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FASB resumes work on its hedge accounting project

In January, the Financial Accounting Standards Board (FASB) went back to work on its project to simplify hedge accounting. So far, FASB members have agreed to include a number of changes from a September 2016 proposal. Here’s more on what’s expected to happen on this project — and when.

What is hedge accounting?

Businesses use derivative instruments and hedge accounting to protect themselves from fluctuations in raw materials prices, interest rates or foreign exchange rates. For example, airlines often use commodity price swaps to save on fuel costs. And international manufacturers can agree to buy a supply of materials at a fixed price in the future to avoid jumps in foreign currency exchange rates or soaring prices caused by market shortages.

Hedge accounting is one of the most complicated issues in financial reporting. Under U.S. Generally Accepted Accounting Principles (GAAP), businesses must measure all derivatives at fair value on the balance sheet. But certain qualifying transactions, gains and losses may be hedged to avoid swings in income. The matched hedge may be price risk, commodity futures risk or foreign currency risk.

Because hedge accounting allows deferral of gains and losses, U.S. GAAP imposes a high threshold before it can be applied. For starters, the hedged transaction must be documented at inception and must be considered “highly effective.” (The term “effectiveness” refers to whether a risk management technique is working.)

Ineffectiveness is recognized in earnings. This threshold is often difficult to meet, so many companies don’t even try to qualify for hedging. Because of this reluctance, some critics say that the financial statements don’t provide an accurate reflection of the companies’ risk management practices.

What’s changing?

The FASB has been reviewing comments submitted in response to Proposed Accounting Standards Update (ASU) No. 2016-310, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, which was released last fall. Based on that feedback, the FASB agreed to include the following changes in its final standards:

  • Companies will be allowed to use hedge accounting for certain components of nonfinancial items. This move is welcomed by businesses that want to manage manufacturing costs or other expenses that are fundamental to their operations.
  • The Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate will be included in the list of acceptable benchmark interest rates for hedges of fixed-interest-rate items. This will allow more transactions to qualify for hedge accounting.
  • The final standard will eliminate the provision in current GAAP that disqualifies a company from using hedge accounting if the company uses the shortcut method but then fails to meet one of the criteria for qualifying for it. Businesses generally felt this provision was punitive.
  • Businesses will be allowed to perform the initial assessment of hedge effectiveness anytime after designating a hedge, but no later than the quarterly reporting date.
  • Changes in the value of a derivative, including its effectiveness, will be recorded in the line item where the hedge is recorded. So, businesses will no longer have to record hedge ineffectiveness separately from the effective portion of the change in value of the hedging instrument.

The FASB is scheduled to discuss complex aspects of hedge accounting in early 2017, with all major decisions expected to be made by the end of March. It will also consider a request from its Private Company Council to ease some of the documentation requirements for private companies.

When will the FASB finish this project?

The FASB is on course to release a final update on hedge accounting this year. But before that happens, the FASB will need to weigh the costs and benefits of the final changes, establish an effective date and determine the transition process to the new accounting.

Those decisions will be followed by an external review of the final standard prior to its publication. Reviews of some standards have gone relatively quickly, but, when a complex accounting issue is involved, a review can last for an extended period. Stay tuned for the latest developments.

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