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On September 8, 2016 the Financial Accounting Standards Board (FASB) issued a proposed Accounting Standards Update (ASU) intended to improve accounting for hedging activities. On June 7, 2017, the FASB voted to proceed with this new standard on hedging activities with the final ASU expected to be published in August 2017. This standard is not expected to be an overhaul of the hedge accounting guidance in FASB Accounting Standards Codification Topic 815 Derivatives and Hedging, but rather focused on targeted improvements to address key issues that have been identified since the original standard was issued in 1998.
There are three common types of hedge accounting: fair value hedges, cash flow hedges and hedges of the net investment in a foreign operation, that are explained further below.
Fair Value Hedges
The risk of being hedged in a fair value hedge is a change in the fair value of an asset or a liability. For examples, changes in fair value may arise through changes in interest rates (for fixed-rate loans), foreign exchange rates, equity prices or commodity prices.
Cash Flows Hedges
The risk being hedged in a cash flow hedge is the exposure to variability in cash flows attributable to a particular risk and could affect the income statement. Volatility in future cash flows will result from changes in interest rates, exchange rates, equity prices or commodity prices. The most common cash flow hedges are interest rate swaps to fix the interest rate on debt instruments with a variable interest rate.
Hedges of Net Investment in a Foreign Operation
An entity may have overseas subsidiaries, associates, joint ventures or branches (‘foreign operations’). It may hedge the currency risk associated with the translation of the net assets of these foreign operations into the group’s currency.
The primary changes related to this new ASU are expected to be the following:
- Hedge accounting will be expanded for nonfinancial and financial risk components to allow institutions to achieve hedge accounting for more of their risk management activities;
- It will decrease the complexity of preparing and understanding hedge results through eliminating the separate measurement and reporting of hedge ineffectiveness;
- Enhancements to transparency, comparability and understanding of hedge results through enhanced disclosures and changes in presentation of hedge results to align the effects of the hedging instrument and the hedged item; and
- Reductions in the cost and complexity of applying hedge accounting by simplifying the manner in which assessment of hedge effectiveness may be performed.
There will be a period of time after the issuance of this ASU before it will be required to be adopted for any organization with current hedging activities, or those that envision using hedges as a risk management activity in the future. The new standard will take effect for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018 for public companies. It will take effect for fiscal years beginning after December 15, 2019 and interim periods within those fiscal years for private companies. Early adoption will be permitted.
The ASU will require an institution to apply the accounting changes through a modified retrospective approach where the cumulative effect of application will be recorded as an adjustment to retained earnings as of the beginning of the most recent fiscal year presented on the date of adoption. The new and modified disclosure requirements and designation of hedging strategies, in most instances, are going to be required on prospectively.
For more information about the project, please visit the FASB’s website at www.fasb.org or contact a member of your GBQ engagement team.