FASB Proposes Further Improvements to Hedge Accounting Guidance
On May 5, 2021, the FASB issued a proposed ASU1 that would clarify the guidance in ASC 8152 on fair value hedge accounting of interest rate risk for portfolios of prepayable financial assets. The proposal would amend the guidance in ASU 2017-123 (released on August 28, 2017), which established a method for making such fair value hedge accounting more accessible, and was issued in response to feedback and questions received from stakeholders. Comments on the proposed ASU are due by July 5, 2021.
The FASB’s objectives in issuing ASU 2017-12 were to better align financial reporting with the results of an entity’s risk management strategy and improve the hedge accounting model by simplifying it. The FASB also issued a proposed ASU4 on November 12, 2019, that would clarify certain amendments made by ASU 2017-12 that are unrelated to portfolio fair value hedge accounting. (For more information about that proposal, see Deloitte’s November 26, 2019, Heads Up.)
The May 5, 2021, proposal would clarify and improve certain aspects of the guidance on the last-of-layer method established by ASU 2017-12. The last-of-layer method enables an entity to apply fair value hedging to a stated amount of closed portfolios of prepayable financial assets without having to consider prepayment risk or credit risk when measuring those assets. The proposed ASU would also rename the last-of-layer method as the portfolio layer method.
Main Provisions of the Proposed Changes
Multiple-Layer Hedges of a Single Closed Portfolio
Entities that apply the last-of-layer method designate a stated amount of the asset or assets that is not expected to be affected by prepayments, defaults, and other factors affecting the timing and amount of cash flows as the hedged item in a fair value hedge of interest rate risk. The hedged item represents a single layer in the closed portfolio. The proposed ASU would expand the current model to explicitly allow entities to designate multiple layers in a single portfolio as individual hedged items. Accordingly, entities would be able to have multiple hedging relationships with a single closed portfolio, resulting in the eligibility for entities to hedge a larger portion of the interest rate risk associated with a portfolio. The current guidance does not address multiple-layer hedges.
Connecting the Dots
Paragraph BC12 of the proposed ASU explains the Board’s proposal to change the name of the last-of-layer method to the portfolio layer method as a result of the expansion to multiple-layer hedges of a single closed portfolio:
To reflect the expansion from a single-layer to a multiple-layer model, the last-of-layer method would be renamed as the portfolio layer method. That change would be reflected throughout Topic 815. The Board believes that the portfolio layer method more aptly describes the strategies that would qualify for hedge accounting under the amendments in this proposed Update because the amount hedged in a given layer need not be the last in the closed portfolio under a multiple-layer strategy.
In addition to questions about the ability to hedge multiple layers of a single closed portfolio, questions have arisen about the types of derivatives that could be used as the hedging instrument in potential multiple-layer hedges. The proposed ASU would give entities the flexibility to use any type of derivative and combination of derivatives (e.g., spot-starting constant-notional swaps with different term lengths, a combination of spot-starting and forward-starting constant-notional swaps, amortizing-notional swaps) under the proposed multiple-layer model that aligns with each individual entity’s risk management strategy.
Other issues that the proposed ASU would address as a result of the expansion to multiple-layer hedges of a single closed portfolio include the identification of the closed portfolio and the designation and dedesignation of hedged layers in a portfolio layer method hedge.
The proposed ASU would require that all assets in the closed portfolio have a contractual maturity date after the end of the earliest-ending hedge period and become prepayable before the latest-ending hedge period. The proposed ASU would also require an entity to perform a documented analysis to support its expectation that the aggregate amount of the multiple hedged items (i.e., the hedged layers) is expected to be outstanding for the periods hedged. The entity must continually update this analysis. These requirements are consistent with those under the current guidance on single-layer hedges.
The proposal would allow entities to designate new hedging relationships and dedesignate existing hedging relationships at any time after the closed portfolio has been identified upon the inception of a portfolio layer method hedge.
The proposed ASU would also provide guidance on the dedesignation of a hedging relationship upon an anticipated breach or the occurrence of a breach (i.e., when the aggregate amount of the hedged layers exceeds the amount of the closed portfolio). This proposed guidance is consistent with the current guidance established by ASU 2017-12 for single-layer hedges but incorporates considerations for multiple-layer hedges.
