Industry Insights

FASB’s Hedge Proposal Needs Tweaks

December 2016
Author:  Anne Coughlan

Anne Coughlan

Director

Audit

201 N. Illinois Street, Suite 700
P.O. Box 44998
Indianapolis, IN 46244-0998 (46204)

Indianapolis
317.383.4000

The comment period recently ended for feedback on the Financial Accounting Standards Board’s (FASB) proposed updates to hedge accounting. Feedback was overwhelmingly positive; there was unanimous support for more closely aligning hedge accounting and reporting with an entity’s risk management activities. Respondents provided practical suggestions for improvement that also highlight some of the continued barriers to widespread adoption of hedge accounting treatment for firms that actively manage their risk exposures with derivatives. FASB will begin redeliberations in 2017; a final standard could be issued by the end of 2017, and FASB previously indicated early adoption would be permitted.

Component Hedging

Respondents unanimously supported amendments that would qualify risk components of nonfinancial instruments as hedge items; however, most felt the “contractually specified” requirement was overly restrictive, highlighting these examples:

  • Spot or at-market noncontractual purchases or sales would be ineligible for inclusion in the pool of hedged forecasted transactions.
  • Currently, price components may or may not be explicitly stated on commodity purchase or sale contracts. Agricultural markets typically involve a large number of small producers delivering many individual shipments of product to local storage facilities. The cost and effort to ensure price components are explicitly stated on every contract would be prohibitive, and smaller companies may not have the bargaining power to rewrite contracts.
  • In certain commodities markets, components may not be specified because market practice is to use the component as a basis in determining the overall price, e.g., a natural gas contract for delivery at a specific location would contain an overall purchase price consisting of an implied Henry Hub price and a locational basis differential.

Respondents suggested the broader language in International Financial Reporting Standards, such as “separately identifiable” and “reliably measurable,” would be more operable.

Respondents hedging energy products also suggested the risk component be highly correlated to the end product’s price. For example, a purchaser of diesel fuel currently hedges with a global crude oil index such as Brent or West Texas Intermediate (WTI). Diesel is refined from crude oil, priced based on the refiner’s cost and then sold after refining, leading to a one-month delay in the correlation between the diesel’s end price and the cost to the refiner. The diesel purchaser can demonstrate the diesel price is highly correlated to the price of Brent Crude with a one-month lag.

Respondents felt there is sufficient auditable evidence of existing industry practice to support risk component hedging without mandating it be contractually specified.

Benchmarks

The proposal would add the Securities Industry and Financial Markets Association Municipal Swap Rate to the list of permitted benchmark rates for hedges of fixed-rate financial instruments. While no one disagreed with this addition, several respondents felt FASB should eliminate the approved benchmark list and move to a principles-based approach requiring any rate to be widely used and quoted.

Forecasted Transactions

FASB’s proposal included an anti-abuse provision related to hedging of forecasted transactions. Respondents sought clarity around the “pattern” that would call into question an entity’s ability to accurately predict forecasted transactions. Respondents felt a distinction was warranted for items outside an entity’s control, e.g., flooding that temporarily shuts down a processing plant or credit events and corporate restructurings.

Presentation

For qualifying fair value, cash flow and net investment hedges, the proposed amendments would require the entire change in fair value of the hedging instrument to be presented in the same income statement line as the earnings effect of the hedge item. Financial institutions noted net interest income and net interest margin are key performance indicators used internally and externally, and the proposed changes would distort these widely used metrics.

Disclosures

Respondents overwhelmingly felt that disclosing “quantitative hedge accounting goals” was duplicative of economic risk information included in 10-K reporting and the current fair value disclosure required by Accounting Standards Codification 820. They felt the disclosure would result in unnecessary time and cost that would be little use to financial statement users.

BKD will monitor the project’s progress as FASB begins redeliberations in 2017.

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