The FASB is expected to issue new hedge accounting guidance in the third quarter. Companies will be able to adopt it upon issuance in any interim or annual period, which would require reflecting the guidance from the beginning of the fiscal year.
The new guidance will include a significant number of changes designed to allow more hedging strategies to qualify for hedge accounting and to simplify its application. While many of the changes will benefit both financial institutions and corporates, a number of the changes were targeted for corporates and should be evaluated. The new guidance will make it easier - and perhaps more beneficial - for corporates to use hedge accounting.
Some of the changes likely to have the biggest impact to corporates are:
For many hedges, companies will be able to avoid performing or repeating complicated quantitative analyses that are currently required. Today, abbreviated methods of assessing effectiveness are only permitted for perfect hedges. Under the new guidance, if certain criteria are met, a qualitative assessment can be applied, even to hedges that are not perfect. A quantitative assessment will only be required at inception. Companies will just have to monitor that there have been no changes to terms in the hedging relationship or in the related markets.
While an initial quantitative effectiveness test is still required for many hedges (even those that qualify for the qualitative approach thereafter), the test can be completed by the end of the quarter in which the hedge is designated, instead of on the hedge inception date.
The standard will allow hedging of a contractually-specified component of the purchase or sale of a nonfinancial item. A contractually-specified component is a price that is linked to an index or rate that is expressly stated in the contract. This is good news for manufacturers who buy raw materials and lock in the prices with derivatives.
Consider, for example, a purchase of aluminum in which the customer pays the London Metals Exchange (LME) price plus a charge for delivery to the customer. Instead of hedging the total price risk of the purchase, as the company would have to do today, the company could hedge just the portion of the purchase that is linked to the LME price. This avoids the ineffectiveness that results from the delivery charge, which is unique to each customer and for which there isn’t a matching derivative that would create the “perfect hedge.”
Under existing guidance, when companies hedge the interest rate risk in a fixed-rate debt instrument, they measure the change in value of the debt based on its total contractual cash flows. This introduces the credit spread - the spread above or below the benchmark interest rate - into the calculation of hedge effectiveness, which results in additional ineffectiveness.
Under the new guidance, companies will be able to measure the debt instrument based on the benchmark interest rate component of the total contractual cash flows, thus eliminating the ineffectiveness caused by the credit spread. Because this is how companies think of the economics of the hedge, hedge accounting will more closely align with their risk management