The FASB issued ASU 2017-12 last year with the objective of making targeted improvements to accounting for hedging activities. While mandatory adoption is not required until 2019 (2020 if private), there are many benefits that may be enticing enough for your organization to consider early adoption.
Companies are no longer required to measure and separately record hedge ineffectiveness
For some hedgers, this may be the single biggest benefit provided by the new guidance. For others, the excitement that comes along with the fancy sticker price quickly fades once they take a look under the hood.
Cash flow hedging strategies involve executing a derivative that settles on a future date (or dates), hedging a forecasted transaction (or transactions) expected to occur on or around those dates. For example, an entity may expect to have 1 mo. LIBOR interest expense based on a rate fixing that occurs on the first day of each month and execute an interest rate swap with corresponding terms. If the underlying loan changes such that the rate now fixes on the 20th business day of each month, there will be a mismatch between the hedge and the forecasted transactions (interest payments).
Under legacy guidance, the entity would be required to model this mismatch, and in some instances record hedge ineffectiveness to the income statement. Under the new guidance, the entity would not be required to record hedge ineffectiveness when their best estimate changes. The entity would, however, 1) still be expected to model the difference to demonstrate that the hedging relationship still qualifies as “highly effective”, and 2) continue to have an economic mismatch between the hedge and the hedged transaction that will eventually manifest itself on the income statement, although the timing of that income statement recognition will be different under the new guidance.
Less administrative burden for certain hedgers of non-financial risk (e.g. commodities)
Legacy ASC 815 included onerous requirements for hedgers of non-financial risks seeking to attain hedge accounting. For example, let’s say a company plans to buy 100 tons of steel in six months, and each of their vendors price steel at the LME Midwest monthly average price plus freight costs. If that hedger executed an over the counter forward contract to buy steel six months forward at the LME Midwest monthly average price (i.e. no economic mismatch), the entity would be required to demonstrate that their hedge was highly effective by comparing the derivative to an exposure that captured all variability in cash flows attributable to the hedged item, inclusive of freight charges. Capturing estimated freight charges creates administrative burden, particularly for procurement teams that work with multiple vendors. Furthermore, changes in estimated freight costs could cause the entity to record hedge ineffectiveness to the income statement and possibly cause the hedge to fail to qualify for hedge accounting.
ASU 2017-12 permits entities to focus on a contractually specified component. In the example above, as long as the LME aluminum price meets the contractually-specified requirement, changes in freight costs would no longer be relevant. We see this as a huge win for hedgers of commodity risk but caution that we have seen a number of practitioners encounter challenges while implementing this new, simplified approach.
More time for hedgers to perform initial prospective quantitative testing
In order to apply hedge accounting, legacy ASC 815 requires public companies to have all hedge documentation completed contemporaneously. Auditors have generally interpreted “contemporaneous” to mean within a day or two. While the FASB kept the contemporaneous hedge documentation requirements in place, public companies are now permitted additional time to perform inception effectiveness testing after hedge designation. However, testing must be completed no later than the end of the reporting quarter.
For example, let’s assume that a public company has a reporting period that runs from January 1, 2019 through March 31, 2019. For trades executed on January 2, 2019, the new guidance provides the entity with almost three months to perform quantitative testing. However, if the company executes a hedge on March 30, 2019, they will have only one day to have their quantitative testing finalized. Under either scenario, the other hedge designation documentation requirements must still be completed contemporaneously, so the only relief provided is for the timing of the quantitative testing.
Allows hedgers to ignore certain timing mismatches between the hedge and the hedged item
In certain instances, ASC 815 permits practitioners to qualitatively determine that their hedge is highly effective. The new guidance specifies that the Critical Terms Match method 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. There is no longer a requirement to perform a de minimis test to demonstrate that the timing mismatch is immaterial to the hedging relationship.
Keep in mind that ASU 2017-12 is relatively new, so regulator and auditor interpretation will continue to evolve in the years to come. Currently, it appears that this strategy will only be permitted for certain hedging instruments. Practitioners may also be required to take on some additional administrative burden to fully take advantage of this simplified approach.
New hedging strategies now qualify
ASC 815 is quite complex and, while the legacy rules were well intentioned, some of the complexity resulted in a number of common economic hedging strategies that simply did not qualify for hedge accounting. Under ASU 2017-12, there are a number of new strategies that now qualify. There are other instances where a strategy may have qualified, but under the new guidance the accounting results better align with the economic objectives that the entity was hoping to achieve. We will cover a number of these strategies in our upcoming webinar.
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