Hedge Accounting Aligned To Risk Management Strategies

by Chris Monteilh and Bill Fellows

How the new simplified standard for hedge accounting can help improve the performance of any business.

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Hedging is a powerful risk management strategy that can reduce income statement volatility and mitigate financial risk. Yet, historically, many businesses have not taken full advantage of hedging because the required accounting was too complex, resource-intensive, and time-consuming. Thankfully, that barrier has now been dramatically lowered, creating a potentially easier path for many more businesses to take advantage of hedging while reducing the operational burden typically associated with hedge accounting.

On January 1, 2019, a new standard from the Financial Accounting Standards Board (FASB) took effect that greatly simplifies and streamlines the accounting requirements for hedge accounting. The new hedge accounting standard was finalized in August 2017 as Accounting Standards Update No. 2017-12 (ASU 2017-12), and many leading businesses that rely heavily on hedging—such as large banks and other financial services companies—have already started taking advantage of the new standard to minimize volatility in their financial statements, enhance predictability in their earnings statements, and improve operating efficiency by simplifying and streamlining their hedge accounting practices.

However, many other cross-sector businesses may not be fully aware of the changes from ASU 2017-12—or may simply have had their hands full implementing FASB's other new accounting standards for revenue recognition and lease accounting—and may be missing out on the benefits of hedging.

According to a mid-2018 poll of more than 3,000 Deloitte webcast participants, one-third of companies (33 percent) “hardly use hedge accounting” and another third (31 percent) are only “moderate users.” What's more, only one in five of the polled companies (21 percent) had adopted or planned to adopt ASU 2017-12 before the January 1, 2019, effective date for calendar-year public companies.

Highlights from the new standard

The main objectives of the new hedge accounting standard are to (1) improve the transparency and understandability of information conveyed to financial statement users about an entity’s risk management activities by better aligning its hedge accounting with those activities and (2) reduce complexity and simplify the application of hedge accounting by preparers.

As with all things related to accounting, details matter. However, in high-level terms, specific changes from the new standard include:

  • Simplifying how the changes in fair value of a hedge are recognized and presented
  • Increasing acceptance of qualitative assessments for hedge effectiveness instead of requiring complex and labor-intensive quantitative models and analysis
  • Eliminating the need to recognize ineffectiveness when accounting for cash flow and net investment hedges
  • Eliminating the requirement to tie variable interest rate cash flow hedges to a specific, controversial benchmark rate (e.g., LIBOR) and accepting the Securities Industry and Financial Markets Association (SIFMA) municipal swap rate as an alternative benchmark rate
  • Allowing the exclusion of cross-currency basis spreads for currency swaps
  • Allowing increased use of simplified methods and shortcuts for a variety of hedge accounting activities

Fair value hedges involving interest rate risk

  • Measurement of hedged item. The option to use the benchmark component of contractual cash flows (i.e., excluding credit) when calculating change in fair value will reduce hedge ineffectiveness.
  • Prepayment risk. The ability to ignore prepayment risk for reasons other than changes in the benchmark rate in a fair value hedge of benchmark interest rate risk can reduce hedge ineffectiveness.
  • Partial-term hedge. The ability to measure changes in fair value using an assumed term based on designated hedged cash flows significantly opens the door for more precise term structure hedging. 
  • Portfolio hedge of prepayable assets. The addition of the “last of layer” method that enables fair value hedges of a portion of a closed portfolio of prepayable assets without having to consider prepayment risk or credit losses creates greater flexibility for banks in hedging interest rate risk. 

Risk component hedging

  • Cash flow component hedges of nonfinancial assets. These can now designate risk as a contractually-specified component of a nonfinancial contract. The expanded scope significantly opens the door for commodity hedging. 
  • Cash flow hedges of contractually specified rates. The concept of benchmark rates is removed for existing variable-rate debt instruments, and entities can designate contractually specified rates. This opens hedging possibilities for additional products and may increase hedge-tagging facility capacity. 
  • Expansion of benchmark rate for fair value hedges. The SIFMA municipal swap rate is now an eligible benchmark interest rate, which should expand benchmark hedging possibilities. 

Net investment hedging

The new standard also changes the application of the spot method of assessing the effectiveness of hedges of net investments in foreign operations by allowing entities to subsequently recognize the excluded component (the spot-forward difference) in income using an amortization approach, while recognizing all changes in fair value (other than the amount recognized in income using the amortization approach) in the cumulative translation adjustment (CTA) section of other comprehensive income.  For entities that utilize qualifying cross-currency interest rate swaps as the hedging instrument, this results in recognizing the periodic interest settlements in earnings and recognizing all other changes in fair value in the CTA.   As a result of these changes, many entities are electing to utilize the spot method.     

To hedge account or not to hedge account 

From a practical perspective, the new hedge accounting standard is optional. At one end of the spectrum, companies that choose not to employ hedge accounting can essentially ignore the new standard even if they hedge for risk management purposes. At the other end of the spectrum, companies that hedge extensively may now benefit from the new, simpler requirements.

The freedom of choice to adopt hedge accounting can cause companies to overlook the financial reporting benefits arising from the new guidance.  

Companies with or without an established risk management program should consider the pros and cons of hedge accounting and determine whether it makes sense to broadly capitalize on the simpler requirements of the new standard to mitigate financial statement volatility. For companies with foreign exchange, commodity, or interest rate risk, capitalizing on the power of hedging could be advantageous.

Chris Monteilh is partner, Audit & Assurance Services, Deloitte & Touche LLP. Bill Fellows is partner, Deloitte Risk and Financial Advisory, Deloitte & Touche LLP.