Financial Instruments: Hedging

WHY DID THE FASB ISSUE A NEW STANDARD ON HEDGING?

The new standard addresses concerns from financial statement preparers about the difficulties associated with applying hedge accounting and its limitations for hedging both nonfinancial and financial risks. It also addresses concerns expressed by financial statement users about the way hedging activities are reported in the financial statements.

The objective in developing the new standard was to better align the accounting rules with a company’s risk management activities, and to simplify the application of the hedge accounting standard.

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HOW WILL THE NEW GUIDANCE IMPROVE FINANCIAL REPORTING?

The new standard will:
  • Expand hedge accounting for nonfinancial and financial risk components to allow companies to qualify for hedge accounting for more of their risk management activities
  • Refine the measurement of hedge results to more closely align hedge accounting with risk management activities
  • Decrease the complexity of preparing and understanding hedge results by eliminating the separate measurement and reporting of hedge ineffectiveness
  • Enhance transparency, comparability, and understandability of hedge results through enhanced disclosures and changing the presentation of hedge results to align the effects of the hedging instrument and the hedged item, and
  • Reduce the cost and complexity of applying hedge accounting by simplifying the way assessments of hedge effectiveness may be performed.
     
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WHAT ARE THE KEY PROVISIONS OF THE STANDARD?

The amendments in the new standard will permit more flexibility in hedging interest rate risk for both variable rate and fixed rate financial instruments, and introduce the ability to hedge risk components for nonfinancial hedges.

The following indexes are eligible to be designated when hedging interest rate risk, and the following risks are eligible to be designated when hedging a nonfinancial item:

INDEXES ELIGIBLE TO BE DESIGNATED IN A HEDGE OF INTEREST RATE RISK



ELIGIBLE HEDGED RISKS FOR NON-FINANCIAL ITEMS



Current GAAP contains limitations on how a company can measure changes in fair value of the hedged item attributable to interest rate risk in certain fair value hedging relationships. The amendments in the new standard will permit certain strategies undertaken for risk management purposes to qualify for fair value hedge accounting and will make it easier for companies to apply fair value hedge accounting to portfolios of prepayable financial assets.

The new standard also will enhance the presentation of hedge results in the financial statements and disclosures about hedging activities by:
  • Requiring changes in the value of the hedging instrument be presented in the same income statement line item as the earnings effect of the hedged item
  • Amending the current tabular disclosure of hedging activities to focus on the effect of hedge accounting on individual income statement line items
  • Requiring a new disclosure that will provide investors with more information about basis adjustments in fair value hedges of interest rate risk.
The new standard also will enhance the presentation of hedge results in the financial statements and disclosures about hedging activities.

To simplify the reporting of hedge results for financial statement preparers and decrease the complexity of understanding hedge results for investors, the FASB has eliminated the separate measurement and reporting of hedge ineffectiveness. Mismatches between changes in value of the hedged item and hedging instrument may still occur but they will no longer be separately reported. For cash flow and net investment hedges, all changes in value of the hedging instrument included in the assessment of effectiveness will be deferred in other comprehensive income and released to earnings when the hedged item affects earnings.

The ASU also includes targeted improvements to simplify assessment of hedge effectiveness. Those simplifications will:
  • Allow a company to perform subsequent assessments of hedge effectiveness qualitatively if certain conditions are met
  • Allow all companies more time to perform the initial quantitative hedge effectiveness assessment, with additional relief provided to certain private companies and not-for-profit organizations
  • Allow a company to apply the “long-haul” method for assessing hedge effectiveness when use of the shortcut method was not appropriate, or no longer is appropriate, if certain conditions are met
  • Clarify that a company may apply the critical terms match method for a group of forecasted transactions if the transactions occur and the derivative matures within the same 31-day period or fiscal month, and the other requirements for applying the critical terms match method are satisfied.

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WHO WILL BE AFFECTED BY THE NEW STANDARD?

The standard will apply broadly to any company that elects to apply hedge accounting.


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WHEN WILL THE NEW STANDARD BE EFFECTIVE?

For public business entities, the standard is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. For all other entities, the standard is effective for fiscal years beginning after December 15, 2019, and interim periods beginning after December 15, 2020.

Early application is permitted in any interim period after issuance of the standard for existing hedging relationships on the date of adoption and the effect of adoption should be reflected as of the beginning of the fiscal year of adoption (that is, the initial application date).


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