The Financial Accounting Standards Board (FASB) recently issued targeted improvements to its guidance that could encourage more companies to engage in hedging arrangements to decrease volatility in their financial statements. Here is a close-up on how businesses can hedge price fluctuations and why businesses and their investors alike approve of the changes to the hedge accounting rules.
Some costs — such as interest rates, exchange rates, and commoditized raw materials — are subject to price fluctuations based on changes in the external markets. Businesses may try to ‘hedge’ against volatility in earnings, cash flow, or fair value by purchasing derivatives based on those costs.
If futures, options and other derivative instruments qualify for hedge accounting treatment, any gains and losses are generally recognized in the same period as the costs are incurred. However, hedge accounting is a common source of confusion (and restatements) under U.S. Generally Accepted Accounting Principles.
To qualify for the current hedge accounting rules, a transaction must be documented at inception and be ‘highly effective’ at stabilizing price volatility. In addition, businesses must periodically assess hedging transactions for their effectiveness.
In August 2017, the FASB issued Accounting Standards Update (ASU) No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. The updated standard expands the range of transactions that qualify for hedge accounting and simplifies the presentation and disclosure requirements.
Notably, the update allows for hedging of non-financial components that are contractually specified and adds the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate to the list of acceptable benchmarks for fixed interest rate hedges.
ASU 2017-12 also eliminates the requirement to measure and report hedge ‘ineffectiveness.’ That is the amount the hedge fails to offset the hedged item.
Instead of reporting hedge ineffectiveness separately for cash flow hedges, the entire change in value of the derivative will be recorded in other comprehensive income and reclassified to earnings in the same period in which the hedged item affects earnings. Companies might still mismatch changes in value of a hedged item and the hedging instrument under the new standard, but they will not be separately reported.
Businesses, investors, and other stakeholders universally welcome the changes to the hedge accounting rules. Although the updated standard goes into effect in 2019 for public companies and 2020 for private ones, many businesses that use hedging strategies are expected to adopt it early, and the FASB has hinted that the changes might encourage more companies to try hedging strategies. Could hedging work for your business? Contact us to discuss your options.