D) the gains and losses disclosed in accordance with paragraph 815-10-50-4A(b) for derivative instruments not designated or qualifying as hedging instruments under Topic 815 (see paragraph 815-10-50-4F).”

For companies that don’t elect hedge accounting, the disclosure presenting derivatives not designated under hedge accounting may require an explanation. If a majority of companies apply hedge accounting upon adoption of the updated standard, companies that don’t designate similar derivative instruments under similar strategies will have financial statements that aren’t easily comparable to their peers. The explanation may not be satisfactory when peers are electing hedge accounting, given that FASB has decreased the burdens associated with such election.

This dynamic should encourage all companies to at least consider applying hedge accounting upon adoption of the updated standard. Key considerations will differ for companies that already use hedge accounting and those that don’t.

Update Adoption Considerations

A question facing companies already using hedge accounting will be whether to become an early adopter of the new standard. Adoption is required for fiscal years beginning after Dec. 15, 2018, and interim periods within those fiscal years. For companies whose fiscal years begin in January, adoption is required for all of 2019.

For companies already applying hedge accounting, the benefits of simplifying their reporting and administrative burden will still carry the cost of changing their reporting to remove ineffectiveness, updating income statement reporting, and updating their disclosures. The cost and burden of early adoption will depend on available resources, given a number of other ongoing accounting standard updates, such as those for revenue recognition and lease accounting.

Upon adoption of the new derivatives hedge accounting standard, companies will need to update their accounting policies and hedge documentation. They will also need to determine whether the short-cut method or the critical terms match (with qualitative quarterly testing) will work best for them.

Financial-asset hedgers with relatively straightforward hedging programs should qualify for the short-cut method or qualitative assessments. Nonfinancial-asset hedgers without perfectly effective hedges will have to consider whether their hedges will qualify under the contractually specified risk-component hedging. If they qualify, they will be able to utilize the critical terms match and qualitative testing.

For companies considering early adoption, it is recommended that deliberations covering all the interim periods of 2018 begin no later than January.

Process changes will be more complex for companies that don’t currently apply hedge accounting. They will have all the same considerations as those that currently apply hedge accounting but will have to perform initial quantitative effectiveness tests and document their hedges. These new processes will also require Sarbanes-Oxley documentation and testing.

There will be new costs for implementing the new processes, and procrastination will almost certainly require outsourced support. Companies should consider beginning their internal assessment in early to mid-2018. In my experience, a majority of nonfinancial-asset hedgers have not adopted hedge accounting and will require additional lead time to comply with the requirements.

Nonfinancial-asset hedgers, such as commodity or energy companies, have to perform quantitative tests such as regression analysis and constant monitoring because they generally don’t meet the critical terms match criteria. The critical terms match simplification requires the entire risk to be hedged, but often there is insufficient market liquidity for perfectly effective hedges. These companies must consider using the risk-component hedging provided for in the updated standard (see next paragraph).

Risk-Component Hedging for Commodity Contracts

The difficulty in utilizing the risk-component hedging allowance is that the component must be contractually specified. Currently, most forward purchase or sales contracts don’t specify the components used in pricing. Companies need to begin modifying contracts to specify the pricing components in order to qualify for component hedging.

Modifying long-term contracts for accounting reasons instead of commercial reasons can add cost. Companies should begin modifying their contracts in the normal course of business as soon as possible to reduce any negotiation cost. This will require coordination between front-office originators and accounting teams. The nonfinancial-asset hedgers that do not have contractually specified risk components will have difficulty achieving the benefits of the component-hedging simplification.

In conclusion, companies that wait until the end of 2018 to adopt the updated FASB standard may face increased implementation costs as well as difficulty realizing the updated standard’s benefits.

Chandu Chilakapati is a managing director in the Valuation Services group at global professional services firm Alvarez & Marsal (A&M).