Hedging - Implementation considerations

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Video , PwC US Jan 08, 2019

Watch our video for quick insights to consider when implementing the FASB’s new hedge accounting guidance.

Our video provides insight on implementation considerations when adopting  the new hedging accounting guidance. Topics covered relate to modifying the excluded component for net investment hedges, qualitative assessments of effectiveness, and revised presentation and disclosure requirements.


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Duration: 7:54


Hi! I’m Adam Kamhi, a Director in PwC’s Financial Markets practice.

Today, I’m continuing our video series on the changes to the hedge accounting guidance with a discussion of several common topics that may arise as companies work through implementation of the new hedging standard. There are three topics we’re discussing:  

  1. Modification to an entity’s excluded component election for net investment hedges;
  2. Using a qualitative method to perform subsequent assessments of effectiveness when a quantitative method was used to perform the initial assessment of effectiveness; and
  3. The revised presentation and disclosure requirements.

So let’s start with excluded components for net investment hedges. The accounting guidance for net investment hedges requires a company to elect whether assessments of hedge effectiveness will be performed using the forward method or the spot method.

Under the current guidance, a company needs to make a one-time policy election for all net investment hedges using derivatives on whether it will use the forward method or the spot method to assess hedge effectiveness. The amendments to the guidance remove this one-time restriction.  Instead, once a company adopts the revised guidance, it will have the ability to switch its election from the forward method to the spot method, or vice versa if the company can support that the revised election will be an improved method of assessing effectiveness.

So let’s say prior to adopting the new guidance, a company’s elected the forward method.  At the time of or after adoption, the company changed to the spot method as it was able to support that the spot method was an improved method. In the future, if the company wants to change its methodology back to the forward method, it will need to consider why factors supporting the change to the spot method no longer support the spot method being an “improved method.” Changes in spot/forward pricing differences would not be an acceptable argument.

The guidance does not dictate how to determine whether something is an improved method for assessing effectiveness. We believe it’s an analysis that will need to be performed based upon the facts and circumstances of each individual company. The analysis will consider among other things, operational, accounting and reporting consideration. Companies may be more focused on this election as a result of the changes to the guidance on the treatment of excluded components. A separate video in our hedging series is available discussing the changes in this treatment.

Now, let’s move on to the second topic, using a qualitative method to assess hedge effectiveness subsequent to hedge inception, when a quantitative method was used at hedge inception.

Under the current guidance, if an entity creates a hedge relationship and is required to perform an initial quantitative assessment of effectiveness, then all subsequent assessments of effectiveness need to be performed quantitatively as well.

Under the revised guidance, if an entity creates a hedge relationship and performs an initial quantitative assessment of effectiveness, subsequent assessments of effectiveness can be performed quantitatively or qualitatively in certain circumstances. So, the key question is, what are the circumstances when an entity can perform subsequent assessments of effectiveness qualitatively?

Let’s consider the following two scenarios. In Scenario 1, the quantitative assessment resulted in close to perfect offset. Although the underlying of the hedged item and hedging instrument do not match, the changes in the underlyings have been very highly correlated over an extended period of time and are expected to continue to be very highly correlated.

The conclusion in Scenario 1 is that qualitative assessments can be performed subsequent to hedge inception, for the following reasons:

  1. The initial quantitative test resulted in close to perfect offset, and
  2. As the underlyings have been and are expected to continue to be very highly correlated, there is no evidence that future quantitative assessments would produce different results compared to those that were produced at hedge inception.

Now, let’s discuss Scenario 2. In this scenario, the results of the quantitative assessment were close to not being considered highly effective and the underlyings of the hedged item and hedging instruments were not, and may not be expected to be, highly correlated over an extended period of time.

Due to the results of the initial quantitative assessment and the potential that the hedge relationship could become ineffective, qualitative assessments cannot be performed in subsequent periods for the fact pattern in Scenario 2.

If a company does qualify to use a qualitative assessment approach, management needs to ensure that it establishes appropriate controls to monitor the terms of the hedge relationship that do not match. If the relationship between those terms begins to deteriorate, careful consideration should be given to determining if and when it may be necessary to perform a quantitative assessment of effectiveness and whether continuing to perform assessments on a qualitative basis is appropriate.

Now, let’s move on to the third topic, presentation and disclosure. Although the application of hedge accounting is elective, if it is elected, a company will need to comply with certain presentation and disclosure requirements.  The new hedging guidance adds new presentation and disclosure requirements that companies should focus on.

The term “ineffectiveness” has been effectively removed from the guidance and all amounts relating to the hedging instrument presented in earnings should be recorded in the same line item where the hedged item effects earnings, including any excluded components.

This change has impacted a number of companies since ineffectiveness may have been reported in a separate income statement line item than where the hedged item was recorded.  In some cases, this has resulted in increased volatility in line items that are closely monitored. For example, in a fair value hedge of interest rate risk on issued debt, to the extent that the hedging relationship does not achieve perfect offset, those differences will be reflected in interest expense under the new guidance.

From a disclosure perspective, for certain fair value hedges, there is a new disclosure that requires basis adjustments that are component of the carrying value of the hedged item to be separately disclosed. In addition, there are also modifications to the disclosures that are designed to provide transparency to the effect of hedge accounting on individual income statement line items. A more detailed discussion on the presentation and disclosure changes can be found in Chapter 12 of our Derivatives and Hedge Accounting guide.

So let’s wrap up. What I have highlighted here are three common implementation matters related to the hedge accounting guidance. It’s important to focus on these issues, and all other aspects of the standard, as you adopt the new guidance. For more information, including our guide and other videos, please refer to the derivative and hedging page on CFOdirect.com. Thank you.

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