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November 2010 Newsletter View in pdf
For many companies the year-end audit is fast approaching. In preparing for an audit of your hedge accounting program, keep in mind the following key control areas:
- Have all derivatives been identified?
- Are all derivatives on balance sheet at fair value?
- Are the values in OCI reconcile-able to future transactions?
- Is the hedge documentation complete and easily accessible?
- Have the effectiveness tests been completed in accordance with the documentation?
- Are the hedged transactions still probable of occurring?
- Have gains and losses been released to income consistent with documentation?
- Have the necessary disclosures, including tabular and non-tabular requirements, been net? (See ASC 815)
While most companies have strong controls to ensure that all hedges are accounted for, it is also crucial that a process for identifying other contracts that meet the technical definition of a derivative is in place and that the conclusions reached through this process are documented. It is generally most effective when that process is centralized in Treasury or Accounting (with other key contacts in legal, purchasing and facilities be trained to spot potential derivatives).
Be prepared to provide details of valuation models and inputs, even when valuations are provided by a third party like Hedge Trackers, LLC (and preferably one that is not the counterparty to the hedge). Valuation inputs will also be required for disclosure purposes – the more subjective the inputs, the more disclosures required.
Amounts recorded in OCI must be supported by appropriate documentation and effectiveness testing. We are seeing more scrutiny by auditors on specific data points within the regression analysis, as well as reviews of the appropriateness of the regression inputs. Also, the expected date of the underlying transaction, which is a key component of the effectiveness measure, is beginning to get more attention, especially as auditors take their lead from the FASB and shift their focus from testing to measurement.
We suggest that you strongly encourage the auditors to begin looking at derivatives and hedge accounting issues early in the audit (preferably at interim). Too often this is an area that is addressed at the very end of the audit when potential issues can easily turn into a last-minute crisis and legitimate programs gutted to meet filing or reporting deadlines.
Excerpts from Exposure Draft Comment Letters
The FASB has published over 2,800 comment letters related to the proposed update to Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities. The overwhelming majority of letters addressed only the substantial changes proposed to financial instruments yet there were a number of letters, including ours, that also addressed hedge accounting. We have summarized below the points addressing hedge accounting submitted by the four largest accounting firms and provided excerpts from their letters on the following pages. We encourage you to read their complete statements at fasb.org.
Three of the four firms supported the move from a “highly effective” standard to a “reasonably effective” standard and the introduction of inception qualitative assessments for less obvious hedge relationships. Deloitte, however, felt “that the changes will replace existing complexities with other complexities that may prove equally or more challenging in practice.” The Big Four Firms unanimously opposed the move to reporting both over and underperformance of cash flow derivatives in earnings. In addition, they opposed the inability to voluntarily dedesignate hedge relationships indicating it was not clear on what “abuses” the FASB was trying to prevent with this proposal. All four also recommended the FASB expand bifurcation of risk concepts for both financial and non-financial instruments. Given that the proposed ASC Update did not specifically address intercompany hedging, it was interesting that three of the firms either indicated their support of intercompany hedging or their belief that changes should not be made to intercompany hedging without “due process”. The firms seemed comfortable with the abandonment of critical terms and short-cut concepts. Each of the firms were interested in retaining the ability to include option time value in the measurement of the hedged item, but there appears to be differences in interpretation of how that included time value will come through income.
PWC Excerpt – Comment Letter #250:
“We support eliminating the high effectiveness threshold, as well as streamlining hedge documentation through the elimination of the current initial and ongoing quantitative effectiveness assessment requirements . . .
We encourage the FASB to work with the IASB to develop principles that would expand the ability of entities to hedge risk components of financial instruments beyond the current specific risks that are eligible and, as indicated earlier, to align other elements of hedge accounting, including portfolio and macro hedging. We do not view the ability to de-designate hedging relationships to be problematic or an area of abuse under the current model.”
Ernst & Young Excerpt – Comment Letter #396:
“We support the Board’s efforts to simplify hedge accounting by moving from a “highly effective” standard to a “reasonably effective” standard for achieving hedge accounting . . . However, there are other aspects of the hedge accounting proposals that we do not support, including (a) the recording of hedge ineffectiveness for “underhedges” in cash flow hedges, (b) the elimination of voluntary de-designations . . . and (c) the requirement (as opposed to an election) to expense the cost of an option when an option is used in a cash flow hedging relationship . . .
We continue to support cash flow hedge accounting for these intercompany cash flows and urge that the existing practice in this area not be curtailed in the final standard . . .
We have long believed that the arguments to permit hedging of components of non-financial risk are compelling and comparable to the arguments used to permit the hedging of components of financial risk.”
KPMG Excerpt – Comment Letter #260:
“We support the proposal’s changes to the assessment of hedge effectiveness to require (1) that a hedging relationship be reasonably effective (rather than highly effective), (2) a qualitative assessment of the effectiveness of a hedging relationship at inception (unless a quantitative assessment is necessary based on facts and circumstances), (3) no ongoing assessment of effectiveness, unless facts and circumstances suggest that the hedging relationship would no longer be reasonably effective and (4) no assumption of perfect effectiveness.
We also support the use of a single hypothetical derivative for purposes of the assessment of effectiveness and measurement of ineffectiveness in a cash flow hedge of a group of transactions . . .
