From Helen’s Desk:
In May of last year the FASB issued an exposure draft that substantially changed accounting for financial instruments in general and significantly modified the hedge accounting requirements originally laid out in FAS133. The response to their invitation to comment was overwhelming: 2200+ comment letters were received. However, very few addressed the substantive changes to hedge accounting or more specifically the substantive changes around effectiveness testing requirements. The FASB has re-issued their invitation to comment, inviting you to compare and contrast the IASB’s November Exposure Draft with its general overhaul of derivative accounting to the FASB’s more sedate proposal. Your comments are requested by April 25, 2011. I recommend submitting them earlier given quarter end schedules and the fact that the boards are already considering the proposals. The FASB has been invited to participate in the IASB discussions on hedge accounting and both Boards have an objective of “convergence”. Interestingly, current international and domestic guidance on hedge accounting is much closer than the two proposals.
There are some fundamental differences that warrant your investigation and perhaps your comments. The few topics summarized below represent the items that we believe will be of interest to the greatest number of you. For those of you that want the full story:
IASB’s Exposure Draft – link
FASB’s Request for Comments that includes the IASB Exposure Draft – link
Amending Hedge Documentation
The FASB introduced the concept of amending hedge documentation requirements when there were changes to hedged notionals, in lieu of current dedesignation/redesignation requirements. The IASB has advanced the idea substantially by recommending that most elements of the relationship documentation can be updated prospectively without triggering a dedesignation/redesignation.
Ineffectiveness Testing
Both boards are throwing out the 80-125% litmus tests that have arisen in hedge relationship testing and accepting reasonably effective hedge relationships. The FASB is proposing requiring effectiveness tests only at inception, and only when the hedge relationship is not an obvious economic relationship (i.e. interest rate swaps hedging tire inventory). They are also eliminating the concept of perfect offset in a hedge relationship (a move toward convergence) thereby increasing the focus on measuring ineffectiveness. The IASB is proposing the elimination of “retrospective” testing, but preserving a prospective testing concept. This would tie into their prohibition on a bias in the hedge relationship ratio, and requirements to update that relationship ratio. For example, if historically an underlying responds 110% to changes in rates, then the ratio of hedgednotional to derivative notional in the hedge relationship would be 110/100.
Cash Flow Ineffectiveness
FASB is proposing recording ineffectiveness for both over and underperformance of the hedge. This rule is probably designed to offset the abuse of hedge relationship ratios, because there is no existing or proposed prohibition on a bias in a hedge relationship. Under the current rules where ineffectiveness reflects over-performance of the derivative without the bias restraint proposed by the IASB, I believe the FASB’s intent was to contain the abuse of the hedge relationship ratio by recording ineffectiveness from both over and underperformance.
Bifurcation of Risk
The IASB is proposing that any component risk may be designated as a hedged item to the degree that the component is “separately identifiable and reliably measured”. This would substantially increase commodity hedging opportunities for many companies. The hedged item would be the commodity price component or adder. Other irrelevant moving parts would not need to be considered within the hedge relationship. On the financial instrument side entities with Prime exposure would be able to hedge the interest rate component like a benchmark hedge. This flexibility was proposed in most letters to the FASB even though the FASB had not commented on bifurcation of risk.
No Voluntary Dedesignation
Once a hedge relationship between a derivative and an exposure is created both Boards are proposing that relationship is to be constant until either the exposure or derivative were terminated. FASB is even requiring the “designation” of a compensating contract. The IASB also offered termination of the relationship as a result of a change in “hedge objective”
Option Premiums
Both boards are offering new solutions for option premiums. IASB has indicated the time value will remain outside of the hedge relationship, but will be either amortized to income (when hedging existing assets or liabilities) or reclassified to income with the hedged item (when hedging anticipated transactions).
The proposals from both boards are clearly designed to stop all the “failing effectiveness” and restatement pain. They seem to be focused on simplifying hedge accounting and improving compliance. We hope they can achieve these objectives and we encourage you to participate in the process by commenting on the proposals. We would be happy to serve as a sounding board or review comments you are proposing at no charge.
