Proposed Accounting Standards Update:
Codification Improvements to Hedge Accounting


Background


On November 12, 2019, the Financial Accounting Standards Board (FASB) issued a proposed Accounting Standards Update (ASU) to clarify certain amendments in Accounting Standards Update No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.
 
Stakeholders are encouraged to review and provide comments on the proposed ASU by January 13, 2020.
 

Why Is the FASB Issuing This Proposed ASU?


The FASB has assisted stakeholders in the implementation of the amendments in ASU 2017-12 since its issuance. Through those interactions, the FASB has identified certain areas that require clarification to better align those areas with the objectives articulated in that ASU. The amendments in the proposed ASU primarily address a change in hedged risk in a cash flow hedge. Hedges in the scope of this guidance would include cash flow hedges of:
  • Interest rate risk
  • Nonfinancial price risk attributable to all changes in the purchase or sale price of a nonfinancial asset or attributable to a contractually specified component thereof. 
The change in hedged risk guidance added in ASU 2017-12 allows the variability in cash flows of the forecasted transaction to change (for example, from one variable interest rate to another variable interest rate or from one commodity index to a different index for the same commodity) if certain criteria are met. Stakeholders asked for additional clarification on whether that change can happen both prospectively (that is, before the forecasted transaction occurs) and retrospectively (that is, after the forecasted transaction occurs) and, if so, how hedge accounting guidance should be applied in those instances.


What Are the Main Provisions in the Proposed ASU and How Would They Improve Existing GAAP?


For cash flow hedges in the scope of the guidance, a change in the hedged risk would not trigger the application of the missed forecast guidance, even if the change in hedged risk is identified after the forecasted transaction occurs. The missed forecast guidance requires an entity to immediately reclassify amounts deferred in accumulated other comprehensive income (AOCI) to earnings when the forecasted transaction is probable of not occurring. A pattern of missed forecasts calls into question an entity’s ability to accurately predict forecasted transactions and apply hedge accounting to similar transactions in the future.
 
As a result of the proposed ASU, missed forecasts are expected to decrease. Consequently, entities’ ability to apply hedge accounting to similar transactions in the future would not be comprised, providing more relevant information to financial statement users.
 


At inception, the forecasted transaction would have to be documented with sufficient specificity such that an entity can identify a transaction that is eligible to be identified as hedged when it occurs, regardless of the hedged risk. If a change in hedged risk is identified after the forecasted transaction occurs, an entity would identify hedged transactions with a revised hedged risk using its hindsight identification method, which would be required to be documented at hedge inception for all hedges in the scope of the change in hedged risk guidance. The requirement to apply a hindsight identification method if the hedged risk changes after the forecasted transaction occurs would apply to all cash flow hedges in the scope of the change in hedged risk guidance.
 
The proposed ASU would clarify that the forecasted transaction and hedged risk are distinct.
 
For example, an entity may hedge the variability in cash flows for a forecasted purchase of 10,000 bushels of wheat in a particular month (the forecasted transaction) attributable to fluctuations in the ABC wheat index (the hedged risk). That distinction is relevant because the proposed ASU would clarify that the hedged risk can change but the forecasted transaction cannot.
 


At hedge inception, an entity would designate its best estimate of the hedged risk expected to be present in the forecasted transaction (as depicted above). Other potential risks that do not represent the entity’s best estimate would not be documented or assessed for hedge effectiveness. At hedge inception and thereafter, the entity would test hedge effectiveness using its then-best estimate of the hedged risk. If there is a change in the best estimate of the hedged risk, an entity would not revise previous assessments of effectiveness. Thus, hedged risks other than the entity’s best estimate would not be incorporated into an entity’s assessment of hedge effectiveness, simplifying those assessments.
 
If a change in hedged risk is identified before the forecasted transaction occurs, hedge accounting can continue if the revised hedged risk tests highly effective; if it does not, hedge accounting is discontinued and amounts deferred up to the date that the change in hedged risk is identified remain in AOCI and are reclassified when the forecasted transaction affects earnings (as depicted below).
 

If the revised hedge risk tested highly effective, the only difference from the diagram below would be that the gains and losses on the derivative would be deferred in AOCI from January 1, 20X1 through March 31, 20X1.

If a change in hedged risk is identified after the forecasted transaction occurs (as depicted on page 3), an entity would not assess effectiveness with the revised hedged risk. All amounts deferred related to the forecasted transaction would remain deferred in AOCI and affect earnings when the hedged transaction affects earnings if the hedge tested highly effective based on the entity’s then-best estimate of the hedged risk. An entity would identify hedged transactions with a revised hedged risk using its hindsight identification method.
 
The proposed ASU includes more detailed illustrative examples. Stakeholders are encouraged to review those examples for additional information on the application of the change in hedged risk guidance.
 


Other amendments in the proposed ASU clarify contractually specific component hedges, foreign-currency denominated debt instruments as hedging instruments and hedged items (dual hedges), and the use of the term prepayable under the shortcut method.
 

Who Would Be Affected by the Amendments in This Proposed ASU?


The amendments in this proposed ASU would apply to any entity that elects to apply any of the following in accordance with Topic 815:
  • Cash flow hedging for risks in the scope of the change in hedged risk guidance
  • Contractually specified component hedging for nonfinancial asset purchases or sales
  • Dual hedging.

When Would the Amendments Be Effective?


The proposed ASU would be effective for all entities for fiscal years beginning after December 15, 2020. For public business entities, the proposed amendments would be effective for interim periods within fiscal years beginning after December 15, 2020. For all other entities, the proposed amendments would be effective for interim periods within fiscal years beginning after December 15, 2021. Early adoption would be permitted for all entities on any date on or after issuance of a final ASU if an entity already has adopted the amendments in ASU 2017-12.

 
 
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