This summer, the Financial Accounting Standards Board (FASB) took its first formal steps to improve the complex topic of hedge accounting. Here are four specific issues the board has decided to target.
- How transactions qualify for hedge accounting
The threshold to qualify for hedge accounting is a key component of the FASB’s hedging project. FASB Accounting Standards Codification (ASC) Topic 815 says that, to qualify for hedge accounting, the relationship between a hedging instrument and the hedged item has to be “highly effective” in achieving offsetting changes in fair value or cash flows attributable to the hedged risk.
U.S. Generally Accepted Accounting Principles (GAAP) don’t define “highly effective.” In practice, most accountants interpret it as an 80% to 125% offset between the change in the hedging instrument’s fair value and the changes in fair value or cash flows of the hedged item or transaction.
The FASB considered whether “reasonably effective” would be a better threshold. But during its meeting on June 29, the board decided to retain the “highly effective” threshold, because members said it would be difficult to quantify the revised terminology.
- Whether to allow component hedging for nonfinancial items
Component hedging of a nonfinancial item also is a hot topic, particularly for manufacturers that want to manage the cost of making their final products by hedging the risk of price changes in raw materials or ingredients.
Currently, GAAP limits the use of hedge accounting for nonfinancial items to changes in the fair value of the entire hedged asset or liability and the risks associated with fluctuations in foreign currency rates. Hedging also can be used to offset the risk of changes in the purchase price or sale price of cash flow hedges. Hedge accounting isn’t permitted for other individual risks, including changes in the value of a principal ingredient or component.
The FASB is considering whether it should allow components of nonfinancial items to be hedged. This move is welcomed by businesses that want to manage manufacturing costs or other expenses that are fundamental to their operations. Manufacturers have asked the FASB to consider the change for several years, because it better reflects their business practices.
For example, the Hershey Company wrote a letter to the FASB in 2011, explaining that the company uses hedging to manage the price of chocolate paste, a key component of its products. The cost of the paste is dependent on changes in the prices of such ingredients as milk and sugar. Raw materials prices can vary widely, and there are active futures, options or forward markets to hedge the expected costs. Under existing GAAP, these contracts can’t qualify for hedge accounting.
FASB practice fellow Nick Milone told the board, “As a consequence of the current hedging model for many entities, they ultimately will not qualify for preferential accounting treatment, therefore the entity either continues to bear commodity price risk, even if prudent risk management would dictate otherwise, or mark their hedges to market and live with the associated volatility.”
- How to improve the “shortcut” method
The FASB also has been discussing whether it should change or eliminate the so-called “shortcut” method, which is allowed in limited circumstances for straightforward hedging relationships. It applies only to hedges of interest rate risk of recognized interest-bearing financial assets and liabilities with an interest rate swap.
The shortcut method allows a business to assume that its hedging relationship is highly effective and bypass the “long-haul” method to prove the qualification for hedge accounting. In April, the FASB’s research team told the board that many banks stopped using the shortcut method because the criteria were so narrow, and they had the resources to deal with traditional hedge accounting.
During the June 29 meeting, the FASB considered a few options to simplify the shortcut method and make it easier for businesses to qualify. Ultimately, the FASB’s research staff recommended eliminating a provision in current GAAP saying that, if a company uses the shortcut method but then fails to meet one of the criteria for qualifying for it, it can’t use hedge accounting at all. Businesses said this provision was punitive.
- How to report fair value hedges of interest rate risks
The interest rate risk topic covers a range of issues, including whether the FASB should expand the definition of a benchmark interest rate that derivative instruments can be pegged to.
ASC Topic 815 provides guidance on the risks that can be hedged in a fair value or cash flow hedge. One risk concerns the changes in a hedged item’s value attributable to changes in a designated benchmark interest rate. GAAP permits the use of the rate on direct Treasury obligations of the U.S. government, the London Interbank Offered Rate (LIBOR) and the Fed Funds Effective Swap Rate (Overnight Index Swap Rate).
Businesses have told the FASB that, if the board allowed the Municipal Swap Rate from the Securities Industry and Financial Markets Association (SIFMA) and the Prime Rate to be considered benchmark rates, more transactions could qualify for hedge accounting. At its June 29 meeting, the FASB decided to add the SIFMA to the list of acceptable benchmark interest rates for hedges of instruments with fixed interest rates. No decision has been made yet regarding the Prime Rate.
In addition, the FASB has agreed that businesses no longer would have to record hedge ineffectiveness separately from the effective portion of the change in value of the hedging instrument. For cash flow hedges, the entire change in value of the derivative would be recorded in other comprehensive income and reclassified to earnings in the same period in which the hedged item affects earnings.
The board plans to issue a package of proposed updates to improve the guidance on hedge accounting. This package would include additional disclosures related to adjustments for fair value hedges, a revision to the table in the financial statement footnotes that shows the effect of hedging on individual income statement line items, and more descriptive disclosures to describe quantitative goals (if any) to achieve hedging objectives.
The FASB’s hedging project is a work in progress intended to give investors more information about businesses’ risk management strategies. In the coming months, the board will continue to fine-tune the details and discuss other ways to clarify this complex topic.