Mandatory adoption of ASU 2017-12 is right around the corner
In August of 2017 the FASB issued ASU 2017-12, Targeted Improvements to Accounting for Hedging Activities, with the main objective of better aligning financial reporting with a company’s risk management activities. In addition, the updated guidance makes certain targeted improvements to simplify the accounting guidance based on feedback received from preparers, auditors, and other stakeholders. The improvements are achieved through changes to both the designation and measurement guidance for certain hedge accounting relationships along with changes to the presentation of hedging activities in the financial statements. The improvements also expand the strategies that qualify for hedge accounting and open opportunities for companies to mitigate unwanted earnings volatility.
ASU 2017-12 impacts any entity that elects to apply hedge accounting. Chatham has seen many corporations early adopt the new standard and implement new strategies as a result of the targeted improvements. The improvements can be classified into three main categories:
Aligning company’s financial reporting with risk management objectives
Commodity Hedge Accounting: The new guidance better aligns the accounting for commodity hedges with how companies manage their non-financial risk. Similar to the current accounting for interest rate and foreign exchange risk, ASU 2017-12 allows companies to isolate a contractually specified component when identifying the risk being hedged. To the extent that an index is referenced in a vendor contract or in a pricing formula, this improvement eliminates the requirement to look at all variability in cash flows, such as transportation fees, taxes and other ancillary costs that may not be correlated with the index itself. This change has been an exciting development for companies desiring to hedge commodity exposures and results in less volatility recognized in earnings from the hedging relationship.
Accounting for Excluded Components: The new guidance allows companies to recognize amounts excluded from the hedging relationship through an amortization approach as opposed to a mark-to-market approach which created income statement volatility under the current guidance. Companies who seek to isolate the cost of hedging, have timing uncertainty around forecasted transactions, or those with certain basis mismatches can apply the spot method and recognize the excluded component over the life of the hedging relationship in a consistent manner. Additionally, this guidance has created advantageous strategies for companies applying net investment hedge accounting as the excluded component is recognized in earnings, thus aligning the financial reporting with the economic objective.
Fair Value Hedge Accounting: The new guidance incorporates various updates to the fair value hedge accounting model that address significant limitations that once existed. These improvements include: 1.) the ability to measure changes in fair value of the hedged item based on the benchmark component of the contractual coupon; 2.) the ability to enter into a partial-term relationship rather than hedging the full term of the debt; 3.) for prepayable instruments, the ability to consider how changes in the benchmark interest rate impact a Company’s decision to settle prior to maturity; and 4.) when hedging a portfolio of prepayable financial instruments classified as assets, the ability to designate an amount that is not expected to be impacted by prepayments (e.g. the “last-of-layer” method).
Enhancing the presentation and disclosure of financial results to provide stakeholders with more transparency on the effect of hedging relationships
Removal of Hedge Ineffectiveness: The new guidance eliminates the requirement to separately quantify and present ineffectiveness in earnings. Once ASU 2017-12 is adopted, all changes in fair value on a hedging instrument is deferred into other comprehensive income (OCI) and reclassified to the line item being hedged when the hedged item impacts earnings. Although the new guidance will change the timing and income statement location for recording hedge ineffectiveness, the underlying economics of a transaction do not change and therefore, if there is an economic mismatch, this is still reflected in the financial statements. However, companies will experience less volatility and will provide financial statement users with more transparency and clarity on hedge results. The update to the measurement guidance allows companies to make certain economic decisions they may not have in the past due to the recognition of ineffectiveness in current earnings.
Simplifying certain aspects of hedge accounting and decrease administration
Additional Timing to Complete Certain Aspects of Documentation: The new guidance provides relief to the timing requirements of certain aspects of hedge documentation. For example, public companies are now permitted to perform inception effectiveness testing after hedge designation, but no later than the first quarterly assessment of effectiveness testing date. The data used in the test is applicable as of hedge inception. Private companies that are not financial institutions have until financial statements are issued to select an assessment of effectiveness method and perform the inception effectiveness test.
Simplification of Critical Terms Match: The new guidance specifies that Critical Terms Match may be used for a group of forecasted transactions when the derivative maturity and the hedged transactions are expected to occur in the same 31-day period or fiscal month. De minimis testing is no longer required.
Ongoing Qualitative Assessments of Effectiveness as Applicable: In certain instances, the new guidance allows companies to perform subsequent assessments of effectiveness on a qualitative basis so long as the company documents and verifies on a quarterly basis that facts and circumstances have not changed such that a quantitative test would be warranted. Additional internal controls are likely required should qualitative testing be used to ensure that facts and circumstances remain unchanged and that the company can continue to assert that the relationship is highly effective.
As companies are transitioning to the new hedge accounting standard, top of mind is getting it right, finding time and capacity to implement, and fully taking advantage of potential benefits. As transition time is approaching, the key steps to think about are providing education to key stakeholders, portfolio review and analysis of the new guidance, redesignation considerations, documentation considerations, disclosure updates, and transition entries. The new guidance is effective for public companies in annual periods beginning after December 15, 2018 and interim periods therein. For all other entities, the guidance is effective for fiscal years beginning after December 15, 2019 and interim periods within fiscal years beginning after December 15, 2020.