On the Radar
Hedge Accounting
Some entities mitigate certain risks by entering into separate
contracts that meet the definition of a derivative instrument. For such
circumstances, ASC 815 allows entities to use a specialized hedge accounting for
qualified hedging relationships. If hedge accounting is not applied, changes in the
fair values of derivative instruments are recognized in earnings in each reporting
period, which may or may not match the period in which the risks that are being
hedged affect earnings. Therefore, the objective of hedge accounting is to match the
timing of income statement recognition of the effects of the hedging instrument with
the timing of recognition of the hedged risk. For further discussion of derivatives
not designated in qualifying hedging relationships, see Deloitte’s Roadmap Derivatives.
Financial Reporting Considerations
What Are the Different Hedge Accounting Models?
ASC 815 provides three categories of hedge accounting, each with its own
accounting and reporting requirements:
Fair Value Hedges
For a fair value hedge to qualify for hedge accounting, the exposure to
changes in the hedged item’s fair value attributable to the hedged risk
must have the potential to affect reported earnings. Examples of
eligible exposures (i.e., hedged items) may include fixed-interest-rate
assets or liabilities, inventory on hand, foreign-currency-denominated
assets or liabilities, a portion of a closed portfolio of prepayable
financial assets (or one or more beneficial interests secured by a
portfolio of prepayable financial instruments), or a fixed-price firm
commitment.
Generally speaking, an entity with a fair value hedge that meets all of
the hedging criteria in ASC 815 would record the change in the
derivative’s (i.e., hedging instrument’s) fair value in current-period
earnings. It would also adjust the hedged item’s carrying amount by the
amount of the change in the hedged item’s fair value that is
attributable to the risk being hedged. The adjustment to the hedged
item’s carrying amount would also be recorded in current-period
earnings. For fair value hedges, both the change in the hedging
instrument’s fair value and the change in the hedged item’s carrying
amount are presented in the same income statement line item and should
be related to the risk being hedged. As a result of applying hedge
accounting in a qualifying fair value hedging relationship, an entity
accelerates the income statement recognition of the impact of changes on
the hedged item that are attributable to the hedged risk. Accordingly,
the entity recognizes the changes in the same period as the changes in
the derivative’s fair value.
Cash Flow Hedges
To be eligible for designation as a hedged item in a cash flow hedge, the
exposure to changes in the cash flows attributable to the hedged risk
must have the potential to affect reported earnings. Examples of
eligible hedged items may include variable-interest-rate assets or
liabilities, foreign-currency-denominated assets or liabilities,
forecasted purchases and sales, and forecasted issuances of debt. The
objective of a cash flow hedge is to use a derivative to reduce or
eliminate the variability of the cash flows related to a hedged item or
transaction.
Generally speaking, an entity with a cash flow hedge that meets all of
the hedging criteria of ASC 815 would record the change in the hedging
instrument’s fair value in other comprehensive income (OCI). Amounts
would be reclassified out of accumulated other comprehensive income
(AOCI) into earnings as the hedged item affects earnings. Those amounts
would also be presented in the same income statement line item in which
the earnings effect of the hedged item is presented. As a result of
applying hedge accounting in a qualifying cash flow hedging
relationship, an entity defers the income statement recognition of
changes in the derivative’s fair value. Accordingly, the entity
recognizes the changes in the same period in which the hedged item
affects earnings.
If it becomes probable that a hedged
forecasted transaction either will not occur or
will not occur without significant delay, an
entity must immediately reclassify amounts from
AOCI into earnings.
Net Investment Hedges
A net investment hedge is a hedge of the foreign
currency exposure of a net investment in a foreign operation. Even
though the translation of a net investment in a foreign operation is
recognized as part of the currency translation adjustment in OCI, there
is a potential earnings risk upon disposition of that investment in the
foreign operation. Accordingly, the foreign currency exposure in a net
investment in a foreign operation is a hedgeable risk. Generally
speaking, an entity with a net investment hedge that meets all of the
hedging criteria of ASC 815 would record the change in the hedging
instrument’s fair value in the cumulative translation adjustment portion
of OCI.
Does the Entity Want to Apply Hedge Accounting?
