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Financial Reporting and Regulatory Update

Third Quarter 2017

Understand the New Rules for Hedge Accounting

A Q&A With Chris Moore of Crowe Horwath LLP

FERF: From a high-level standpoint, can you summarize the new hedging standard update?

CHRIS MOORE: The update is going to make a variety of changes to the hedge accounting model. Broadly speaking, the FASB expanded the risks that can be hedged, simplified quarterly effectiveness assessments, eliminated the separate recording of hedge ineffectiveness, and allowed many simplifications to be adopted transitionally into existing hedges.

FERF: What were some of the FASB’s goals in developing the ASU?

CHRIS MOORE: The FASB had several goals, starting with making hedge accounting more closely reflect a company’s risk management activities and providing financial statement users with more decision-useful information about the effectiveness of an entity’s hedging activities. Additionally, the update makes targeted improvements to simplify the hedge accounting model, documentation, effectiveness assessments, and disclosures.

Under the standard, hedge accounting is going to change in a variety of fashions. For cash flow hedges, the FASB eliminates the concept of benchmark interest rates and instead will allow companies to hedge any contractually specified rate within a financial instrument. For example, companies now will be allowed to hedge the prime interest rate without having to identify the hedged risk as overall changes in cash flows, which was operationally difficult.

This standard also will allow the designation of contractually specified components of the forecasted purchase or sale of nonfinancial assets within a hedged transaction. For example, companies can hedge the copper component of a forecasted purchase or sale of brass, provided that the settlement of that contract is contractually tied to copper prices. Because of this change, companies that use commodities may wish to evaluate existing contracts and consider modifying their settlement provisions to improve their ability to hedge a commodity contract.

Last, with the elimination of the separate recording of ineffectiveness, the full change in fair value of the cash flow hedge derivative will be recorded directly in other comprehensive income. This will simplify the accounting of cash flow hedges that are not fully effective, and it may result in a company pursuing risk management strategies that might be undesirable under the current standard due to accounting complexity.

FERF: Are fair value hedges evolving?

CHRIS MOORE: Yes. The FASB also made several changes to fair value hedges. Companies can now measure the change in the fair value of a fixed-rate financial instrument using either the contractual coupon’s cash flow or the portion of the cash flows related to a benchmark interest rate. Measuring the change in fair value using benchmark rate cash flows instead of the coupon will reduce ineffectiveness for fair value hedges significantly.

Partial-term hedges also will be permitted, meaning companies now can hedge two years of a 10-year fixed-rate financial instrument, without the difference in term duration causing ineffectiveness. A difference in term durations often would preclude the use of hedge accounting.

Most significantly to the fair value hedge model, the FASB added what’s known as the last-of-layer method. This method will allow companies to hedge closed portfolios of prepayable fixed-rate instruments without consideration of prepayment provisions or the remaining life within the effectiveness assessment. In general, companies simply will evaluate on a quarterly basis whether they expect the last layer of the pool during the remaining life of the hedge to not go below the hedged amount. Because hedging pools of fixed-rate financial assets is very difficult under the existing literature, this change represents a significant simplification.

FERF: How will documentation change?

CHRIS MOORE: The update makes simplifications to hedge documentation through two relevant changes. Within shortcut hedges, companies will be allowed to include a long-haul method to apply later should it be determined that the shortcut method could not be applied or is no longer appropriate.

Also, for many long-haul hedges, quarterly effectiveness assessments may now be performed qualitatively, with quantitative assessments used only when the facts and circumstances indicate that they are needed. Said differently, many hedges that require quarterly regression analysis today may in the future require only a qualitative analysis.

The update also permits private companies other than financial institutions and certain not-for-profit entities to take additional time for completion of an initial quantitative hedge analysis, although the initial qualitative documentation still is required at the inception of the hedge.

These changes and a few others will greatly simplify the application of hedge accounting.

FERF: Are there changes to hedge-related financial disclosures?

CHRIS MOORE: Disclosures will change, but minimally so. The ineffectiveness disclosure from the tabular footnote presentation is not needed because ineffectiveness no longer will be recorded separately. Disclosures also are expanded related to basis adjustments in fair value hedges, in part due to the addition of the last-of-layer method.

FERF: How are the changes expected to benefit investors?

CHRIS MOORE: Currently, derivatives that are not designated as hedges – also referred to as freestanding derivatives – are carried at fair value through earnings, which can cause earnings volatility. In addition, hedge ineffectiveness is recorded separately from the effective portion of the hedge.

