Hedge accounting is changing – for the better, no less!
There are a few items in FASB’s Sept. 8 Exposure Draft that should be noted, as these will affect all interest rate hedgers taking special hedge accounting:
- Most critical for those designating interest rate swaps as cash flow hedges is the elimination of ineffectiveness reporting – the concept of measuring ineffective amounts is going away. Once the expectation of being highly effective is met, derivatives will be marked to market with the total change in value recorded in other comprehensive income (equity).
- Cash flow hedge accounting treatment will expand to include any contractually specified interest rate index, e.g. Prime. The expansion will open up interest rate hedging to include prime and other published interest rates.
- Fair value hedge accounting requirements will be relaxed, and will allow more flexibility to define the hedged item so that its terms better match the hedging instrument, minimizing P&L impact from mismatches between the two. For example, when hedging a fixed income instrument, hedgers will be allowed to model the hedged item based on the benchmark component of its coupons (excluding credit), as opposed to its full contractual coupons. This will eliminate a major source of ineffectiveness which exists under current fair value hedge accounting rules.
- Partial term hedging in fair value relationships will become feasible. For example, a hedger will be able to convert the first 3 years of fixed coupons of a 5-year debt issuance to variable rate using a 3-year swap, and model the hedged item using an assumed maturity of 3 years. These kinds of strategies are generally not eligible for hedge accounting under current rules, given the current requirement to use the contractual maturity of the hedged item when measuring its change in fair value for the designated hedged risk. Such partial-term strategies will also be eligible for the shortcut method of accounting under the proposal.
- The SIFMA municipal swap rate will become an eligible benchmark interest rate. This will allow those who invest in or issue fixed rate tax exempt securities to hedge the SIFMA component of their fair value changes, as opposed to their entire fair value changes which, which will reduce hedge ineffectiveness.
- An initial effectiveness test remains a requirement for cash flow and fair value hedges, however both retrospective and the ongoing prospective effectiveness tests can be replaced with qualitative assurances that the critical terms of the hedged item have not changed. In addition, there is more opportunity to apply qualitative effectiveness testing at inception, reducing analytical requirements.
- Documentation of a “back-up test” at designation provides a safety net, in the event short-cut treatment is applied, but found to be inappropriate after hedge designation.
- Initial quantitative effectiveness testing is no longer required “contemporaneously” with hedge execution, but will be required before the earlier of the date financial statements are issued for that quarter or when the hedge relationship is terminated.
- Disclosure tables have changed and more disclosures will be required.
For more information on these recent accounting changes, contact us at 408-350-8580 or visit hedgetrackers.com.