FASB updates hedge accounting rules

The Financial Accounting Standards Board’s (FASB’s) guidance on reporting hedging transactions is complicated. In fact, hedge accounting is currently a leading cause of restatements — and some companies refrain from using hedge accounting to avoid the cost and hassle of compliance. But that could change, now that the FASB has issued Accounting Standards Update (ASU) No. 2017-12, Derivatives and Hedging (Topic 815) — Targeted Improvements to Accounting for Hedging Activities.

The much-anticipated standard expands the activities that qualify for hedge accounting and simplifies the rules for reporting hedging transactions. For example, hedging relationships are required to be “highly effective” in order to qualify for hedge accounting, however, the prior FASB rules required a complex qualitative analysis at the inception of the hedging transaction and then throughout the duration of the hedge. This new accounting guidance still requires an initial quantitative demonstration of hedge effectiveness, but allows for a qualitative assessment to support hedge effectiveness over the remaining life of the hedge.

A need for change

Some businesses buy derivatives — such as futures, options or swaps — to “hedge” their exposure to spikes in raw material prices, foreign exchange rates and interest rates. Under existing U.S. Generally Accepted Accounting Principles (GAAP), changes in the value of derivatives must be recorded at fair value in a company’s financial statements.

Under certain conditions, companies may employ hedge accounting, which involves designating a derivative instrument to a hedged item and then recognizing gains and losses from both items in the same period. When done right, hedge accounting keeps the price swings out of reported earnings, avoiding volatility that can be a source of concern for investors and lenders.

Stakeholders have criticized the current guidance, because it doesn’t allow companies to properly recognize the economics of hedging strategies. Often, the effects of hedging on a company’s financial statements are difficult for stakeholders to interpret. Some businesses also complain that the strict rules prevent some bona fide risk management techniques from qualifying for hedge accounting.

Relaxed qualifications

Hedge accounting generally allows deferral of gains and losses. To qualify for hedge accounting, the relationship between a hedging instrument and the hedged item has to be “highly effective” in achieving offsetting changes in fair value or cash flows attributable to the hedged risk.