fasb’s targeted improvements to hedge accounting, asu 2017-12

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FASB’s targeted improvements to hedge accountingASU 2017-12

Jon Howard, Accounting Services Partner, Deloitte & Touche LLP

March 20, 2018

Copyright © 2018 Deloitte Development LLC. All rights reserved. 2FASB’s targeted improvements to hedge accounting

Agenda

• Background and overview

• General hedging requirements

• Cash flow hedges of nonfinancial assets

• Hedges of financial assets and liabilities

• Net investment hedges

• Impact on disclosures

• Effective date and transition

• Q&A

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BackgroundTargeted improvements to accounting for hedging activities

ASU 2017-12: Reasons for project

Better align an entity’s financial reporting with its risk management

activities

Improve relevance and depict a more faithful

representation of hedging activities for

investors

Reduce complexity and costs


What hasn’t changed?Targeted improvements to accounting for hedging activities

• Concept of hedging the benchmark interest rate for fair value hedges of financial items

• Availability of shortcut and critical terms match methods

• Voluntary hedge dedesignations

• A number of disclosure requirements

• Highly effective threshold for all hedges

• General documentation requirements

• Required prospective and retrospective hedge effectiveness assessments

• Ability to hedge components of financial items

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OverviewTargeted improvements to accounting for hedging activities

Ineffectiveness


Components excluded from the hedge effectiveness assessmentTargeted improvements to accounting for hedging activities

Recognition model for excluded components (option time value, foreign exchange forward

points, cross-currency basis spreads)

Mark-to-market approach

Systematic and rational amortization approach

or

• In each period, recognize any difference between the change in FV of the excluded component and the amount recognized in earnings under the amortization approach in OCI (or CTA portion of OCI for net investment hedges).

• The change in fair value of a currency swap attributable to a cross-currency basis spread has been a source of ineffectiveness and volatility since the Credit Crisis.

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Cross-currency basis spreadsTargeted improvements to accounting for hedging activities

• Issuers may exclude the portion of the change in fair value of a currency swap attributable to a cross-currency basis spread

−Has been a source of ineffectiveness and volatility since the Credit Crisis

−The spreads are present in the measurement of the hedging instrument, but not the hedged item

• Issuers that elect to exclude the cross-currency basis spread will:

−Amortize the excluded component present at recognition

−Subsequent changes in the fair value due to changes in the cross-currency basis spread should be deferred in OCI


Hedge effectiveness assessmentTargeted improvements to accounting for hedging activities

Initial Prospective Quantitative Hedge Effectiveness Assessment

The ASU requires an initial prospective quantitative assessment of hedge effectiveness in most circumstances:

• Entities required to complete the initial quantitative prospective assessment of hedge effectiveness by the end of the hedge inception reporting period:

−Up to 3 months for public companies and all financial institutions

−Nonpublic, nonfinancial institutions—may be up to a year

• Quantitative assessments would use data as of hedge inception

• An initial quantitative assessment is not required if the hedge qualifies for the shortcut or critical terms match methods (or other methods that assume perfect effectiveness)

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Subsequent Qualitative Hedge Effectiveness Assessments

• Entities may elect to perform subsequent retrospective and prospective qualitative assessments of hedge effectiveness if:

−Initial prospective quantitative assessment demonstrates that the hedging relationship is “highly effective”

−The entity can, at hedge inception, “reasonably support an expectation of high effectiveness on a qualitative basis in subsequent periods”

−Documentation must specify:

◦ How qualitative assessments will be performed, and

◦ The alternative quantitative assessment that will be performed if the entity can no longer support a “highly effective” offset qualitatively

−Subsequent qualitative assessment election done on a hedge-by-hedge basis



Timing of documentation of assessment

• Public companies and all financial institutions

−Hedge documentation timing requirement did not change (i.e., at inception)

−As previously noted though, completion of effectiveness assessment can be deferred up to 3 months

• Private companies that are not financial institutions as well as not-for-profit entities

−Must prepare limited hedge documentation at hedge inception

−Not required to perform and document all initial and subsequent hedge effectiveness assessments (whether quantitative or qualitative) until their next set of interim (if applicable) or annual financial statements is available to be issued

• Note—Relief relates only to timing of performance and documentation of effectiveness assessments, not to the documentation’s content or frequency of effectiveness assessments

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Loosening the reins on critical terms and shortcutTargeted improvements to accounting for hedging activities

