Public and private companies can expect improvements to hedge accounting, as it is becoming more transparent for financial statement users. With the issuance of Accounting Standards Update (ASU) No. 2017-12, Targeted Improvements to Accounting for Hedging Activities, users will see enhancements to comprehensibility and interpretability and can better understand the risks and various exposures they might face with hedging. According to the Financial Accounting Standards Board (FASB), previous generally accepted accounting principles (GAAP) sometimes did not permit recognition of the economic results of hedging strategies. The overarching premise of this ASU is to address the need for financial reporting to more closely align with risk management programs and company activities.
Some key points of this update include, but are not limited to: the overall risk component of hedging, fair value hedging of interest rate risk, and various recognition and presentation effects. Currently, GAAP limits some types of designation on certain cash flow and fair value hedging relationships. To alleviate the limitations that GAAP imposed, the risk component has changed for forecasted purchases or sales of nonfinancial assets and cash flow hedges of interest rate risks of variable-rate financial instruments. Fair value hedges of interest rate risks also are affected. The update has eliminated the requirement that only the overall variability in cash flows or foreign currency risk can be designated as the hedged risk, as well as the requirement to designate only the overall variability in cash flows as the hedged risk. The FASB also has added a Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate as an eligible benchmark interest rate for the United States.
The FASB determined that, in the past, limitations for designating a hedged item in a fair value hedge of interest risk and measuring changes in fair value hedging did not properly align with entities’ risk management strategies. The update will now designate these differently by permitting an entity to measure changes in fair value based on the benchmark rate component of the contractual coupon determined at hedge inception. The update will also permit an entity to measure a hedged item on a partial term by assuming it reflects only the designated cash flows being hedged. Various components of prepaid assets will now be easier to hedge overall as well. For example, after the update, prepayment risk will not be included in the measurement of a hedged item for a closed portfolio prepayable financial asset.
Before the update, there was no regulatory guidance on presentation for hedge accounting. Changes in fair value will now be presented on the same income statement line with the earnings effect of the hedged item. This will allow users to gain a better understanding of the results and costs of an entity’s hedging program. The recognition of changes in a cash flow hedge has also been modified with regard to comprehensive income. Once implemented, changes in fair value for highly effective cash flow hedges will be reported on other comprehensive income rather than running through the income statement. For a fair value hedge, changes in fair value will be reported on current earnings.
As the new update requires presentation differences, it also requires new disclosures. These include a tabular disclosure related to the effect on the income statement of fair value and cash flow hedges as well as a disclosure of related cumulative basis adjustments for fair value hedges. The requirement to disclose the ineffective portion of the change in fair value of hedging instruments will no longer be required. Overall, the implemented update should be applied as a cumulative-effect adjustment. This allows the elimination of the separate measurement for the ineffectiveness of a hedge to “accumulated other comprehensive income,” and an adjustment to the opening balance of retained earnings to the beginning of the fiscal year adopted.
This new standard is effective for public companies for fiscal years beginning after December 15, 2018, and all other entities for fiscal years beginning after December 15, 2019, and interim periods beginning after December 15, 2020. Early adoption is permitted in any interim period after ASU No. 2017-12 has been issued.
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