What You Need to Know about Hedging

In the coming months, the FASB will issue an Exposure Draft that proposes improvements to the hedge accounting model for financial instruments and nonfinancial items. The proposed standard is intended to improve and simplify the requirements related to hedge accounting, and to more closely align them with companies’ risk management activities. The Board expects the proposed amendments to benefit not only companies but also users in their understanding of the hedge results and the costs of hedging programs.
The proposed standard is intended to improve and simplify the requirements related to hedge accounting, and to more closely align them with companies’ risk management activities.

Many companies today use derivative instruments to hedge their exposure to certain risks. To account for these transactions, companies may elect to use hedge accounting (after meeting certain criteria) to minimize the accounting volatility of the derivatives. They often apply hedge accounting, for example, when hedging revenue or expenses that are not yet reported—such as forecasted sales or purchases.

Companies also use hedge accounting to hedge certain risks such as changes in interest rates associated with financial assets or liabilities that are not measured at fair value through net income.

However, stakeholders have told the FASB that the current standard on hedge accounting is very detailed and complex.

For example, preparers have indicated that applying the standard is difficult, especially when trying to ensure that the results accurately reflect their company’s risk management objectives and strategies.
Stakeholders have told the FASB that the current standard on hedge accounting is very detailed and complex.

Meanwhile, some financial statement users note that when a company applies the current accounting requirements, the results sometimes don’t match the actual economics of its hedging relationship. Investors have said that this can lead to financial reporting results that are hard to understand and interpret. These investors have told the FASB that they would like the reported results to better help them understand a company’s risk exposure and how they manage the risk.

Based on this initial feedback from stakeholders, the FASB drafted a proposal that is intended to more closely align hedge accounting with a company’s risk management strategy and more clearly present the effect of hedge accounting on the financial statements.
The core principle of the proposal is that hedge accounting should be permitted for a broader range of financial and nonfinancial risk management strategies than under current GAAP.

The core principle of the proposal is that hedge accounting should be permitted for a broader range of financial and nonfinancial risk management strategies than under current GAAP.

For example, the proposed guidance would enable companies to more easily apply hedge accounting for risk management strategies that either:
  1. Do not qualify for hedge accounting under current GAAP or,
  2. Do qualify, but the reported results in earnings do not reflect the actual effectiveness of its risk management strategy.
Additionally, the proposal is intended to reduce the operational burden of documenting and assessing the effectiveness of hedging relationships. For example, companies would:
  • No longer have to separately measure and record hedge ineffectiveness
  • Be able to perform qualitative hedge effectiveness testing after an initial quantitative test of hedge effectiveness
  • Have additional time to prepare the initial quantitative test of hedge effectiveness.
The proposed presentation and disclosure changes would also provide users with a more complete overview of the impact of hedge accounting on the income statement and balance sheet.

For example, additional disclosures regarding whether a company met its quantitative hedging goals (if any) would provide users with more complete information about the success of the company’s hedging programs. The revised tabular disclosures would focus on the effect that hedge accounting has on individual income statement line items.
The FASB plans to issue an Exposure Draft in mid-2016.

The FASB plans to issue an Exposure Draft in mid-2016. All stakeholders are encouraged to review and provide feedback on the proposal.

The effective date will be determined after the Board considers stakeholder feedback on the amendments in the proposed Update.

More information on the project can be found here.