August 2010 Special Edition Exposure Draft Newsletter View in pdf

Hedge Trackers consultants visited the FASB July 12th to investigate rumors that intercompany hedging is again at risk in the pending redline version of the exposure draft. We were surprised to learn that the FASB staff believe that abolishing the ability to hedge “intercompany transactions that eliminate in consolidations” is a change in the guidance. (After all, what intercompany transactions don’t eliminate in consolidation?) We took the opportunity to explain that corporations with foreign functional subsidiaries depend on hedging non-functional currency intercompany transactions to protect themselves from the exposure that arises from sourcing in one currency and selling in another. It was clear that they are not focused on the impact that the functional currency election has on a company’s ability to hedge exposures directly. I suggested the only way to reasonably implement this clarification would be to add a functional currency election “holiday”, which intrigued staff members who admitted to numerous petitions over the years for Held-to-Maturity and other holidays—but they’d never had a request for a functional currency holiday. This may in fact be the only way US corporations will be able to protect their margins in the future if hedging of intercompany transactions no longer qualifies for special accounting treatment. For those companies already USD functional around the globe, there will be no negative effect from the intercompany restrictions.

Exacerbating the risk that the language from the 2008 exposure draft will be reinserted is the FASB’s latest estimate that the redline version of Topic 815 won’t be available until “late August”. Note the redline is also expected to excise the intercompany hedging examples that now exists in the guidance.

If you have local currency subsidiaries and hedge intercompany exposures to protect consolidated margin you need to 1) highlight to senior management the impact on your hedge program should intercompany hedging be prohibited, 2) press your auditor firm to lobby against the prohibition BEFORE the redline is issued, 3) raise the concern to your bankers (who frankly are overwhelmed with the potential impact of the financial instrument re-write and not focused on hedge accounting), 4) start drafting a comment letter based on the 2008 exposure draft language as the staff suggested the plan is to re-insert the 2008 language in the redline draft, and 5) encourage your peers to do the same. There are at present over 150 comment letters and not a single letter addresses the changes to hedge accounting.

The ED also addresses new criteria involving dedesignation. Entities would no longer be permitted to arbitrarily discontinue hedge accounting by simply removing the designation of a hedging relationship. Instead, the hedging relationship can only be discontinued if the qualifying criteria for designating a hedging relationship are no longer met or if the hedging instrument expires or is sold, terminated, or exercised.

The goal of this new guidance is increased comparability and transparency in the financial statements. The Board believes that “because the economics of the relationship between the hedging instrument and hedge item have not changed, the accounting should not change”, thus encouraging entities to only dedesignate for actual economic transactions.

This could potentially create a problem for FX hedgers. Audit firms disagree on whether the actual booking of a previously forecasted non-functional currency transaction qualifies for automatic dedesignation because the criteria for designating a hedge relationship are no longer met. If the derivative designation doesn’t change when the nature of the hedged item changes (from anticipated to recorded), cash flow hedgers will need to execute two different hedges for a single economic exposure: a cash flow hedge through booking and a remeasurement hedge from booking to cash conversion.

This may also effect Fair Value hedges of commodities or net investments in subsidiaries where the underlying changes and hedged proportions are changed.

Many of the changes included in the ED relate to effectiveness testing and measurement. Shortcut method (for interest rate swaps) and critical terms match method (for other risks/instruments) would be eliminated. However, the quantitative testing (i.e. regression, sensitivity testing) required by the “long haul” method is replaced in many cases by a qualitative approach. The hedger will only need to demonstrate that an economic relationship exists between the hedge and the hedged item.

With the quantitative testing requirement being virtually eliminated for many hedge relationships, the focus in the future will be on identifying and measuring the effective changes in the underlying hedged transaction. According to paragraphs 122-126 of the ED, the measurement of hedge ineffectiveness shall be based on a comparison of the change in fair value of the actual derivative designated as the hedging instrument and the present value of the cumulative change in expected future cash flows on the hedged transaction. The amount to be deferred in accumulated other comprehensive income will be the amount associated with the changes in fair value of the present valued hedged transactions’ cash flows. This is a fundamental change in the cash flow concept as under current guidance OCI reflects the portion of the derivative that is effective and under the proposed guidance OCI will reflect the entire change in value of the hedged item. This means any over or under performance of the hedge will be reflected in income, similar to fair value and net investment hedging. (Currently only over performance of a cash flow hedge is reflected in income.)

