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Criteria to Qualify for Hedge Accounting May Be Revised

The FASB resumed its work on simplifying hedge accounting after setting the subject aside while it worked on the other phases of its financial instruments project. The accounting board is looking at the criteria used to permit the use of hedge accounting.

The FASB on February 25, 2015, resumed its discussions to simplify hedge accounting, a complex issue the board hasn’t addressed in depth in almost five years.

The discussions mean the FASB is returning to a subject it set aside not long after it released Proposed Accounting Standards Update (ASU) No. 1810-100,Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities—Financial Instruments (Topic 825) and Derivatives and Hedging (Topic 815), in 2010. The proposal called for changes to hedge accounting as part of a broader package of improvements to financial instrument reporting.

The board didn’t make any decisions, but it did consider how it could revise hedge accounting.

“In plain English, we’re asking how do you qualify for hedge accounting and what are you allowed to call a hedged item?” a FASB staff accountant told the board.

The FASB plans to do more research and come back with more details about how to revise the qualification criteria for hedge accounting and whether it should let hedge accounting be used to offset the risks of the components of nonfinancial items.

The comments in response to the 2010 proposal revealed that accountants were frustrated about the criteria needed to qualify for hedge accounting and the effect on earnings from using hedge accounting. Reported earnings don’t reflect the effectiveness of a company’s risk management strategies, they said.

Topic 815, Derivatives and Hedging, says 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 to qualify for hedge accounting.

U.S. GAAP doesn’t define “highly effective,” but most accountants interpret it as an 80 percent to 125 percent offset between the changes in fair value of the hedging instrument and the changes in fair value or cash flows of the hedged item or transaction, FASB staff accountants said.

In Proposed ASU No. 1810-100, the FASB floated a more subjective threshold of “reasonably effective” instead of “highly effective.” It also called on companies to skip the mathematical assessment of hedge effectiveness and instead assess qualitative factors to demonstrate that an economic relationship exists between the changes in value of the hedging instrument and the item or transaction being hedged. Under the proposal, companies would only have to perform a quantitative assessment if they couldn’t qualify for hedge accounting by assessing qualitative factors first.

Most businesses and accountants said they liked the changes but were concerned that “reasonably effective” wasn’t clear enough and would leave some complicated accounting in place if there wasn’t further guidance.

FASB members debated whether they should define a numerical threshold for “reasonably effective,” set non-numerical indicators for the threshold, or stick with the amendments in Proposed ASU No. 1810-100, and let auditors decide the meaning.

Some board members said they were uncomfortable with not mentioning a numerical threshold.

“It’s going to be an awkward conversation, but actually I think we would inform the system better if we gave some indication numerically about how we think about it,” FASB member Thomas Linsmeier said.

FASB member Harold Schroeder, a former analyst and portfolio manager, told the board that whatever it decided, it would have to ensure that companies presented and disclosed hedging information as clearly as possible.

“Because otherwise all this is totally opaque to investors, and they’re getting no value out of this information — largely where we are today,” Schroeder said.

The board also discussed whether it should allow companies to use hedge accounting for the components of nonfinancial items, such as the rubber in tires.

Topic 815 limits hedging for nonfinancial items to changes in the fair value of the entire hedged asset or liability and the risks associated with fluctuations in foreign currency rates and the risk of changes related to the purchase price or sales price for cash flow hedges. Companies aren’t allowed to designate the market price risk of a separate component of a nonfinancial item as a hedged risk.

The comments submitted in response to Proposed ASU No. 1810-100 showed that companies wanted the FASB to reconsider the restriction.

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