Project Updates

Accounting for Hedging Activities

Last Updated: January 16, 2008 (Updated sections are indicated with an asterisk *)

The staff has prepared this summary of Board decisions for information purposes only. Those Board decisions are tentative and do not change current accounting. Official positions of the FASB are determined only after extensive due process and deliberations.

Objective
*Decisions Reached at the Last Meeting
*Summary of Decisions Reached to Date
*Next Steps
*Board Meetings/Other Public Meeting Dates
Background Information
Contact Information

Objective

The objective of the Accounting for Hedging Activities project is to amend Statement 133, Accounting for Derivatives and Hedging Activities, to achieve the following:

1. Resolve practice issues that have arisen under Statement 133.

2. Simplify accounting for hedging activities.

3. Improve the financial reporting of hedging activities to make the accounting model and associated disclosures easier to understand for users of financial statements.

4. Address differences in the accounting for derivative instruments and hedged items or transactions.

*Decisions Reached at the Last Meeting

View the FASB Action Alert for a summary of decisions reached at the December 20, 2007 meeting.

*Summary of Decisions Reached to Date

Fair Value Hedge Accounting Approach

In May 2007, the Board voted to develop a fair value approach to hedge accounting. The approach would eliminate many elements that exist under the current hedge accounting model, including bifurcation-by-risk, the shortcut method, critical terms match, and the requirement to quantitatively assess effectiveness in order to qualify for hedge accounting. The approach would also require independently measuring the hedging instrument and hedged item (hypothetical derivative for forecasted transactions) for all changes in fair value.

Scope

The Board decided to retain hedge accounting for items currently within the scope of Statement 133.

Fair Value Hedges

Requirements for Fair Value Hedges

The Board decided to require formal, contemporaneous documentation of the following at the inception of the hedging relationship:

1. The hedging instrument

2. The hedged item or items

3. A qualitative evaluation of the nature of the risk that the entity is attempting to hedge and the reason that the derivative should be effective in offsetting changes in the hedged item’s fair value resulting from the hedged risk. Unless the hedged risk relates to one of the exceptions to the fair value hedge accounting approach approved by the board, the hedged risk must be the risk of all changes in fair value of the hedged item. To qualify for hedge accounting, the qualitative evaluation must demonstrate that (a) an economic relationship exists between the hedging instrument and hedged item, and (b) the derivative should be expected to reasonably offset changes in the hedged item’s fair value related to the hedged risk. In certain situations, a quantitative analysis may be more effective in demonstrating the relationship between the derivative instrument and the hedged risk. After inception, an entity would need to reassess effectiveness if circumstances indicate that the hedging relationship is no longer effective. These circumstances would depend on the nature of the hedged item and hedging instrument.

The Board decided to permit hedge accounting after initial recognition of the asset or liability. However, the Board decided not to permit the ability to discontinue fair value hedge accounting by simply removing the designation of the hedging relationship.

Measurement of the Hedged Item

The Board agreed that the carrying value of the hedged item should be adjusted for changes in fair value during the hedge period.

Cash Flow Hedges

Requirements for Cash Flow Hedges

The hedged forecasted transaction must be probable to occur and may be designated as a single transaction or a group of individual transactions., The Board decided to require formal, contemporaneous documentation of the following at the inception of the hedging relationship:

1. The hedging instrument

2. The hedged transaction

3. A qualitative evaluation of the nature of the risks that the entity is attempting to hedge and the reason why the derivative should be effective in offsetting the variability in the hedged transaction attributable to all risks. Unless the hedged risk relates to one of the exceptions to the fair value hedge accounting approach approved by the board, the hedged risk must be the risk of all changes in the hedged cash flows. In order to qualify for hedge accounting, the qualitative evaluation must demonstrate that (a) an economic relationship exists between the hedging instrument and hedged forecasted transaction, and (b) the derivative should be expected to reasonably offset the variability in the hedged cash flows attributable to all risks. In certain situations, a quantitative analysis may be more effective in demonstrating the relationship between the derivative instrument and the hedged risk. After inception, an entity would need to reassess effectiveness if circumstances indicate that the hedging relationship is no longer reasonably effective. These circumstances would depend on the nature of the hedged transaction and hedging instrument.

The Board decided not to permit the ability to discontinue cash flow hedge accounting by simply removing the designation of the hedging relationship. Additionally, the Board decided not to allow an entity to elect the fair value option upon the issuance of debt for which it had designated a cash flow hedge of the forecasted debt issuance.

