Implementing changes in accounting rules can be a real drag, but the new hedge accounting standard may be an exception to this generality. Many companies welcome this update and may even want to adopt it early, because the new rules are more flexible and attempt to make hedging strategies easier to report on financial statements.
Hedging strategies today
Hedging strategies protect earnings from unexpected price jumps in raw materials, changes in interest rates, or fluctuations in foreign currencies. How? A business purchases futures, options, or swaps and then designates these derivative instruments to a hedged item. Gains and losses from both items are then recognized in the same period, which, in turn, stabilizes earnings.
The existing rules require hedging transactions to be documented at inception and to be ‘highly effective.’ After purchasing hedging instruments, businesses must periodically assess the transactions for their effectiveness.
The existing guidance on hedging is one of the most complex areas of U.S. Generally Accepted Accounting Principles. So, companies have historically shied away from applying these rules to avoid errors and restatements.
In turn, investors complain that, when a business opts not to use the hedge accounting rules, it prevents stakeholders from truly understanding how the business operates. The new standard tries to address these potential shortcomings.
Future of hedge accounting
Accounting Standards Update (ASU) No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, expands the strategies that are eligible for hedge accounting to include 1) hedges of the benchmark rate component of the contractual coupon cash flows of fixed-rate assets or liabilities, 2) hedges of the portion of a closed portfolio of prepayable assets not expected to prepay, and 3) partial-term hedges of fixed-rate assets or liabilities.
In addition, the updated standard:
- Allows for hedging of nonfinancial components, such as corrugated material in a cardboard box or rubber in a tire
- Eliminates an onerous penalty in the ‘shortcut’ method of hedge accounting for interest rate swaps that meet specific criteria
- Eliminates the concept of recording hedge ‘ineffectiveness’
- Adds the Securities Industry and Financial Markets Association Municipal Swap Rate to a list of acceptable benchmark interest rates for hedges of fixed-interest-rate items
- Revises the presentation and disclosure requirements for hedging to be more user-friendly
ASU 2017-12 also provides practical expedients to make it easier for private businesses to apply the hedge accounting guidance.
The update will be effective for public companies for reporting periods starting after December 15, 2018. Private companies and other organizations will have an extra year to comply with the changes, but many companies are expected to adopt the amended standard for hedge accounting ahead of the effective date.
If you use hedging strategies, contact us to discuss how to report these complex transactions and whether it makes sense to adopt the updated rules sooner rather than later. While many companies expect to adopt the amendments early, the transition process calls for more work than just picking up a calculator and applying the new guidance.