Targeted Improvements to Hedge Accounting: Latest Update

The FASB continues to fine-tune its improvements to hedge accounting rules, which are due for final release later this quarter with early adoption available at the start of a company’s fiscal year.

The general trend has been to relax the hedge accounting requirements so that those requirements are not a deterrent to the election of hedge accounting, thus making hedge accounting more accessible to derivatives users. This trend remains intact with the latest tentative board decisions made by the FASB related to hedge accounting.

At its March 22, 2017 meeting, the FASB finalized new rules related to the treatment of excluded components, both in terms of how the excluded components will be recognized in earnings and which items may be considered excluded components in hedging relationships. Whereas under current accounting rules excluded components are reported in earnings on a fair value or mark-to-market basis, under the new guidance the excluded components will be eligible to be released into earnings using an “amortization” approach.

In addition, the cross currency basis spread, which represents a cost/benefit embedded in an FX derivative transaction, will be able to be treated as an excluded component under the new guidance. These are significant changes that will allow hedgers more flexibility under GAAP hedge accounting rules. Importantly, these changes are alternatives to the current approaches as opposed to required modifications, and companies can continue to apply their current approaches to the treatment of excluded components.

The updates align with coming changes to international hedge accounting rules under IFRS 9, where the currency basis can be excluded from effectiveness assessment, and in limited cases, excluded components are eligible for amortization. For companies with dual GAAP and IFRS reporting requirements, similar approaches could be applied with respect to these excluded components, simplifying the reporting process. For GAAP-only reporters, it is not clear why one would want to exclude the cross currency basis from effectiveness assessment in cash flow hedging relationships, since inclusion of the cross currency basis in the modeling of a hypothetical derivative is permitted (unlike IFRS 9), and the cross currency basis is generally not a source of hedge ineffectiveness in cash flow or net investment hedge relationships. In addition, hedge ineffectiveness will no longer be required to be measured under GAAP, which in many cases is an incentive to not exclude components of derivative fair values from effectiveness assessment. So the change related to cross currency basis seems more consistent with the FASB offering an alternative for hedgers who must comply with the IASB’s treatment of the cross currency basis.

The ability to amortize excluded components will be more attractive than the current treatment for GAAP-reporters. This is particularly true for option users, where a time-value-included approach may present complications when the timing of the hedged transaction is not predictable. As long as the spot relationship can be expected to be a highly effective option, premiums can be predictably amortized under the proposed update, avoiding the time value changes that created undesired P&L volatility under current rules. For users of forward contracts, the amortization of forward points may be less beneficial, as there will be less incentive to exclude forward points under the proposed GAAP changes. Most forward hedges with time value included are likely to be treated as perfectly effective for accounting purposes given there will no longer be a requirement to measure ineffectiveness.

Nonetheless, the ability to amortize forward points can only benefit hedgers using forward contracts, in those situations where it makes sense to exclude forward points, or a time value included approach cannot be proven to be highly effective.