On February 14th, the FASB held a public board meeting where they clarified certain provisions in the hedge accounting framework amendments issued in 2017.1
Constituents have raised questions about the new amortization model for recognizing excluded components in earnings. The FASB discussed a currency swap with a fair value of zero designated as the hedging instrument in a hedge of a net investment when hedge effectiveness is being assessed using the spot method.
In this fact pattern, the FASB considers it reasonable for the entire change in “clean” fair value of the currency swap (i.e., the change in fair value excluding interest accruals) to be deferred in the cumulative translation adjustment (CTA) section of other comprehensive income, and concluded that the recognition of interest accruals in earnings would be a systematic and rational method for recognizing the excluded component.
Using this approach, the amount reported in CTA at the end of the hedging relationship will equal the cumulative impact of changes in foreign exchange spot rates on the notional amount of the currency swap over the life of the hedging relationship.
If the currency swap has a fair value other than zero at the time of designation, reporting entities will likely need to amortize an amount other than the interest accruals to ensure that only the cumulative impact of changes in foreign exchange spot rates remains in CTA at the end of the hedging relationship.
The FASB also acknowledged that currency swaps could be structured with non-standard payment terms designed to allow for more favorable interest accrual amounts to be recognized in earnings relative to currency swaps with standard payment terms, but cautioned that reporting entities should consider whether their amortization methodology results in a "systematic and rational" method for recognizing the excluded component in earnings.
For prepayable instruments designated in fair value hedges of benchmark interest rate risk, the new standard permits companies to consider only the impact of the benchmark interest rate on the prepayment feature.
The FASB concluded that contingently exercisable prepayment features that are not contingent on interest rates (a) do not need to be incorporated into the measurement of the change in value of the hedged item (e.g., debt) due to changes in the benchmark interest rate until the contingent event occurs, and (b) are eligible for designation under the last of layer approach.
An exception is when a contingency is credit related (e.g., a feature that allows the investor to put debt back to the issuer upon an event of default by the issuer). In these situations, (a) the contingent feature must be measured in a manner consistent with GAAP prior to the amendments to the hedge accounting framework, and (b) the instrument would not be eligible for the last of layer approach if this were the only prepayment feature.
The FASB clarified two items related to the new tabular disclosure requirements for basis adjustments in fair value hedges:
For fair value hedges of interest rate risk that exist upon adoption of ASU 2017-12, when an entity has elected to modify how it measures the hedged item (e.g., to be based on the benchmark rate component of the contractual coupon cash flows), any adjustments to the proportion of the designated hedged item or derivative would not result in a dedesignation of the hedging relationship. However, reporting entities may not add new hedged items or hedging instruments to the hedging relationship without dedesignation.
1ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities
The FASB's discussions clarified certain questions raised by reporting entities as they adopt the new guidance. The 2017 amendments to the hedge accounting framework were adoptable upon issuance, but are required to be adopted by public companies for fiscal years beginning after December 15, 2018 and private companies a year later.
The FASB will meet on March 7th to discuss additional hedge accounting implementation issues, including the last of layer approach and designating a contractually specified component as the hedged risk.