Interest Rate Hedge Accounting for Variable Rate Debt
Under the new guidance, companies that hedge variable rate debt will be required to change the way they assess hedge effectiveness and measure and record any hedge ineffectiveness.
The new guidance will allow companies to perform ongoing effectiveness assessments on a qualitative basis if the hedging relationship hasn’t changed and if hedge mismatches are not expected to occur. Quantitative effectiveness testing will continue to be required at inception of the hedging relationship.
The new guidance will also require that all derivative gains and losses be deferred in other comprehensive income (OCI) for designated hedges. Those deferred gains and losses will then be reclassified from OCI into earnings during the period in which the hedged transactions impact earnings.
In addition, companies will be required to record all changes in fair value in the same income statement line item as the item being hedged, thereby eliminating a company’s ability to choose where to present hedge ineffectiveness. This includes derivative gains and losses related to items explicitly excluded from the hedging relationship and also gains and losses reclassified from OCI to earnings when the hedged transactions impact earnings. The only exception to this will be for amounts reclassified out of OCI when a missed forecasted transaction occurs, in which case a company would be permitted to select the income statement account to record those amounts.
Today, companies are required to measure and record ineffectiveness for all hedging relationships that aren’t designated under a “short-cut” method. Companies may need to recognize some ineffectiveness in their current period earnings if a hedge is not perfectly effective, as only the effective portion of the derivative gains and losses can be deferred in OCI. In those cases, today’s guidance provides flexibility in determining the appropriate line item to record gains and losses that are reclassified from OCI.
Companies are also required to perform a quantitative effectiveness assessment at each reporting period when the “short-cut” method is not used. This quantitative test enables companies to prove that their hedges are “highly effective” and qualify for hedge accounting.
Although the new guidance will change the timing and income statement location for recording hedge ineffectiveness, it doesn't change the underlying economics of a derivative transaction. True economic mismatches may still exist in a hedging relationship, and those mismatches will eventually be reflected in the income statement. As a result, companies will continue to see earnings volatility if a hedge does not provide complete offset between the derivative and the hedged item or transaction. Accordingly, companies should apply the same level of discipline in establishing their economic hedging programs as they apply today.
Prepare for the new hedge accounting standard by learning about Chatham’s 8-Step Transition and Implementation Process.
Contact us today to learn more. CorpAcctgTeam@chathamfinancial.com