• Critical terms match for a CF hedge of a group of forecasted transactions if the transactions occur and the hedging derivative matures within the same 31-day period or fiscal month

• “Back-up” long-haul method for certain hedges designated as shortcut if:

−The hedge was highly effective

−The entity documented at hedge inception which long-haul methodology it would use to measure hedge ineffectiveness as a back-up

• Shortcut criteria would be amended to allow partial-term fair value hedges of interest risk to qualify for the shortcut method

• Codifies certain practices related to the change in variable cash flows method and hypothetical derivative methods for cash flow hedges


Component hedging not just for financial transactions anymoreTargeted improvements to accounting for hedging activities

• Nonfinancial purchases and sales

• Purchases/sales of nonfinancial assets containing a contractually specified component, may be eligible for component hedging if:

−The exposure related to variability in cash flows attributable to the component exists throughout the life of the hedge

• Hedges for longer than the contractual term or for a not-yet-existing contract are permissible if certain criteria are met

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Changes to hedges of financial assets/liabilitiesTargeted improvements to accounting for hedging activities

Acceptable designated risks for fair value hedges of interest rate risk have increased.

• New FV hedging strategies include:

−Benchmark interest rate component of coupons

◦ New benchmark component for FV hedges: SIFMA

−Partial-term hedging

−Prepayable debt—may consider only how changes in benchmark interest rate impact decision to prepay

−Last of layer approach—hedging closed portfolio of prepayable assets (or beneficial interest in portfolio of prepayable assets)

Cash flow hedging:

• Benchmark interest rate replaced with contractually specified rate


Benchmark component of couponsTargeted improvements to accounting for hedging activities

Example: Company ABC issues 10-year fixed-rate debt

• Principal: $100 million

• Interest: 7% per annum, payable semi-annually

10-year $100 million notional swap

• Pay variable: 6-mo LIBOR

• Receive fixed: 4.5% per annum

• Net settles every 6 months

Benchmark component of

coupons

Hedged item for purposes of measuring change in FV:

10-year fixed-rate debt


• Interest: 4.5% per annum, payable semi-annually

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Partial-term hedgingTargeted improvements to accounting for hedging activities



• Interest: 7% per annum, payable semi-annuallyBenchmark

component of coupons


5-year fixed-rate debt



Combination of benchmark

component and partial term

Qualifies for shortcut method!

5-year $100 million notional swap





Prepayments due to benchmarkTargeted improvements to accounting for hedging activities




• Callable at par by issuer after 5 year anniversary

Benchmark component of

coupons


10-year fixed-rate debt, callable after year 5



• Issuer’s decision to call debt is based on LIBOR swap rate + 2.5%

10-year $100 million notional swap, settles semi-annually



• Counterparty may terminate after year 5

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Strategies available for callable debtTargeted improvements to accounting for hedging activities




• Callable at par by issuer after 5 yr anniversary

Derivative/Hedging Options:

• Today: 10-year swap, terminable after year 5

• Same derivative – ineffectiveness of credit spread can be ignored:

−Component of coupon

−Benchmark impact on prepayments

• Partial-term hedge:

−Swap up to 5 years can ignore prepayment risk

−Swap beyond 5 years needs to consider termination option in swap


Additional benefits of new identifiable risksTargeted improvements to accounting for hedging activities

Portfolio hedging

Example: Insurance Co XYZ holds $200 million of fixed-rate corporate bonds

• Interest rates vary—benchmark component of coupons makes them all similar

• Maturities vary—partial-term hedge makes them similar

• Callable bonds—combination of strategies may make them similar

• Mix callable and non-callables?

What about convertible debt?

Example: Company EGC issues 10-year convertible notes:


• Interest rate: 2%

• Convertible at option of holder at $10/share

• Callable by issuer after year 5

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Last of layer approachTargeted improvements to accounting for hedging activities

Example: Bank MSG holds $200 million of fixed-rate residential mortgages

• Interest rates: range from 3-8% per annum

• Remaining maturity dates: ranging from 28–30 years

Bank MSG is confident that $150 million of mortgages will remain in 3 years

Swap:

• Notional: $150 million

• Term: 3 years

• Pay fixed: 4% per annum

• Receive variable: 3-month LIBOR



Last of layer approachTargeted improvements to accounting for hedging activities

Criteria:

• Closed portfolio of similar items

• Prepayable financial assets or beneficial interest(s) in portfolio of prepayable financial assets

• Probable that bottom layer will remain throughout hedge ($150 million in example)