Measuring and Reporting Ineffectiveness

Under the fair value hedge accounting approach for cash flow hedges, the measurement of hedge ineffectiveness would be based on a comparison of the change in fair value of the actual derivative designated as the hedging instrument and the change in fair value of a perfect derivative, which would be expected to perfectly offset the hedged cash flows. The change in fair value of the perfect derivative would be regarded as a proxy for the present value of the cumulative change in expected future cash flows on the hedged transaction. The Board decided to require that the balance of accumulated other comprehensive income reflect the cumulative change in the fair value of the perfect derivative, effectively requiring that ineffectiveness be reported in earnings for both overhedges and underhedges.

Foreign Currency Hedges

The Board decided to retain the ability that currently exists in Statement 133 for all of the following as an exception to the fair value hedge accounting approach: a) an entity may designate the risk of changes in fair value attributable to changes in foreign currency exchange rates in a fair value hedge, and b) an entity may designate the risk of changes in functional-currency-equivalent cash flows attributable to changes in foreign exchange rates in a cash flow hedge. Additionally, the Board decided to retain the current Statement 133 guidance related to net investment hedges.

Accounting for an Entity’s Own Debt

If an entity synthetically creates variable-rate debt by issuing fixed-rate debt and entering into a receive fixed/pay variable interest rate swap, it may designate the interest rate swap as a hedge against the exposure to changes in the fixed-rate debt’s fair value attributable to changes in the designated benchmark interest rate at inception of the debt. Similarly, if an entity synthetically creates fixed-rate debt by issuing variable-rate debt and entering into a receive variable/pay fixed interest rate swap, it may designate the interest rate swap as a hedge against the exposure to variability in expected future interest cash flows attributable to changes in the designated benchmark interest rate at inception of the debt.

The Board decided to permit an entity to designate foreign currency exchange risk or a combination of foreign currency exchange rate risk and interest rate risk in addition to just designating interest rate risk as the hedged risk at inception of its own debt.

Disclosures

The Board decided to require an entity to disclose a reconciliation between the carrying value of hedged items at the end of the reporting period and what the carrying value would have been prior to any cumulative fair value adjustments.

The Board decided to require an entity to disclose as part of its debt disclosure (a) that it uses derivative contracts (interest rate swaps) to convert a portion of its fixed-rate debt to variable-rate debt or variable-rate debt to fixed-rate debt, (b) how the maturity structure of the derivatives correspond to the maturity structure of the hedged debt, and (c) the overall weighted average interest rate on a contractual basis and including the effects of derivatives.

Effective Date and Transition

The Board decided that the proposed Statement should be effective for fiscal years beginning after November 15, 2008 and to not permit early adoption. The Board decided to require prospective application of the guidance in the proposed Statement for fair value hedges and limited retrospective application (cumulative catch-up) of the guidance in the proposed Statement for cash flow hedges.

Amendment to Statement 159

The Board decided to amend the scope of Statement 159 to permit a one-time fair value option at the initial adoption of the proposed Statement for eligible assets and liabilities currently hedged under Statement 133.

*Next Steps

The staff will begin drafting an Exposure Draft for vote by written ballot.

*Board Meetings/Other Public Meeting Dates

The Board meeting minutes are provided for the information and convenience of constituents who want to follow the Board’s deliberations. All of the conclusions reported are tentative and may be changed at future Board meetings. Decisions become final only after a formal written ballot to issue a final Statement, Interpretation, FSP, or Statement 133 Implementation Issue.

Background Information

FASB Statement No. 133, Accounting for Derivatives and Hedging Activities, was originally issued in 1998. That Statement provides special accounting for hedging activities because of differences in the way derivative hedging instruments and hedged items or transactions are recognized and measured. However, since Statement 133 became effective, the FASB has been asked to address numerous issues on many aspects of hedge accounting. As a result, at the January 31, 2007 meeting, the Board directed the staff to research (a) issues causing difficulties in the application of hedge accounting and (b) potential approaches to accounting for hedging activities.

Based on that research, the staff identified seven issues that cause significant difficulties in hedge accounting:

1. Strict documentation requirements

2. Lack of clarity regarding when dedesignation and redesignation is necessary

3. Which hedged items or hedged transactions could be included in a group

4. How effectiveness should be assessed and what should be included in effectiveness testing

5. How cash flows and different aspects of the discount rate should be incorporated into the measurement of a hedged item to determine the change in value attributable to an individual hedged risk

6. How ineffectiveness should be measured in a cash flow hedge and what features should be included in a perfect hypothetical derivative

7. What the consequences should be for failing to meet the criteria for hedge accounting

Those issues were presented to the Board at the May 23, 2007 meeting, where the Board officially added a project to its agenda to address the accounting for hedging activities.

Contact Information

Kevin Stoklosa
Project Manager
kmstoklosa@fasb.org

Shea Malcolm
Practice Fellow
shmalcolm@fasb.org

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