Hedge Accounting Rules: Relief (Still) on the Way

An exposure draft which will update current hedge accounting rules is in the works, though delayed. Hedgers can expect relief from some of the more onerous hedge accounting requirements.

The FASB has acknowledged that current hedge accounting rules are restrictive with respect to accommodation of hedgers’ actual financial risk management practices. The new rules are designed to relax some of the constraints in the current guidance, as well as eliminate some of the reporting requirements which have been perceived as having limited value by users of financial statements. Summarized below are some of the key changes that hedgers can expect in the new guidance.

Component Hedging of Commodity Price Risk

Commodity hedgers have been at a disadvantage under current hedge accounting rules, due to the requirement that the all-in transaction price for a commodity transaction be the designated hedged risk, as opposed to the component of that price risk which is being hedged. Frequently these hedged transactions involve price differentials which are not easily hedged, creating hedge ineffectiveness and increasing the likelihood that hedges may not qualify for hedge accounting at all. Under the proposed rules, commodity hedgers would be able to hedge the commodity price component of a transaction that is specified in the associated contract (similar to the way interest rate hedgers can hedge the LIBOR component of interest rate risk under current rules). This change provides an opportunity for commodity hedgers to reassess current and proposed hedging strategies, and apply hedge accounting more widely as part of their risk management activities.

Fair Value Hedges of Interest Rate Risk

The proposed changes for interest rate hedgers will allow for defining the hedged transaction in a fair value interest rate hedging relationship, such that the hedged item will be a better match for the hedging instrument that would likely be used for a given strategy. The new guidance would include changes relating to excluding the credit component of a coupon when measuring the change in value of a fixed rate debt instrument due to benchmark interest rate movements, and accommodation of partial term hedging in fair value hedging relationships, strategies which either have the potential for large amounts of hedge ineffectiveness, or are disallowed entirely, under current hedge accounting rules. The shortcut method is preserved, with the requirements relaxed somewhat, such that the risk of having to reclassify entire swap gains and losses to income due to minor “foot-faults” with respect to meeting shortcut criteria is greatly reduced.

Concept of Hedge Ineffectiveness Eliminated

Hedge ineffectiveness will no longer need to be measured, reported, or disclosed under the new rules. The requirements for effectiveness testing will remain, but the ongoing need to measure the ineffective portion of an otherwise effective hedge will go away. This is a practical change, as these measured amounts of hedge ineffectiveness are typically immaterial, and can require significant effort to quantify, due to the construction and maintenance of hypothetical derivatives which are usually needed (for cash flow hedges). In addition, reported ineffectiveness amounts may have been of limited use to users of financial statements, who will likely not be concerned if a hedge is 90% effective vs. 100% effective.

Hedgers should be encouraged by the coming changes, which will make hedge accounting more accessible to those managing financial risk, and facilitate the development and maintenance of new and existing hedge programs.

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