Not all derivatives will be designated as hedging instruments in qualifying
hedging relationships under ASC 815. For example, an entity that owns shares
of a publicly traded stock can economically hedge price changes in that
stock by entering into financially settled options or forwards related to
that stock. If both the hedging instrument (i.e., the derivative) and the
hedged item (i.e., the stock) are recognized on the balance sheet at fair
value, with changes in fair value recognized in earnings in each reporting
period, no specialized accounting is needed to match the recognition of
gains and losses on the derivative with the recognition of those on the
stock investment.
In addition, some derivatives may be entered into as economic hedges of risk
but may not qualify for hedge accounting because they are related to an
exposure that is not a qualifying hedge accounting exposure. Further, hedge
accounting is optional, so some entities choose not to apply it to
qualifying hedging relationships because they perceive that the costs of
such accounting exceed its benefits.
Note that derivatives that are used as economic
hedges but are not designated in qualifying
hedging relationships require special
consideration for financial reporting purposes.
Finally, some derivatives are entered into for
speculative purposes and are not part of a risk
mitigation strategy.
Does the Hedging Relationship Qualify for Hedge Accounting?
ASC 815 outlines the types of items that qualify as the hedging instrument
(generally, derivatives that are not written options) and the hedged item.
In addition, the guidance permits an entity to hedge the risk of changes in
the entire fair value of the hedged item or in all the item’s cash flows,
but an entity may hedge certain other risk components of the hedged item as
well. The nature of the risks that may be hedged depends on whether the
hedged item is a financial asset or liability or a nonfinancial asset or
liability. An entity is permitted to hedge any of the risks individually or
in combination with other risks. The most common component risks that
entities hedge are interest rate risk, foreign currency risk, and the risk
of changes in contractually specified components of the forecasted purchase
or sale of nonfinancial assets.
Before a hedging relationship can qualify for the application of hedge
accounting, an entity must demonstrate that the hedging instrument is
“highly effective” at offsetting the changes in the fair value or cash flows
of the hedged item. ASC 815 does not explicitly define a quantitative
threshold that would be considered highly effective; however, in practice, a
hedge is considered highly effective if the change in the hedging
instrument’s fair value provides offset of at least 80 percent and not more
than 125 percent of the change in the fair value or cash flows of the hedged
item that are attributable to the risk being hedged.
Finally, when issuing its initial accounting and reporting requirements for derivatives in FASB Statement 133 in June 1998, the FASB noted that
“concurrent designation and documentation of a hedge is critical; without
it, an entity could retroactively identify a hedged item, a hedged
transaction, or a method of measuring effectiveness to achieve a desired
accounting result.” The way in which entities comply with those requirements
is commonly referred to as the hedge designation documentation. Most aspects
of the hedge designation documentation must be completed at the inception of
the hedging relationship, including identification of the method of
assessing whether the hedging relationship is highly effective.
Changing Lanes
ASU
2017-12 added the “last-of-layer” method to ASC
815, which enables an entity to apply fair value hedging to closed
portfolios of prepayable financial assets without having to consider
prepayment risk or credit risk when measuring those assets. In March
2022, the FASB issued ASU 2022-01, which
expands the current single-layer model to allow multiple-layer
hedges of a single closed portfolio of financial assets under this
method. The last-of-layer method is renamed the “portfolio layer
method” to reflect this change.
On the Horizon
On September 25, 2024, the FASB issued a proposed ASU that would make targeted
improvements to hedge accounting. Comments were due on November 25, 2024. As of
the date of this publication, the proposed ASU has not been finalized.
Deloitte’s Roadmap Hedge
Accounting provides an overview of
the FASB’s authoritative guidance on hedge accounting as
well as our insights into and interpretations of how to
apply that guidance in practice. For guidance on the
identification, classification, measurement, and
presentation and disclosure of derivative instruments,
including embedded derivatives, see Deloitte’s Roadmap
Derivatives.
Contacts
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Jonathan Howard
Audit & Assurance
Partner
Deloitte &
Touche LLP
+1 203 761
3235
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For information about Deloitte’s hedge accounting service offerings, please
contact:
|
|
Jonathan Prejean
Risk &
Financial Advisory
Managing
Director
Deloitte &
Touche LLP
+1 703 885
6266
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