FASB Proposes Improvements to Hedge Accounting Guidance
Overview
On September 25, 2024, the FASB issued a proposed ASU1 that would amend certain facets of the hedge accounting guidance in ASC
815.2 The proposed ASU is intended to address issues raised by stakeholders
during the implementation of ASU 2017-123 and more recent concerns that have surfaced as a result of the global
reference rate reform initiative. Comments on the proposal are due by November
25, 2024.
Background
In 2019, the Board issued a proposed ASU, Codification Improvements to Hedge
Accounting, with the intention of clarifying various aspects of the
guidance that was amended by ASU 2017-12. However, stakeholders provided
feedback that the proposed amendments would not sufficiently resolve certain
issues and that the guidance needed further clarification. In addition,
respondents to the FASB’s 2021 invitation to comment, Agenda
Consultation, expressed concerns that the current guidance in U.S. GAAP was
negatively affecting the decision-usefulness of financial information provided
to investors.
On the basis of this and other stakeholder input, the Board decided to address
five discrete issues in the new proposal. The purpose of the amendments is to
better enable “entities to achieve and maintain hedge accounting for a greater
number of highly effective economic hedges” while reducing the occurrence of
missed forecasted transactions and unintuitive hedge dedesignation events.
Main Provisions of the Proposed Amendments
Similar Risk Assessment for Cash Flow Hedges
The proposed ASU would amend the existing requirement that
cash flow hedges of groups of individual forecasted transactions that use a
single derivative as the hedging instrument share the same risk exposure.
Instead, the proposal would require such groups to have a similar
risk exposure. Further, the proposed ASU would clarify that the quantitative
threshold for similar is consistent with the highly
effective4 threshold used in the assessment of hedge effectiveness. The amended
guidance is intended to expand the population of hedged risks eligible for
aggregation in a single group or pool, thereby reducing cost, complexity,
and the risk of unintuitive missed forecasts in the application of these
hedging strategies.
In addition, the proposed ASU would restore the guidance that, before the
issuance of ASU 2017-12, required entities to perform shared risk
assessments at hedge inception and on an ongoing basis. The proposal also
clarifies that in some cases, entities may conduct such assessments on a
qualitative basis (on a hedge-by-hedge basis) in a manner similar to the
approach described in the guidance in ASC 815-20-35-2A through 35-2F on
qualitative effectiveness assessments.
Under the proposal, entities are also explicitly permitted to conclude that
the risk exposures in a group of forecasted transactions are similar if the
hedging instrument is highly effective against each risk in the group.
Connecting the Dots
In paragraph BC22 of the proposed ASU, the Board
acknowledges that in current practice, some entities use a
dual-purpose assessment, commonly known as the test-to-worst
approach, in which they perform the same assessment to determine
hedge effectiveness and shared risk exposure. Under this approach,
entities have concluded that if a hedging instrument is highly
effective against the least effective risk in the group, it must
also be highly effective against all other risks in the group. The
proposed amendments expressly permit entities to use this
quantitative approach, which is expected to reduce the cost and
complexity of hedge accounting for entities that seek to hedge a
group of forecasted transactions that have a similar, but not
necessarily the same, risk exposure and for which the hedging
instrument may therefore have varying degrees of effectiveness
against those risks. Entities using a test-to-worst approach should
exercise caution and thoughtfully determine which risk or risks in
the group are the least effective in any given period to ensure that
the eligibility criteria for hedges of groups of forecasted
transactions have been met.
Hedging Forecasted Interest Payments on Choose-Your-Rate Debt Instruments
ASC 815 does not specifically address how an entity should
consider the uncertainty (i.e., “optionality”) associated with designating
and continually assessing a cash flow hedge of interest payments on an
existing choose-your-rate (CYR) debt instrument5 (sometimes referred to as “you-pick-’em” debt). The proposed ASU seeks
to eliminate diversity in practice by establishing prescriptive guidance on
the designation and assessment of hedge effectiveness for cash flow hedges
involving this ubiquitous debt instrument. The Board envisions that the
proposed amendments will reduce the potential for “unintuitive accounting
outcomes” that often occur when entities make economically prudent decisions
to exercise their purchased optionality and then change the rate on which
interest is accrued on the CYR debt instrument. Key provisions of the
proposed guidance — including requirements related to scope, hedge
designation, and assessments of hedge effectiveness — are summarized as
follows:
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Scope — Application of the guidance would be limited to cash flow hedges of variable interest payments on existing CYR debt instruments. That is, the proposed ASU would preclude entities from applying the guidance by analogy to other circumstances.