Under the new standard, hedge accounting should be easier to achieve, which will result in fewer freestanding derivatives. And hedge ineffectiveness will not be recorded separately. These changes will result in cleaner financial reporting.

FERF: How does the ASU affect private companies?

CHRIS MOORE: Other than transition timing, this standard makes minimal distinction between public and private companies. A few years ago, the FASB’s Private Company Council issued ASU 2014-03 to simplify cash flow hedges for variable-rate debt. That standard is still in effect, but its incremental benefits will be mitigated substantially by the new ASU. In many ways, I expect this update will be preferable to the Private Company Council standard for private companies.

FERF: Did the standard evolve after the exposure draft was released?

CHRIS MOORE: The main difference between the exposure draft and the final version was the addition of the last-of-layer approach for fair value hedging, which has the possibility to change the face of hedge accounting as we know it, particularly for financial companies. Currently, hedging prepayable fixed-rate assets and fair value hedges is very difficult. And for pools it’s next to impossible. The last-of-layer approach will make that much easier.

FERF: Given the simplification aspects of the standard, is it likely that companies that were reluctant to enter into hedges may be more willing to do so?

CHRIS MOORE: Yes. I think that all companies should take a fresh look at the revised hedge accounting model under this ASU. The inclusion of new strategies that companies previously may have wanted but couldn’t attain, along with additional simplifications, may allow those companies that were on the sidelines to become hedgers as a result.

Some people looked at the current hedge accounting model and said, “We have better things to do with our time. It’s too difficult. I’m just going to carry it as a freestanding derivative.” Now I think some companies will take a fresh look and may choose to apply hedge accounting.

FERF: Is this likely to affect some industries more than others?

CHRIS MOORE: The banking industry might benefit the most, particularly with the last-of-layer method and partial-term hedges. But within this ASU, there is something for everyone. Commercial companies are going to benefit with commodity hedging by allowing hedges with contractually specified components. And all companies will benefit from changes in the shortcut method, qualitative effectiveness assessments, and no longer having to record ineffectiveness separately.

FERF: Does the hedging standard align with some of the other major standards that companies are working on implementing now?

CHRIS MOORE: There isn’t much interrelationship between this standard and others. As far as timing, for public business entities (PBEs), the standard is effective for years beginning after Dec. 15, 2018. And for non-PBEs, the standard is effective for years beginning after Dec. 15, 2019.

Early adoption is permitted in any interim period after the update was issued – potentially as soon as the third quarter of 2017 – for financial statements that have not been issued. If a company early adopts the standard in an interim period, any adjustments must be reflected as of the start of the fiscal year that includes that interim period.

During the transition, companies also are allowed another one-time transfer of securities from heldto- maturity (HTM) to available-for-sale (AFS), but only if those securities are eligible for the last-oflayer fair-value hedge method, so not all HTM securities are eligible to be transferred. As far as other standards, the current expected credit loss model, or CECL standard, is somewhat easier for AFS securities than it is for HTM. Some companies may choose to use the transition of the new hedging standard to move securities from HTM to AFS, to simplify the application of CECL.

FERF: Will the role of auditors evolve under the new standard?

CHRIS MOORE: Auditors are still going to be interested in the details because the details will still matter. And all the things we discussed here will need to be captured effectively and accurately, with specificity, in the hedge designation memo. That complexity remains, so we still will be paying attention to the details within the designation memos and the application of quarterly effectiveness assessments as described by that memo.

FERF: If companies are considering early adoption of the new hedging standard, are there any obstacles that they need to be aware of?

CHRIS MOORE: This ASU is quite lengthy – 405 pages. It was only recently issued, and I think everyone is still digesting the details within these new methods. Also, the standard allows many of these simplifications to be added to existing hedges without resulting in a dedesignation. These elections, as well as the HTM to AFS transfer, can be made only at transition. So, although early adoption is permitted, companies doing so will need to carefully evaluate their transition elections before adopting the standard.

Hedge accounting, although simpler, will still be complex. Companies are going to need to work with their auditors and consultants and be thoughtful about how they apply it.

However, the update goes a long way to improving the operability of the existing hedge accounting model, and many in the industry are quite excited by these changes. The update has been several years in the making and has grown to include many changes that will help to simplify hedge accounting.