FASB Proposes Further Improvements to Hedge Accounting Guidance (May 21, 2021)

 

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.

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.