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Hedge Designation:
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Entities would consider the contractual terms of the existing CYR debt instrument when designating the parameters of the hedging relationship. For example, an entity would not be permitted to hedge forecasted interest payments that extended beyond the stated maturity date of the CYR debt instrument.
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Entities would designate the initially selected interest rate index (and tenor of that rate, if applicable) as the hedged risk.
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If an entity selected a different interest rate index or tenor (or both) after hedge inception, the hedged risk would be changed to mirror that election.
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Automatic hedge dedesignation would not be required if this selection altered the number and timing of hedged forecasted interest payments within the hedged period.
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Entities would be permitted to designate at hedge inception that forecasted interest payments would also be derived from replacement debt for the specified hedged period.
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Automatic hedge dedesignation would not be required if the initial interest rate index and tenor of the replacement debt instrument match an interest rate index and tenor available under the original CYR debt instrument.
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Assessments of Hedge Effectiveness:
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Entities would not consider possible changes in cash flows that would occur if a different interest rate index or tenor was selected on a future date.
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If an entity selected a different interest rate index or tenor (or both), the entity:
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Would perform a final retrospective assessment of hedge effectiveness on the basis of changes in cash flows attributable to the previously selected interest rate index or tenor.
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Would begin prospectively assessing hedge effectiveness solely on the basis of changes in cash flows attributable to forecasted interest payments on the newly selected hedged risk unless or until such hedged risk is subsequently changed.
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Cash Flow Hedges of Nonfinancial Forecasted Transactions
Under an approach in ASC 815 often known as the contractually specified
component (CSC) model, entities may designate, as the hedged risk in a cash
flow hedge of a forecasted purchase or sale of a nonfinancial asset, any
variable price component explicitly referenced (or expected to be explicitly
referenced) in the pricing formula of the associated purchase or sales
agreement. After the issuance of ASU 2017-12, stakeholders consistently
expressed concerns that under the CSC model, the application of hedge
accounting is limited for common risk management strategies — most notably,
forecasted nonfinancial transactions to be consummated in the spot
market.
The proposed ASU would replace the CSC model with a
principles-based approach that permits hedges of variable price components
that are clearly and closely related (as described by ASC 815-10-15-32(a)
and (b)6 on the normal purchases and normal sales scope exception) to the
nonfinancial asset being purchased or sold. This proposed guidance would
expand the application of hedge accounting, most notably by expressly
allowing entities to hedge price components in forecasted nonfinancial
spot-market transactions. The proposal would add ASC 815-20-25-22C, which is
reproduced below.
ASC 815-20
Proposed Content
25-22C An entity may designate the
variability in cash flows attributable to changes
in a component (or subcomponent) of the forecasted
purchase price or sales price of a nonfinancial
asset as the hedged risk in a cash flow hedge as
follows:
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If the purchase price or sales price of the nonfinancial asset is not determined pursuant to a pricing formula in an agreement, the hedged variable component is clearly and closely related (as described in paragraph 815-10-15-32(a) through (b)) to the nonfinancial asset being purchased or sold.
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If the purchase price or sales price of the nonfinancial asset is determined pursuant to a pricing formula in an agreement, the hedged variable component is either:
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Explicitly referenced in the agreement’s pricing formula and clearly and closely related (as described in paragraph 815-10-15-32(a) through (b)) to the nonfinancial asset being purchased or sold
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Clearly and closely related (as described in paragraph 815-10-15-32(a) through (b)) to a variable component that meets the conditions in (b)(1) (that is, a “subcomponent”). (Throughout Subtopic 815-20, reference to a subcomponent refers only to the designation guidance in this subparagraph.)
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The Board observed7 that the market (forward or spot) in which an entity expects to
purchase or sell a nonfinancial asset may affect its determination of
whether the forecasted transaction presents an exposure to cash flow
variability that could affect reported earnings,8 potentially limiting the population of eligible hedged risks in
forecasted nonfinancial transactions consummated in the forward market (as
compared with those consummated in the spot market). Accordingly, the FASB
proposed ASC 815-20-25-22C, under which the eligibility criteria for hedge
accounting would be bifurcated.
