Hedge accounting. The term alone sends shivers down the spine of even veteran accountants, unfamiliar with its supposed vagaries and complexities. Sure, hedging isn’t the most popular of topics in the accounting world these days, especially with rev rec and other spotlight hogs capturing all the attention, but risk is risk and companies will always have to mitigate it best as possible to keep them out of its often harmful grasp.
Whether introducing you to the subject or refamiliarizing your team with the importance of risk management and hedge accounting under ASC 815, Embark thought it best to give you a primer of sorts. Risk might be a four-letter word, but that doesn’t mean it’s inherently evil like disco or processed cheese. So give us a few minutes as we update you on hedge accounting, its utility, and what accountants should look for as they enter the risk management fold.
Hedge Accounting From 30,000 Feet
The premise behind hedge accounting is simple. FASB provides leeway in conventional accounting standards to help companies reduce the impact of uncertainty or even lock-in gains through derivatives and non-derivative instruments, all by way of ASC 815. The guidance is specifically for private companies with assets less than $100 million in assets which, for instance, take out variable rate loans and need to hedge themselves against interest rate risk down the road.
Rather than exposing themselves to the undulations of an often turbulent rate environment, companies can use fixed interest rate swaps to ensure rate stability. In other words, they take out an insurance policy of sorts to protect them against the unknown beasts that lurk in the interest rate shadows. Along the way, the companies can remove many of the accounting issues and complexities associated with variable rate loans that could negatively impact their balance sheets and income statements.
Know Your Way Around ASC 815
Thankfully, FASB recognized that hedge accounting had gradually become a pain in the typical accountant’s side over the years. Perhaps this stemmed from the foreboding stack of restrictions within the previous guidance, or maybe just a more scrutinizing environment and fear of the SEC. Whatever the cause, cue ASU 2017-12, an attempt to reinvigorate the standards with a more straightforward approach to hedging activities.
The effective dates for the new guidelines are already on the horizon so time isn’t necessarily on your side -- fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. While we encourage you to take a closer look at the guidance and update for a more granular understanding of the hedge accounting standards, the ASU 2017-12 update focused its changes to the guidance on a few main areas, including:
Better Align Hedge Accounting With a Risk Strategy
The updated guidance provides more flexibility for firms in both their variable rate and fixed rate hedging strategies, also introducing the ability to hedge against risk in nonfinancial hedges. It also requires a company to present the earnings effect of the hedge instrument in the same income statement line item as the earnings from the hedged item itself. Likewise, the update changes how a company measures and records hedge ineffectiveness, also enhancing how a company reports any amounts excluded from their ineffectiveness testing. Companies can now adopt either an amortization approach or continue with the mark-to-market that’s more in line with GAAP.
Simplified Hedge Effectiveness Testing
Speaking of testing, ASU 2017-12 lets companies subsequently test their hedge ineffectiveness qualitatively under certain conditions. This gives companies the freedom to switch to the quantitative/long-haul method for assessing effectiveness if the shortcut method is no longer appropriate. Companies also now have more time to perform their initial qualitative ineffectiveness assessment to begin with.
Revamped Disclosure Requirements
The updated guidance requires disclosures on new cumulative basis adjustments for fair value hedges as well as the effect on the income statement of fair value and cash flow hedges. Finally, the updated hedge accounting standards also eliminate the need for disclosures regarding the ineffective portion of the change in fair value of hedging instruments.
Again, we advise you to read further into the updated guidance but, to give you a general feel for the general direction FASB is heading with hedge accounting, companies should no longer let the previous murkiness around the standards prevent them from jumping into the derivatives pool when appropriate. The water isn’t nearly as cold as you might have once thought it was.
Hedge Accounting Best Practices
As for the nitty gritty of hedge accounting, there are a few points that your friends here at Embark want you to keep in mind. First, remember that once you enter into a fixed rate swap, the effective hedge must materially be near zero. Materiality, in this particular case, is in the eye of the beholder as there isn’t concise guidance on an actual definition, so it’s on each company to deem something material or immaterial.
Also, the terms of the agreement or the settled date need to be effectively the same, within a couple of days or so. Ideally, the swap needs to match up almost one-for-one with the terms of the initial variable rate loan. At any point in time, if the hedge ineffectiveness becomes too large, you’ll have to recognize it in the AOCI (accumulated other comprehensive income) section of the income statement.
There’s also an important distinction for companies defined as financial institutions as they are excluded from this guidance update. FASB wrote this new guidance with smaller companies in mind, the ones that don’t have a fortune to spend on valuation. Consult ASC 942 to see if your firm meets the definition of a financial institution for these purposes.
Lastly, if you fall within the jurisdiction of the updated guidance today, don’t assume that you can say the same tomorrow. Keep an eye on your total asset value to see where you stand against the $100 million asset threshold. Remember, that threshold only matters at the date of your financial statements, not if you break through it during the year. Maintain your financial bearings to eliminate unneeded surprises.
So there you have it. Obviously, we went over the basics and kept it simple, but that’s a summary of the new hedge accounting update. While smaller companies might find the updated standards to be a much-needed reprieve from the old, somewhat cumbersome guidance, we understand that there will still be difficulties in sorting through all of it. That, of course, is where Embark enters the fray, no stranger to valuations or any of the other nuances so critical to these standards. If you find yourself confused, overwhelmed, or even slightly befuddled over your hedge accounting, never forget that Embark is just a phone call away.