The updated guidance will remove today’s requirement to separately measure and report hedge ineffectiveness. Instead, all changes in the fair value of a derivative in a hedging relationship will be recognized in either other comprehensive income (OCI) (for cash flow and net investment hedges) or to the financial statement line item being hedged (for fair value hedges). All amounts deferred in OCI will be reclassified into earnings during the period in which the hedged transactions occur, or when it becomes probable that the hedged transactions will not occur.
Also, 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 will be for amounts reclassified out of OCI when a missed forecasted transaction occurs, in which case a company will be permitted to select the income statement account to record those amounts.
The current guidance requires companies to measure and recognize ineffectiveness from hedging relationships each reporting period. Companies are allowed to defer changes in fair value from derivative instruments into OCI only for the amount deemed “effective.” To the extent a derivative is ineffective, the applicable changes in fair value must be recognized in current period earnings. Today’s guidance permits flexibility in choosing the specific income statement line item to present hedge ineffectiveness. This same flexibility is permitted when determining where to recognize changes in fair value related to items intentionally excluded from the hedging relationship. Importantly, a different line item may be elected for ineffectiveness and excluded item recognition than for the effective portion of the hedge and OCI reclassifications.
Although this new guidance will change the timing and income statement location for recording hedge ineffectiveness, it doesn't impact 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