• Requires partial-term hedging election

Effect:

• Prepayments and defaults are applied to top layer first ($50 million in example)

• Partial dedesignation required if portion no longer expected to be outstanding

• If “last of” layer is impacted before dedesignation, hedge accounting ceases

• Dedesignations result in allocation of basis adjustments to individual assets

- Basis adjustments are proportional to amount de-designated

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Changes from ASU 2017-12Net investment hedging

Pre-ASU 2017-12 Post-ASU 2017-12

Forward Method • Effective portion of changes in fair value go to CTA

• Ineffectiveness in P&L

• All changes in fair value go to CTA

Spot Method • Changes in fair value due to changes in spot rate go to CTA

• Swaps: periodic “interest” settlements go to earnings

• All other changes in fair value go to earnings

• Changes in fair value due to changes in spot rate go to CTA

• Swaps: periodic “interest” settlements go to earnings

• Forwards: forward points amortized into earnings

• CTA is “plug” for fair value changes not addressed above


Forward vs. spot method considerationsNet investment hedging

• Both methods are methods of assessing hedge effectiveness

• An entity shall consistently use the same method for all of its net investment hedges in which the hedging instrument is a derivative (815-35-35-4)

• An entity may change its method in accordance with 815-20-55-55 through 55-56A (815-35-35-4)

• A change from excluding certain components…to including such components or vice versa is a change in assessing hedge effectiveness (815-20-55-55c)

• A change in method should be to an “improved” method that shall be applied to similar hedges prospectively (815-20-35-19 and 815-20-55-56A)

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Disclosure requirementsTargeted improvements to accounting for hedging activities

• No longer required to disclose amounts of hedge ineffectiveness

• New Requirements:

−Tabular disclosure of FV or CF hedging activity effects on individual income statement line items, as well as the total amounts reported for those line items affected by hedging activity

−For FV hedges—carrying amounts and cumulative basis adjustments of items designated and qualifying as hedged items

−The difference between the change in fair value of an excluded component and the initial value of that excluded component recognized in earnings under a systematic and rational method


Effective date and transitionTargeted improvements to accounting for hedging activities

Effective Dates:

• PBEs: Fiscal years beginning after 12/15/18 and interim periods therein

• All others: Fiscal years beginning after 12/15/19, interims within fiscal years after 12/15/20

• Early adoption is allowed during any interim or annual period:

−If adopted during an interim period – transition adjustments as of beginning of fiscal year

−Also must complete all transition elections by end of quarter of adoption

Transition:

• Modified retrospective approach to existing hedging relationships

−Cash flow and net investment hedges: adjust OCI for prior ineffectiveness

−Effects of any modified hedge relationships also in cumulative-effect adjustment

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Transition electionsTargeted improvements to accounting for hedging activities

One-time elections:

• Reclassify debt securities eligible for last of layer approach from HTM to AFS

• Existing hedges:

−Modify hedge documentation:

◦ Shortcut—add fallback methodologies for long-haul

◦ Change hedge assessment to qualitative

−Fair value hedges—modify relationships:

◦ Apply benchmark component (may also de-designate a portion)

◦ Apply benchmark impact on prepayment options

◦ Exclude cross-currency basis spread from hedge assessment and amortize into earnings

◦ Change method for excluded components to amortization approach


Transition elections (cont.)Targeted improvements to accounting for hedging activities

One-time elections:


−Cash flow hedges:

◦ Modify risk to contractually specified component or interest rate


−Net investment hedges


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Early adoption considerationsTargeted improvements to accounting for hedging activities

Early adoption allowed during interim periods


−Modification of any existing hedges must be done by end of quarter of adoption

−Cumulative effect of adoption is as of beginning of fiscal year

• Similar hedges—similar assessments (exception for pre- and post-adoption)

• Transfers from HTM

• ICFR over hedge accounting:

−Process for qualitative assessments

−Change in designated risks may require different data for quantitative assessments


Issues being discussedASU 2017-12 – Targeted improvements to hedge accounting

• Definition of “prepayable”

− Qualification for last of layer approach

• Net investment hedge with a cross-currency interest rate swap:

−Transition from forward to spot method (must de- and re-designate):

◦ Improved method of assessment

◦ Off-market swap at time of re-designation

• Last of layer approach

− Basis adjustments

− Multiple layers

• Contractually specified components and spot purchases

• Changes in the hedged risk of a forecasted transaction

fasb’s targeted improvements to hedge accounting, asu 2017-12

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