For entity’s including time value in the assessment and measure of effectiveness, the trick is going to be figuring out how to capture the expected date of the hedged transaction(s) to model a derivative that matches such expected date. For most cash flow hedging relationships, the designated forecasted transactions are related to a group of transactions within a specified period. In this case, entities will be allowed to model a derivative that would settle within a reasonable time period (generally one month) of the cash flows related to the hedged transactions. It also appears that companies should not assume the underlying’s maturity date equals the hedge maturity date.

As the focus shifts away from assessing effectiveness, and moves towards measuring actual ineffectiveness in a hedging relationship, entities are going to have to establish processes and procedures to support how they determine the expected date of the forecasted transaction in order to best reflect the appropriate amounts of hedge ineffectiveness in income.

Warm up your spell check, drag out your accounting text books, pull up fasb.org and share your reactions to the FASB’s proposed changes to derivative accounting and financial instrument reporting. The comment letter process is a key part of the FASB’s efforts to improve financial reporting. They see comment letters as “essential to develop[ing] the best solutions to accounting and reporting issues and prevent[ing] standards that are unworkable in application, too costly, or even inconsistent with basic concepts.”

Specifically your input to the FASB should address questions they have poised to you as preparers and or users of financial statements as well as support for or concerns you have about the basis or practicality of the proposal. Prepare “articulate, well-presented arguments that emphasize theoretical support” as well as examples that address specific implementation issues. Letters that just applaud or deride positions will be given little weight as the FASB is not trying to win a popularity contest (remember stock options). Obviously, avoid derogatory comments. I was surprised to read comments like “I am amazed that we are even having this discussion” and “The proposal to have banks mark their loans to market is idiotic at best” among the 150+ letters already submitted.

Areas that you might consider addressing in a comment letter include (one or two points critical to your company accompanied by company specific facts and applications would be best):

• Affirm move to qualitative support for effective relationships, to reduce ridiculous costs associated with regressing obviously effective relationships (give examples) and supporting some through very rigorous (and expensive) audit validations.
• The need to hedge currency risk when corporations manufacture or have costs in one currency and generate revenues in another and how often the intercompany exposure is the only non-functional currency transaction that meets the remaining criteria for hedge accounting.
• Request clarification whether currency cash flow hedges are automatically dedesignated when a hedged transaction is recorded or if dedesignation is required (closing out the hedge and executing a second derivative to protect the same cash flow.)
• Position that voluntary dedesignation is not an abuse of hedge accounting and that executing two offsetting transactions in the market place in order to get a different accounting effect is inefficient and burdensome.
• Support accelerating the effective date for changes to the derivative accounting portion of the exposure draft.

Currently, entities accounting for options under DIG Issue G20 may elect to include time value in effectiveness testing. Under the current approach both the entire fair value time value and intrinsic value of the option are considered effective and are included in the effective component and deferred in OCI until the underlying transaction is recognized, at which time the effective components (time and intrinsic, if any) is reclassified to the effective account. This is a popular approach as it allows for deferral of the option cost, providing matching of the timing of the option cost recognition and income statement geography with the hedged transaction(s).

Under the proposed guidance the entity would still record the effective changes in time value and intrinsic value to OCI, but the option cost would then be separately amortized to income “on a rational basis” over the life of the option. It is unclear what that rational basis might be, possibly straight line, but certainly the timing will not align with the underlying. The premium will impact earnings over the life of the option not when the underlying is recorded. The complexity multiplies if entries need to contemplate the amortization of each caplet or floorlet in interest rate caps, floors and collars. We will be looking for more clarification on this issue in the redline version.