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Hedge Accounting Project Moves Ahead and Focuses on Nonfinancial Items

The FASB is starting to discuss how to improve U.S. GAAP’s requirements for hedge accounting, which have been criticized as overly complex and too restrictive. The accounting board may consider easing requirements for hedge accounting for nonfinancial items, such as the raw materials or ingredients manufacturers use to manage the costs of making their final products.

The FASB is at an early stage of determining whether it should loosen its current hedge accounting model to allow hedge accounting for nonfinancial items, such as raw materials that manufacturers use to manage the cost of making their final products.

In U.S. GAAP, Topic 815, Derivatives and Hedging, limits the use of hedge accounting 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. Hedging can also be used to offset the risk of changes in the purchase price or sale price of cash flow hedges. Hedge accounting isn’t permitted for other individual risks, including changes in the value of a principal ingredient or component.

Critics say the restrictions are overly complex and too limiting. The inability to qualify for hedge accounting can add unwarranted spikes to company earnings.

The Hershey Co. in a 2011 letter to the FASB said it uses hedging to manage the price of chocolate paste, a key component of its products. The cost of the paste is dependent on changes in the prices of ingredients, like milk and sugar, used to make it. The prices can vary widely and there are active futures, options, or forward markets to hedge the future costs, the candy maker wrote.

“Application of this standard adversely impacts our ability to use derivatives, such as commodity futures contracts, to hedge commodity cost changes in products purchased from third parties, even though the risk of commodity cost changes is no different than the risk we would have if we were manufacturing the product ourselves,” the company wrote.

If the FASB were to permit a wider use of Topic 815, the board would have to consider a wide variety of secondary issues, which the FASB discussed at its April 7, 2015, meeting. The board did not take formal action and expects to do more research before its next steps.

The basis for the April 7 discussion was the idea that the FASB might allow hedge accounting for nonfinancial items. If the FASB were to take this path, it would have to consider several additional issues, including whether to have a different threshold to qualify for hedge accounting for nonfinancial items, what the threshold should be, how to prevent abuses of hedge accounting, and how to present hedge “ineffectiveness,” which means a hedge has not offset an instrument’s change in value.

The threshold is a major topic in hedge accounting.

Topic 815 says the relationship between a derivative contract and the hedged item has to be “highly effective” in achieving offsetting changes in fair value or cash flows attributable to the risk to qualify for hedge accounting. U.S. GAAP doesn’t define “highly effective,” but accountants tend to say a hedge is effective if the change in value for the derivative is between 80 percent and 125 percent of the change in value of the cash flow that’s been forecasted for the asset or liability.

The board is considering whether to change the threshold to the more flexible “reasonably effective.” Under one scenario, a business would be allowed to defer the entire gain or loss in other comprehensive income until the hedged item affected earnings.

The challenge is pinning down what “reasonably effective” means. The FASB did not reach a consensus on what it might consider.

The board also must consider whether it should allow different thresholds for financial and nonfinancial hedged items.

The FASB’s research staff said companies and accountants would be able to handle having two different thresholds, but, for simplicity’s sake, most preferred one.

The board must also decide if it wants to prescribe how to account for hedges that are deemed ineffective in company income statements.

Considered a fundamental principle of hedge accounting, hedge ineffectiveness is the amount by which the change in the value of the hedging instrument does not exactly offset the change in the value or cash flows of the hedged item or transaction. The ineffectiveness must be recognized in earnings immediately, FASB staffers said.

There is no specific requirement, however, for recognizing ineffectiveness in the income statement. Some companies recognize it in the same line item as the hedged item’s gain or loss, while others recognize it in a separate line item, such as “other income/expense.”

The FASB’s research staff said it favored letting companies use judgment on where to present the numbers, but there were mixed views among board members.

“I believe that companies are entering into hedging transactions specifically to manage their costs,” FASB member Lawrence Smith said. “For that reason, the amount of ineffectiveness ought to be recorded with that cost line.”

The FASB’s examination of hedge accounting is a revival of a project the board put on hold as it dealt with other issues related to financial instruments.

The FASB in May 2010 issued 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) , a comprehensive proposal with changes to the overall accounting for financial instruments plus targeted changes to hedge accounting.

Later in 2010, the IASB published a separate proposal that was considered markedly different from the FASB’s. The FASB followed up in February 2011, repackaging the IASB’s document via Discussion Paper (DP) No. 2011-175, Selected Issues About Hedge Accounting (Including IASB Exposure Draft, Hedge Accounting) , and releasing it for public comment.

The FASB then said it would not resume its work on hedge accounting until it finished the standards on credit losses and classification and measurement of financial instruments.

The U.S. board says it will publish those standards in the third quarter of this year.

The hedge accounting project appears to be less of a fundamental reconsideration of U.S. GAAP and more of a chance to do targeted improvements. The FASB also has said it does not aim to publish an identical standard to the IASB’s but rather examine existing accounting and make it simpler. In doing so, the U.S. board plans to “consider opportunities” to align with international accounting standards, according to the FASB’s project page.

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