Some companies wanting to take full advantage of simpler accounting rules on hedging are pausing to ask a few questions, and even rulemakers are taking a fresh look to see if they need to clarify things.
In August, the Financial Accounting Standards Board issued Accounting Standards Update No. 2017-12 to give companies some long-sought simplifications on how to account for derivative instruments that are part of a company’s hedge strategy. The board considered a number of different approaches over several years to improve hedge accounting before settling on the “targeted improvements” standard that takes effect in 2019, with early adoption permitted.
Hedge accounting has been widely regarded as one of the most complex areas of U.S. GAAP, fraught with detailed requirements that dish out harsh consequences for missteps, even inadvertent ones. It has been a common cause of restatement, and it has proven difficult—in some cases impossible—for companies to structure transactions that would qualify for the benefits of hedge accounting, which is to reduce the risk of volatility in the income statement. As such, companies have been eager to put FASB’s simpler accounting standard to work.
Yet, as preparers of financial statements are digging in, they are discovering some uncertainties. “With any new standard, there are going to be questions,” says Chris Moore, a partner at Crowe Horwath. “Hedge accounting is certainly complicated, and these are significant changes, so people have to think through the details,” he says.
In many cases, early adopters are still able to move forward with adopting the new hedge accounting standard, even with some questions still begin debated or explored, says Moore. “There’s enough new and exciting stuff in this ASU that those who want it are going to early adopt,” he says. “We’re going to see a lot of early adoption this quarter.”
Compared to many of the bigger new standards companies are adopting—new rules for revenue recognition, leases, and financial instruments—the new hedging standard represents incremental rather than wholesale change, says Moore. “If you’ve already mastered hedge accounting before, this is not that big of a hurdle to take on these new changes,” he says.
“Some hedging strategies were so difficult before that companies just gave up. Treasuries and risk managers are hearing of the improvements and finding it’s true, so they're rethinking some things. And it’s healthy to revisit and not be stuck in the way things have always been done.”
Rob Royall, Derivatives and Financial Instruments Leader, EY
Still, there are questions on some specific aspects of the standard that are causing some companies to lift their pencils and ask FASB for clarifications. “There are so many different improvements all throughout the standard, you could have one early adopter wrestling with one part of the standard and another early adopter moving forward in a completely different, unrelated area,” says Rob Royall, derivatives and financial instruments leader at EY.
Big 4 firms have been comparing notes on their interpretations of many of the questions, says Royall, but there are a handful of questions where even national office leaders could not be certain of their answers. “There are less than seven or eight issues where the Big 4 firms collectively agreed they weren’t sure what FASB intended the actual mechanics to be,” he says.
Ryan Brady, a partner at Grant Thornton, says many of the questions focus on prepayable financial instruments and net investment hedges. Companies also have some questions about transition issues, especially one-time elections they must make to move from the old accounting to the new accounting.
With respect to prepayable financial instruments, companies had questions about how to define prepayable instruments. “That’s important because some significant provisions of the new guidance are only applicable to prepayable financial assets,” says Brady. “It’s important to get that clarified.”
FASB addressed that definition in a recent public meeting and cracked open the master glossary of the Accounting Standards Codification to clarify. It determined prepayables include instruments that are currently exercisable and prepayable at any time, instruments with certain contingent prepayment features, and instruments with conversion features. The board also said prepayables would not include instruments where contractual maturity can be accelerated due to credit.
FASB guidance on hedge accounting so far
Based on tentative decisions at a recent board meeting, the FASB concluded:
Financial instruments that meet the definition of prepayable include the following:
instruments that are currently exercisable and prepayable at any time;
instruments with certain contingent prepayment features (that is, based on the passage of time, the occurrence of a specified event other than the passage of time, and the movement in a specified interest rate);
instruments with conversion features.
Instruments for which contractual maturity can be accelerated due to credit would not meet the definition of prepayable. The Board agreed with the staff’s conclusions. Further information on this issue will be posted to the Hedge Accounting Implementation webpage.
With respect to net investment hedges, FASB concurred with its staff interpretation, which focused on the amortization of excluded components when the hedging instrument is a cross-currency interest-rate swap that is off-market (that is, does not have a fair value of zero) at hedge inception. Specifically, an amortization method should be used that would not violate the guidance in paragraphs 815-35-35-6 through 35-7. That is, at the end of the hedging relationship, only amounts of the swap related to spot changes on the notional amount of the net investment should remain in currency translation adjustment. Therefore, any systematic and rational approach that results in the off-market nature of the swap equaling zero at the end of the hedging relationship is acceptable. However, structuring of cross-currency interest-rate swaps designated in net investment hedges to achieve a specific accounting result is not considered rational in the context of a systematic and rational approach.
That definition should be plenty clear enough to any companies that had doubts or uncertainties, says Moore. “It’s not only specific, but I think it’s generous,” he says.
The clarification in the prepayables definition will make it easier for companies to pursue an entirely new type of hedge now permitted under the new standard called a “last-of-layer” hedge, says Jonathan Howard, a partner at Deloitte. A last-of-layer hedge enables companies to establish a fair-value hedge for a portion of a closed portfolio of prepayable financial assets without having to consider repayment risk or credit losses.
Companies had questions about some of the nuances of different types of instruments that could potentially be prepayable under certain circumstances, says Howard. If there were a fault on a debt instrument that could be called in, for example, or if an entity’s credit rating was to change as a result of an acquisition that might affect a particular outstanding debt, do those kinds of contingencies make an instrument prepayable? “FASB is saying look at anything that could be settled by either party early,” he says.
Another area of questioning is focused on net investment hedges, says Brian Zenk, a partner at PwC. Those are hedges companies use to manage foreign currency risks that are inherent in investments in foreign operations. “The standard represents a major change to how people previously accounted for net investment hedges,” he says.
The specific requirements of the new standard have led to some puzzlement about how net investment hedges should be reflected in financial statements, most notably in the income statement, says Zenk. This is one area where companies looking for clarification may be waiting for more specific guidance from FASB before jumping into new contracts, he says.
Some accounting leaders are even seeing companies expand their hedging strategies now that hedge accounting is easier to achieve. “Some hedging strategies were so difficult before that companies just gave up,” says Royall. “Treasuries and risk managers are hearing of the improvements and finding it’s true, so they’re rethinking some things. And it’s healthy to revisit and not be stuck in the way things have always been done.”
That’s not to say all companies are rushing headlong into new approaches, says Royall. “They’re also busy adopting other things,” he says, like revenue recognition, leases, credit losses, and dealing with the implications of tax reform.