We agree with the proposal that entities should be permitted to use total changes in cash flows or intrinsic value when measuring ineffectiveness related to a purchased option. We support the amortization of the time value component of the purchased option beginning earlier than current practice . . .
We do not agree with the proposal’s limitation on an entity’s ability to dedesignate a hedging relationship . . . We also do not agree with the proposed change that would require entities to record in earnings ineffectiveness related to underhedges for cash flow hedging relationships.”
Deloitte – Comment Letter #255
“We do not support the contemplated changes to existing hedge accounting requirements because we do not believe that the benefits will outweigh the costs or that the proposed changes will simplify hedge accounting. Instead we believe that the changes will replace existing complexities with other complexities that may prove equally or more challenging in practice . . .
We propose that an assessment related to current measurements be required each reporting period . . .
We believe that when the cumulative change in fair value of the hedging instrument is less than the cumulative change in the hedged item, no ineffectiveness should be recognized in earnings . . . such ineffectiveness in earnings would be to defer in accumulated OCI (AOCI) a nonexistent gain or loss on the hedging instrument and to recognize in earnings a nonexistent loss or gain on the hedged item . . . The Board had not made publicly available its proposed amendments to Codification . . . We strongly encourage the Board to release these proposed amendments for public comment and to provide interested parties with adequate time (e.g., 90 days) to review them and submit comments to the Board.”
Hedge Trackers – Comment Letter #1494
The proposed guidance provides greater flexibility and simplicity in establishing hedge relationships and appropriately focuses efforts on calculating and properly recording derivative gains and losses. We remain concerned with the proposal to report gains and losses on anticipated transactions in earnings . . .
Please provide real examples across risk categories that include appropriate strategies for estimating forward pricing on exposure inputs that are illiquid and not publically available …
We are very concerned about the substantial increase in audit fees and possible Type 3 valuation disclosures that may be a natural extension of the need to support the earnings and OCI effects of commodity or other “overall” change in cash flow hedges where the underlying is often impacted by noisy, illiquid and non-transparent components of the change in value.
Please provide an example of the requirement to amortize the option premium “in a rational manner” . . . Please distinguish between circumstances that would result in (involuntary) dedesignation of a hedge relationship and those circumstances that would require an amendment to inception documentation . . . consider clarifying ASC 815-20-25-35 as follows: “If two separate hedges are designated, the cash flow hedge relationship would terminate (that is, be dedesignated as qualifying criteria are no longer met) when the hedged sale or purchase occurs and the foreign-currency-denominated receivable or payable is recognized.” (Suggested additions are in bold.)
Overall, we believe the implementation guidance requires more details on practical application of both existing and proposed rules. We believe the FASB should 1) affirm that companies may hedge non-functional currency transactions that do eliminate in consolidation, perhaps inserting an additional requirement that the long/short currency position of the hedge be reflected in 3rd party transactions on the consolidated level or 2) offer a functional currency election holiday . . . We believe that eliminating short-cut and match term treatments together with eliminating burdensome statistical analysis, that generally provides limited value, substantially reduces restatement risk . . .
We applaud the recognition of foreign currency changes in value of 3rd party debt being recorded in OCI. Recording currency gains and losses in OCI supports this “natural hedge” relationship without forcing the parent to hedge the remeasurement gain/loss on the debt, thereby nullifying the economic hedge and necessitating cash flow hedges to re-establish the relationship between the debt and the revenue . . . We would invite the FASB to reconsider the current inability to bifurcate separately identifiable commodity and other risks.
IASB on Options Amortization
The IASB held their last meeting of the hedge accounting project on October 27, 2010 and have instructed their staff to prepare an exposure draft, with its issuance to be followed by a 90 day comment period. Updated guidance is scheduled for issuance by June 2011
During this last meeting the IASB seemed to make a substantial change to their historic position of excluding time value on options from the hedged item. They chose to consider the time value on the option as a premium, similar to an insurance premium. As a result of this change in perspective, they propose that this premium be looked at in 2 ways, dependent on the hedged item. If the hedged item transaction is defined as being associated with an anticipated transaction, the time value changes would accumulate in OCI and be “recycled” to earnings, apparently together with the hedged item. This would be similar to current G20 treatment under US GAAP.
For hedged items that are already recognized transactions (inventory, debt, etc.) the change in value would accumulate in OCI, with the portion related to the current period being transferred to earnings. This seems to approach the FASB proposal in the ASC Update where the premium is amortized to income in a rational manner.
There is an additional twist to the IASB proposal. In each period the cumulative amount reclassified to income would represent either the cumulative change in time value (market value) or the cumulative change per the amortization schedule. In the notes published it suggested the change to income would be the lesser of the two but this should be checked carefully as it seems too good to be true.
The meeting notes do not address if excluding time value would continue to be an election. We look forward to the issuance of the new draft and the opportunity to wade through this together in the future.
- IASB (www.iasb.org)
- AICPA IFRS resources site (www.ifrs.com)
- SEC Roadmap to IFRS (www.sec.gov/spotlight/ifrsroadmap.htm)
- Deloitte (www.iasplus.com)
- PricewaterhouseCoopers (www.pwc.com/gx/en/ifrs-reporting/index.jhtml)
- EY (www.ey.com/GL/en/Issues/IFRS)
- KPMG (www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/IFRS-briefing-sheets/Pages/default.aspx)