However, in addition to addressing hedges of variable price components
explicitly referenced in an agreement’s pricing formula that are clearly and
closely related to the nonfinancial asset being purchased or sold (proposed
ASC 815-20-25-22C(b)(1)), the proposal seeks to broaden the application of
hedge accounting by permitting an entity transacting in the forward market
to hedge variable price components that are clearly and closely related to
any explicitly referenced variable component meeting the conditions in
proposed ASC 815-20-25-22C(b)(1)). The proposal refers to these components
as “subcomponents.”
The proposed amendments are expected not only to expand the application of
hedge accounting for nonfinancial forecasted transactions but also to reduce
the risk of missed forecasts for highly effective economic hedges. For
example, the Board notes in paragraph BC66 of the proposed ASU that “an
entity [that] experiences an unexpected shortfall in the forecasted amount
of a nonfinancial asset to be purchased under a forward contract and makes
up the shortfall through a spot market purchase” can preserve hedge
accounting under this revised model if (1) the component that is being
hedged is clearly and closely related to the forward price and the spot
price of the nonfinancial asset and (2) all other requisite conditions for
the application of cash flow hedge accounting have been met.
Hedging Nonfinancial Components in Contracts Accounted for as Derivatives
The proposed ASU would also “clarify that entities may designate a
variable price component in a contract that is accounted for as a
derivative as the hedged risk if the associated forecasted purchase or
sale of the nonfinancial asset qualifies to be a hedged forecasted
transaction.” In proposing this guidance, the FASB seeks to address the
diversity in practice related to whether hedge accounting can be applied
in these situations.
Net Written Options as Hedging Instruments
The proposed ASU would permit an entity to assume that certain terms of a
hedged forecasted transaction match those of the hedging instrument (if such
instrument is a compound derivative composed of a written option and a
non-option derivative) when performing the net written option (NWO) test in
ASC 815-20-25-88 through 25-97 to determine eligibility for cash flow hedge
accounting.
Connecting the Dots
Lending institutions that make variable-rate loans to customers
frequently hedge their interest rate exposure by using pay-variable,
receive-fixed interest rate swaps. When those loans include a floor
on the variable rate, lending institutions may choose to enter into
interest rate swaps with mirror-image floors (i.e., a written option
with a non-option derivative) to better mitigate their exposure to
cash flow variability attributable to interest rates. After
cessation of the London Interbank Offered Rate (LIBOR), it is common
for lending institutions to make floored loans that are tied to the
term Secured Overnight Financing Rate (SOFR) and enter into floored
interest rate swaps in which the variable leg is tied to Daily SOFR.
Under current GAAP, these lending institutions would not be eligible
to apply cash flow hedge accounting because in accordance with the
NWO test, different underlyings in the hedged item and hedging
instrument are indicative of the absence of symmetry between
potentially favorable and unfavorable cash flows.
As amended, ASC 815-20-25-88 would specify that for cash flow hedges of
interest rate risk in which the hedging instrument is a combination of a
written option and any other non-option derivative instrument, “an entity
may make the following simplifying assumptions when performing the [NWO] test”:
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“The underlying interest rate embedded within the hedged forecasted transaction matches the interest rate in the hedging instrument if that interest rate is a derivation of the same nonleveraged index (for example, the underlying interest rate in the hedging instrument is based on Daily SOFR, and the underlying interest rate in the hedged forecasted transaction is based on SOFR Term).”
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“The timing in which the hedged forecasted transaction is expected to occur and the settlement of the hedging instrument match if the hedged forecasted transaction occurs and the hedging instrument settles within the same 31-day period or fiscal month.”
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“The interest rate reset date of the hedging instrument and the hedged forecasted transaction match if the reset date associated with the hedged forecasted transaction and the hedging instrument occurs within the same 31-day period or fiscal month.”
Foreign-Currency-Denominated Debt Instrument as Hedging Instrument and Hedged Item (Dual Hedge)
Under ASC 815, entities are permitted to simultaneously designate a single
foreign-currency-denominated debt instrument as both (1) a hedging
instrument in a hedge of a net investment in foreign operations and (2) a
hedged item in a fair value hedge of interest rate risk. In practice, this
combination of hedging relationships is commonly referred to as a “dual
hedge.”
