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Hedge Accounting Proposal Planned for September Release

The FASB agreed to publish a proposal to amend its hedge accounting standard. If finalized, the proposed changes will complete the accounting board’s ambitious plan to revise the guidance for financial instruments in U.S. GAAP.

The FASB agreed at its July 13, 2016, meeting, to publish a proposal amending the guidance for hedge accounting in U.S. GAAP.

The accounting board’s research staff expects to have the proposal ready for publication in September for a 75-day comment period, which would let FASB members begin reviewing the comments in the first quarter of 2017. Given the issue’s complexity and the proposal’s anticipated length — the staffer supervising the project estimates it will run 350 pages — the FASB agreed to a somewhat longer-than-average comment period.

“People need time to review this,” said Jeffrey Gabello, the project manager.

The FASB agreed to “decisions that will substantially increase the information to investors and how investors think about hedging activities and how management thinks about hedging activities,” said FASB Chairman Russell Golden.

The board decided most of the proposal’s key elements in 2015 and determined the guidance for making the transition to the revised accounting in March 2016. But as the staff was drafting the proposal, it determined that some other issues had to be resolved, and that was point of the most recent meeting.

After a brief debate, the board agreed with some staff recommendations regarding the “critical terms match,” a somewhat simplified approach that can be applied to determine if a hedge contract is effective. If the underlying instrument’s face value, the maturity date, and the agreed-upon location of the settlement match with those of the derivative, the hedge is deemed effective, which means the change in its value or cash flow offsets the change in value or cash flow of the underlying instrument

The board agreed with a staff recommendation that the critical terms match can be used for a cash flow derivative if the transactions occur and the derivative matures within the same 31-day period and the other requirements for a critical terms match are satisfied.

Board members spent some time debating whether a 31-day period should be considered a calendar month, a 31-day period in which the transaction date is the midpoint, or a 62-day period extending 31 days before and after the transaction.

“It could be plus or minus 31 days, and we could make that a little bit more clear,” said FASB member Harold Schroeder. “Every transaction, regardless of when it falls in a particular month, gets this plus or minus 31-day range.”

Board members also agreed to let some fair value hedges qualify for what is known as the shortcut method for determining if a hedging contract is effective because they felt that this approach matched its previous decisions to align the accounting for derivatives with a company’s risk management strategy.

The board also agreed that the transition to the new standard would no longer permit use of the retrospective method, which calls for amending prior periods in the financial statements to reflect the new accounting. Typically, the FASB will require companies and other organizations to use the retrospective method because it allows for easier comparisons of financial information. But, as FASB member Marc Siegel observed, there would be so many adjustments to financial statement items such as retained earnings that investors would not be able to properly analyze the financial statements.

Instead the transition to the new accounting will employ a modified retrospective approach that calls for recording the cumulative effective of the amended guidance at the time it is adopted.

If the hedge accounting proposal becomes a final set of amendments to U.S. GAAP, the FASB will complete a process described at length in the 2010 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). The proposal was a comprehensive package with changes to the overall accounting for financial instruments and loan write-downs, with some targeted changes to hedge accounting. After the proposal was released, the board decided to split its financial instruments project into three phases, which allowed it to more quickly address the guidance for loan write-downs in the wake of the global financial crisis.

The first phase was finished in January 2016 with the publication of ASU No. 2016-01, Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The update largely retained U.S. GAAP’s existing classification and measurement requirements for loans, debt securities, and financial liabilities. But it made some targeted changes, such as the accounting for equity investments that are not measured under the equity method. The second phase was completed in June with the publication of ASU No. 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which requires banks and other businesses to speed up the recognition of losses on loans, securities, and receivables.

For in-depth analysis of the FASB’s standard for the classification and measurement of financial instruments, please see Catalyst: U.S. GAAP — Classification and Measurement, also on Checkpoint.

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