Yesterday, August 28, 2017, the Financial Accounting Standards Board (FASB) issued the long awaited update to the Financial Instrument Standard. The update is a giant leap forward that will make derivative and hedge accounting easier for preparers of financial statements to implement and easier for users to understand. The update will require all preparers to change their mindset around hedge accounting. However, this giant leap ultimately may have fallen a little short for commodity hedgers.
Before I provide my overview of the benefits, impacts and opportunities for improvement, I would like to thank the FASB for inviting me to their deliberations in December. I was thoroughly impressed with the Board’s deep consideration and understanding of the input provided and concerns raised by constituents. Overall, I believe that the cost of deliberation and resulting delays were outweighed by the overall benefits of the update.
The key changes accomplish the goals of encouraging use of hedge accounting and create consistency between financial statements and risk management practices. An overview of the changes are highlighted below:
- No more ineffectiveness – The FASB has decided that if a company qualifies for hedge accounting, then any “ineffectiveness” will ultimately flow through earnings at the time the hedge is settled. This is a change in mindset that will impact all companies currently using hedge accounting. For Cash Flow Hedges and Net Investment Hedges that qualify for hedge accounting, the entire change in fair value of the hedging instrument will be recognized in Other Comprehensive Income (OCI) until the hedge settles. At settlement, the amount will be reflected in the same income statement line item as the hedged item. For Fair Value hedges, the change in fair value of the hedging instrument and hedged item will adjust the income statement line item of the hedged item.
- Simplified hedge documentation – The FASB decided to maintain the highly effective requirement for qualifying for hedge accounting but made changes to allow for easier compliance. The key changes are to make the short cut method and critical terms match less difficult to achieve. Hedge documentation completed within the same financial reporting quarter as the inception of the hedge relationship will be considered timely in support of hedge accounting. And for highly effective hedges, qualitative determination is allowed in subsequent quarters minimizing the number of regression analyses required each quarter. The administrative burden should be far less with these changes.
- Risk component hedging for contractually specified components – The FASB recognized that non-financial asset hedgers had difficulty complying with the hedge accounting requirements using total cash flows and limitations to benchmark rates. The change will allow companies to designate contractually specified risk components as the hedged risk. The same concept is extended to financial instruments that have risk components that are not benchmark interest rates. This mitigates the requirement to constantly update the list of benchmark interest rates and allows financial institutions to more readily qualify for hedge accounting on contractually specified variable rate hedges.
- Disclosures – The changes described above necessitated a change in disclosures. Specifically, new tabular disclosures will specify the income statement line item in which the hedged item is recorded. The disclosures will also require companies to state the objectives of their hedge program. This will be required for all derivatives, not only derivatives designated in hedge accounting relationships. Companies will have to explain why they are or are not using hedge accounting. Special exceptions may be made for speculative trading.
The changes in the update will impact all preparers. The update should be met with open arms for most companies. For those companies already utilizing hedge accounting, the changes will likely be updated hedge documentation and consideration for qualitative assessments or short cut/critical terms match. For companies that aren’t currently using hedge accounting, the update will allow for consideration of moving to hedge accounting. The requirement to disclose why hedge accounting is not utilized may create some incentive to utilize hedge accounting. Overall, the impact to most companies will be research, planning and updating their accounting and disclosures. Some companies will require more time to adopt the standard because their contracts may not currently specify the risk component that they are hedging.
The contractually-specified component is the key area that I believe has room for improvement. In our deliberation session in December, I was the primary spokesperson for commodity hedgers and it seems I wasn’t persuasive enough. The concerns are that the contractually-specified component will place a burden on commodity hedgers that don’t currently use hedge accounting and must renegotiate contracts for non-commercial reasons. The contractual specification requirement, the highly effective hurdle, and the conceptual difference on “ineffectiveness” lead to a divergence from IFRS.
The IFRS update is still more flexible and will more readily allow for hedge accounting for commodity hedgers. Despite the differences from IFRS, I believe the FASB has successfully issued an update that meets their goals and will be met with broad acceptance. I will present industry specific articles in the near future on the specific industry considerations, but overall I expect many companies will be looking to early adopt.
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.