Upon an anticipated breach, the entity is required to partially or fully dedesignate the hedge. In the event of a breach, the entity is required to fully dedesignate the hedge. For a breach of a multiple-layer hedge, the proposed ASU would require the hedged layer with the shortest period remaining until its maturity date to be dedesignated first and so forth on the basis of layer duration until the entity can support its expectation that the stated amount hedged is expected to be outstanding for the period hedged.
Accounting for Fair Value Hedge Basis Adjustments Under the Portfolio Layer Method
The proposed ASU would also expand and clarify the guidance on accounting for fair value hedge basis adjustments under the portfolio layer method for both single-layer and multiple-layer hedges.
As an entity would for any other fair value hedge, it should adjust the basis of the hedged item for the change in fair value that is attributable to changes in the hedged risk (i.e., interest rate risk) as of each reporting date. However, in a portfolio layer method hedge, the hedged item (i.e., the hedged layer) is related to multiple prepayable assets within a closed portfolio, but not necessarily all of the assets within that portfolio. Accordingly, the basis adjustment would be a portfolio-level basis adjustment under the proposed ASU (i.e., it would not be allocated to individual assets within the portfolio). The current guidance does not specify whether basis adjustments should be maintained on a closed portfolio basis or on an individual asset basis. If the assets in the closed portfolio are presented within more than one line item on the balance sheet, an entity would be required to use a systematic and rational method to allocate the portfolio-level basis adjustment to the associated line items. However, the proposed ASU clarifies that an entity should not allocate those basis adjustments on a more disaggregated basis for any disclosures not otherwise required by ASC 815. An entity should disclose the total amount of the basis adjustments as a reconciling amount in any affected disclosures. This clarification would be an amendment of the current guidance, which states that the allocation of basis adjustments may be required by other areas of GAAP.
The current guidance requires that the portfolio-level basis adjustment be allocated to the individual assets within a closed portfolio upon a dedesignation of a hedging relationship. The proposed ASU does not change this requirement. In the event of a breach of a portfolio layer hedge, the proposed ASU would require entities to identify the cause of the breach to record the reversal of the basis adjustments associated with the breach in the income statement line item affected by the breach (i.e., if the cause of the breach was prepayment, the basis adjustment would be recognized in interest income; if the cause of the breach was credit default, the basis adjustment would be recognized in accordance with the applicable impairment guidance).
Finally, the proposed ASU would provide guidance on how the portfolio layer method guidance interacts with other areas of GAAP. Questions have arisen regarding how the last-of-layer method guidance would interact with ASC 3265 or other impairment guidance for entities that have not yet adopted ASC 326. The proposed ASU would explicitly prohibit entities from considering basis adjustments related to existing portfolio layer method hedges when measuring credit losses on the assets included in the closed portfolio.
Reclassification of Held-to-Maturity Debt Securities
Entities would be able to reclassify debt securities that qualify as being in a portfolio layer hedging relationship from the held-to-maturity category to the available-for-sale category as of the adoption date.
Proposed Effective Dates and Transition
The FASB has not set any potential effective dates for the proposed ASU’s amendments. The Board plans to determine the potential effective dates after considering stakeholder feedback on the proposed ASU.
The proposed optional multiple-layer hedge strategy would apply prospectively. The proposed amendments related to the fair value hedge basis adjustments under the portfolio layer method, except for the disclosure requirements under other areas of GAAP, would need to be applied on a modified retrospective basis through a cumulative-effect adjustment to the opening balance of retained earnings. An entity would have the option of applying the proposed disclosure requirements in other areas of GAAP either prospectively or retrospectively.
FASB Proposed Accounting Standards Update (ASU), Fair Value Hedging — Portfolio Layer Method.
FASB Accounting Standards Codification (ASC) Topic 815, Derivatives and Hedging.
FASB Accounting Standards Update No. 2017-12, Targeted Improvements to Accounting for Hedging Activities.
FASB Proposed Accounting Standards Update, Codification Improvements to Hedge Accounting.
FASB Accounting Standards Codification Topic 326, Financial Instruments — Credit Losses.