ASC 815 requires entities to record the gain or loss on remeasurement of a
foreign-currency-denominated debt instrument that is designated in a highly
effective net investment hedging relationship as a cumulative-translation
adjustment (as part of accumulated other comprehensive income [AOCI]) until
the net investment is substantially liquidated. In a dual hedge, because the
basis of the foreign-currency-denominated debt instrument is also adjusted
for changes in its fair value that are attributable to changes in the
designated interest rate before its remeasurement for changes in foreign
currency exchange rates, the gain or loss on the remeasurement of the fair
value hedge basis adjustment is also deferred in AOCI as a result of the net
investment hedge. Consequently, there is an imperfect offset between the
changes in fair value of (1) the derivative hedging instrument for the fair
value hedge that is recognized in earnings and (2) the
foreign-currency-denominated debt, a portion of which is recognized in OCI
under the net investment hedging relationship.
The proposed guidance would remove this mismatch by requiring entities to
exclude the fair value hedge basis adjustment from the assessment of the
effectiveness of the net investment hedge when the hedging instrument is
debt that is part of a dual hedge. As a result, the remeasurement for
changes in spot rates on the fair value hedge basis adjustment would be
recognized in earnings and offset against the remeasurement of the
derivative that is designated as the hedging instrument.
Proposed Effective Date and Transition
Effective Date
The Board will determine the effective date after considering stakeholder
feedback on the proposed ASU.
Transition
Entities would be required to apply the proposed guidance in the ASU
prospectively for existing hedging relationships as of the date of adoption,
with early adoption permitted. In addition, “entities may either be required
or permitted to modify critical terms of certain existing hedging
relationships, without dedesignating the hedge.”
Contacts
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Jonathan Howard
Audit &
Assurance
Partner
Deloitte &
Touche LLP
+1 203 761
3235
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Chase Hodges
Audit &
Assurance
Partner
Deloitte &
Touche LLP
+1 404 631
3918
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Harrison Braaksma
Audit &
Assurance
Senior Manager
Deloitte &
Touche LLP
+1 503 539
7785
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Dan Cronin
Audit &
Assurance
Manager
Deloitte &
Touche LLP
+1 216 589
5188
|
|
|
Kevin Machut
Audit &
Assurance
Manager
Deloitte &
Touche LLP
+1 312 486
6978
|
Footnotes
1
FASB Proposed Accounting Standards Update (ASU),
Hedge Accounting Improvements.
2
FASB Accounting Standards Codification (ASC) Topic 815,
Derivatives and Hedging.
3
FASB Accounting Standards Update No. 2017-12, Targeted Improvements to
Accounting for Hedging Activities.
4
ASC 815 does not define highly effective, but
in practice this term has been interpreted to be an 80 percent to
125 percent offset between the change in the fair value of the
hedging instrument and the change in the cash flows of the
forecasted transaction attributable to the hedged risk.
5
As amended, ASC 815-20-25-3(d)(1)(viii) would define
a CYR debt instrument as a “variable-rate debt instrument that
permits the borrower to select at each reset period the interest
rate index from a list of contractual options (including the tenor
of the interest rate, if applicable) upon which interest is
accrued.”
6
ASC 815-10-15-32(a) and (b) state that “[t]he
underlying in a price adjustment incorporated into a contract that
otherwise satisfies the requirements for the normal purchases and
normal sales scope exception shall be considered to be not clearly
and closely related to the asset being sold or purchased in any of
the following circumstances:
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The underlying is extraneous (that is, irrelevant and not pertinent) to both the changes in the cost and the changes in the fair value of the asset being sold or purchased, including being extraneous to an ingredient or direct factor in the customary or specific production of that asset.
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If the underlying is not extraneous as discussed in (a), the magnitude and direction of the impact of the price adjustment are not consistent with the relevancy of the underlying. That is, the magnitude of the price adjustment based on the underlying is significantly disproportionate to the impact of the underlying on the fair value or cost of the asset being purchased or sold (or of an ingredient or direct factor, as appropriate).”
7
See paragraph BC51 of the proposed ASU.
8
See ASC 815-20-25-15(c)(2).