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Review to Determine Scope of Proposed Changes to Hedge Accounting

As the FASB prepares to revamp the standard for hedge accounting, the accounting board may eliminate two of hedge accounting’s more controversial aspects that many companies believe will greatly simplify it. The changes may also require companies to keep investors informed about their overall risk management strategy.

The FASB took a step toward revamping U.S. GAAP’s provisions for hedge accounting at its September 23, 2014, meeting, when it asked its staff to reexamine amendments proposed four years ago and consider how they might be modified.

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), said the FASB would eliminate two components of hedge accounting that generate considerable controversy — the so-called “shortcut” method of measuring the effectiveness of hedges and the “critical terms match” used to qualify financial instruments for hedge accounting. The proposed standard also calls for applying a lower threshold in determining whether a hedge is effective, meaning that a derivative instrument has offset a change in an asset or liability’s value and eliminated a gain or loss that would appear on the earnings statement.

Eliminating the shortcut method and critical terms match would greatly simplify hedge accounting for many companies. Financial executives and auditors won’t have to precisely measure how well a derivative instrument matched specific cash flow or fair value features of an asset or liability, calculate the difference, and adjust earnings. What they’d have to do instead remains unclear.

The staff plans to come back to the board with the findings from its research at an upcoming meeting.

Board members said they favor the changes, and they also want the research staff to consider an approach that would give investors an idea of how well a company is managing risk, perhaps through new presentation and disclosure requirements. The FASB didn’t rule out an even broader approach suggested by the staff that would bring U.S. GAAP more into line with what the IASB has done in IFRS 9, Financial Instruments. The international standard, unlike Topic 815, Derivatives and Hedging, allows for hedging of components of non-financial assets and groups of assets, liabilities and net positions.

The board clearly took to heart the staff’s report that its outreach to executives and investors in industries that do a lot of hedging—such as airlines, agricultural production, food and beverage manufacturing, oil and gas, industrials, utilities, insurance, and banking—revealed considerable confusion over how Topic 815 should be applied to their activities and doubt about the usefulness of the information it produces.

Board member Harold Schroeder, a former bank analyst and fund manager, said he had never heard of the shortcut method until he joined the board in February 2011.

When a staff member admitted that the current test for measuring the effectiveness of a cash flow hedge was “incomprehensible,” board member Thomas Linsmeier asked, “Do you think that is the only thing about this meeting that’s incomprehensible?”

The staff member said that was a fair point.

“Users’ minds are blown when you start talking about perfect hypothetical derivatives,” said another staff member, in reference to the analysis that has to be done to determine if a derivative lets a company avoid recording a change to earnings.

“They aren’t the only ones,” said FASB Chairman Russell Golden.

Board member Marc Siegel said investors care as much about the instruments companies choose not to hedge as what they do hedge. Because Topic 815 fails to reflect that, he called it seriously flawed.

That led Linsmeier to complain that the board’s tendency to get “into the weeds” and “build a mousetrap” on issues such as hedge effectiveness obscures whether a company’s overall risk management program is worth the cost involved. “I’m trying to figure out a way to get those insights,” he said, noting that such a holistic approach would go well beyond the staff’s recommendations concerning the exposure draft.

However, board member Lawrence Smith said he didn’t understand what Linsmeier was suggesting the board do. FASB Vice Chairman James Kroeker said he hoped that Linsmeier wasn’t suggesting an approach that was broader than the staff recommendations.

“I’m not prepared to discuss it,” Kroeker said.

“Perhaps a better way of thinking about this is, think about disclosures and presentations first, and that will help us determine what hedge effectiveness is and is not,” Golden said.

Linsmeier heartily endorsed that suggestion. “That’s exactly it,” he said. “I’d like to flip the thought process.”

Schroeder said he had thought of suggesting a similar approach twenty minutes earlier in the discussion. When a staff member cautioned that such an approach would be challenging, Golden suggested that the staff meet with individual board members to see if the approach was feasible. The board voted unanimously in favor of Golden’s suggestion.

As for international convergence, Golden said it might be possible to gain a considerable amount of convergence with IFRS 9, even under the more limited amendments the staff presented.

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