Seeking to tidy up hedge accounting, the Financial Accounting Standards Board (FASB) recently made several decisions that facilitate companies’ ability to take advantage of the favorable accounting treatment that reduces income-statement volatility.
Besides making it easier for companies to attain hedge accounting treatment when hedging commodity-price swings (see commodity hedging story), the board decided to propose changing language that currently can result in restating financial statements. It also proposed revisions to facilitate hedge accounting for financial hedges.
What it means for treasury and finance
Achieving hedge accounting is critical for companies because U.S. generally accepted accounting principles (GAAP) as well as international accounting standards require reporting the fair value of derivative hedges in the income statement, potentially creating volatility quarter to quarter. Hedge accounting permits the hedged items’ changes in value to also appear in the profit-and-loss account, offsetting the derivative and thereby reducing volatility.
The extent to which the hedge and hedged item offset each other is referred to as the transaction’s “effectiveness,” and to remain effective the change in their values or cash flows must remain within 80 percent and 125 percent. In a comprehensive guide published in December called “Financial Reporting Developments; Derivatives and Hedging,” Ernst & Young notes that hedge accounting requires companies to consider the likelihood of a swap counterparty defaulting.
Initially, “a company must consider the likelihood of the swap counterparty’s compliance with the contractual terms of the hedging derivative that require the counterparty to make payments to the company.” That includes a basis for concluding on an ongoing basis that the hedging relationship is anticipated to be highly effective in achieving offsetting changes in fair values or cash flows.
Most large multinationals today choose to monitor those transactions’ effectiveness on a regularly basis, typically quarterly using regression and sensitivity analysis, in a method commonly referred to as “long haul” accounting. For interest-rate swaps, however, that burden can be reduced to the initial assessment of a counterparty’s default probability. That eliminates the burden to complete ongoing analysis, a boon especially for companies without the resources of the big multinationals.
Short-cut method is an exception
E&Y notes, however, that Securities and Exchange Commission staff has clearly stated its view that the short-cut method is a rules-based exception to general hedging guidance in ASC 815. Consequently, if companies misapply the method, even inadvertently, they can no longer apply hedge accounting to the transaction, even if they switch to the more substantive long-haul method.
The FASB staff presented the board with five packages—A through E—of non-mutually exclusive alternatives, including one that eliminated the use of the short-cut method altogether. Packages A and B provided two ways to permit “trivial” differences between contracts, in order to retain short-cut accounting. That alternative would allow companies to retain the short-cut method even if their assessment of hedge effectiveness is found to mildly wonton, a situation that today would require restatement.
“I can’t support alternatives A or B. I think [they] will end up having an endless list of requests for expanding the list [of differences] going forward and I don’t want to provide that curse for future boards,” said board member Thomas Linsmeier.
Package A also allowed companies to apply the long-haul method if use of the short-cut approach was determined to be no longer appropriate, as did Package C.
The FASB staff recommended alternative C, which didn’t permit any ways to reconcile trivial differences between contracts but allowed companies to switch to the long haul method, based on input from industry participants who said it provides better information to investors than if companies lost hedge accounting altogether. Five of the seven FASB board members voted in favor of alternative C.
“I can see why somebody might say that is [giving companies] a second chance [to get hedge accounting treatment],” said James Kroaker, another board member. He added that current accounting requires a company to restate if the short-cut method proves to be inappropriate, as if it hadn’t hedged at all—a problem for investors trying to gauge a company’s risk.
“This says I restate to the next closest assessment of what I would have done (under the long-haul method),” Kroaker said.
The FASB board also addressed financial instrument hedging issues, approving a multi-faceted package of proposed changes. The changes include enabling partial term fair value hedges, a boon to companies which may want to swap only the first five years of a 10-year bond issuance into floating-rate payments, a tactic for which hedging accounting treatment is now difficult to come by. The package also contains a provision facilitating hedge accounting for callable debt.
The FASB staff said it anticipates incorporating the decisions the board made into an exposure draft by the fourth quarter, targeting issuance of the exposure draft for public comment by year-end. The decided to pursue hedge accounting improvements last November.