The updated hedge accounting rules issued by the Financial Accounting Standard Board on Monday should cut the costs and burdens of derivatives accounting for companies and encourage fearful ones to enlist in the hedge accounting regime, FASB vice chairman James L. Kroeker said in an interview with CFO immediately following the announcement.
Based on the feedback from corporate executives in the form of comment letters and roundtables in the runup to the accounting standards update, Kroeker feels that hedge accounting will become cheaper and less administratively burdensome for companies. To be sure, the accounting board hasn’t been able to amass quantitative assessments of the cost savings, largely because corporate estimates have been hard to come by.
Even financial report preparers who regularly use derivatives to hedge commodity and interest-rate exposures “can’t estimate the cost” of hedge accounting rule changes, says Kroeker. “You call them and ask them how much they will save, and it’s not like they will say, “this will save us X.”
Nevertheless, financial statement preparers “agree that, qualitatively, this will be a cost savings and certainly [reduce] the burden on them doing all that’s required in hedge accounting,” he adds.
The new standard takes effect for public companies for fiscal years, and interim periods within those fiscal years, starting after December 15, 2018. For private companies, the comparable deadlines are for fiscal years beginning after December 15, 2019, and for interim periods for fiscal years beginning after December 15, 2020. The board permits companies to adopt the standard before the effective dates.
Amending a 1998 standard, FASB’s objective in issuing the update is “to better align hedge accounting with an organization’s risk management activities in the financial statements,” according to a FASB summary. Further, “the ASU simplifies the application of hedge accounting guidance in areas where practice issues exist,” the board says.
One of the main practice issues FASB has targeted for simplification — and a prime source of potential cuts in corporate compliance costs — is the current requirement that companies measure and report hedge “ineffectiveness.”
That’s the amount the hedge fails to offset the hedged item. But the board reckoned that hedge ineffectiveness is a tough concept for companies to measure and report and a hard one for investors to grasp. Thus, FASB decided to eliminate the requirement that companies measure and report hedge ineffectiveness, according to the ASU.
“The simplification here is that if you have a derivative that’s a highly effective one, you won’t have to measure ineffectiveness going forward,” the FASB vice chairman says, noting that taking such measures can require a company to set up and maintain a “complex mathematical model.” And that can be a costly proposition.
Current generally accepted accounting principles enable companies to use hedge accounting only for the portion of the hedge deemed to be “highly effective,” meaning that the changes in the value of the hedged item and the hedging derivative significantly offset each other. (One reason corporate derivatives users find the ability to employ hedge accounting desirable is that it enables them to avoid having to report hedge results on their income statement, a situation that can make earnings appear a lot more volatile.)
Kroeker doesn’t think that eliminating the requirement to report hedge ineffectiveness sacrifices the rigor of the existing hedging rules. “The standard still maintains the high bar [that] in order to achieve hedge accounting you have to have the derivative be highly effective at offsetting the risk that you’re trying to hedge, and that’s maintained,” he says. “And initially [the standard still requires the preparer] to make a quantitative assessment to make that determination.”
Another way the ASU makes life easier for finance and accounting executives is that it gives companies more time to document a hedge, Kroeker notes. In particular, private companies that aren’t financial institutions and certain non-profits won’t have to continuously document their testing of hedge effectiveness.
Instead, FASB decided to provide relief for such companies by lining up the timing of the performance and documentation of effectiveness testing with the issuance of their quarterly and annual financial statements. “Private companies have told us that given their resources, it’s particularly challenging in the current environment to actually have all of that documentation contemporaneously,” Kroeker adds.
The measure also aligns the performance and documentation of hedge testing with the 10-Qs and 10-Ks of public companies. To be sure, public companies will still have to document their intent to hedge an underlying exposure at the date of entering into the hedge.
But the ASU provides some clarity on when public companies should report testing results. Until now, although public companies have had up to three months to do the initial testing of a hedge’s effectiveness, there’s been little guidance about how soon the results of those tests must be documented.
In the absence of guidance, companies have been following the practice of documenting the first hedge tests within 24 to 48 hours. The guidance under the new ASU, however, specifies that public companies have up to three months to document their initial hedge testing.
Overall, in issuing the ASU, FASB wants to change the hedging rules to more closely reflect the underlying economics of derivatives deals and to match the accounting to the way companies actually manage their risks. For instance, the new update will enable companies to account for the specific components of a nonfinancial risk that are being hedged, rather than having to provide the broader reporting that’s currently required.
Thus, according to the ASU, “[the] amendments remove the requirement in current GAAP that only the overall variability in cash flows or variability related to foreign currency risk could be designated as the hedged risk in a cash-flow hedge of a nonfinancial asset.”
“There were a number of commonly employed risk management strategies where the limits of hedge accounting prohibited directly accounting [for] components,” says Kroeker.
In reporting a derivative transaction that covered specifically fluctuations in the price of corn, for instance, a company might be required to calculate and report other expenses, such as insurance and transportation, to be included in a total purchase price. Under the new update, however, “you could hedge directly to a component of the price, which is a commonly employed risk management strategy that the accounting rules didn’t allow you to hedge directly,” Kroeker explains.