Is FASB Hedging on Hedge Accounting?

Despite having a nip-and-tuck plan in the works to simplify hedge accounting, the Financial Accounting Standards Board may now be thinking of doing something more drastic.

As part of its controversial plan to revise overall accounting for financial instruments, FASB proposed some ideas last May for making the complex area of hedge accounting a little easier to follow. The proposal would lower the threshold to qualify for hedge accounting, where a financial instrument and the derivative purchased to offset the risk of that instrument can be accounted for together. Hedge accounting tends to produce a more favorable result, primarily by reducing volatility in financial statements, compared with accounting for unrelated instruments separately.

In that proposal, FASB suggested eliminating some of the stumbling blocks that tend to trip up companies on their way to qualifying for hedge accounting, says Bob Uhl, a partner with Deloitte & Touche. It would require companies to show a hedge is at least “reasonably effective” rather than meeting the current threshold of “highly effective” to quality for hedge accounting. It also would do away with prescriptive methods for assessing effectiveness that have led to problems, even restatements.

But now FASB is giving some indications that it may consider walking back the May proposal and pursuing a more encompassing plan like the one the International Accounting Standards Board is backing.

IASB issued a proposal in December that calls for more fundamental changes to hedge accounting, says Mark Scoles, a partner with Grant Thornton. “IASB's proposal is more all encompassing, changing things more dramatically,” he says. “FASB's approach was more surgical, changing things in hedge accounting that have been problematic,” he says.

Without yet acting on the May proposal, FASB has asked its U.S. constituents to provide comments on the IASB proposal, suggesting it may be planning to stroll down IASB's path. But it's too soon to say for sure, says Uhl. “A lot of the ideas IASB issued in their exposure draft in December were thought about well before,” he says. “FASB had that information available to them when they issued their exposure draft in May. They discussed those issues and decided not to go that far, so it's not as if they haven't thought of it before.”

IASB proposes to expand the scope of what can be hedged and what can be used as a hedge, says Faye Miller, national director of the professional standards group at accounting firm McGladrey & Pullen. Its plan focuses more on the risk-management objectives of hedging, she says, while FASB's plan would retain restrictions on what kinds of instruments or assets can qualify for hedge accounting.

For example, says Uhl, the IASB plan would allow companies to hedge non-financial instruments, like commodities. “Say you're buying electricity,” he says. “If you think natural gas is a component of electricity, you would be able to hedge the natural gas component.” The IASB proposal would also allow a company to hedge combinations of items and derivatives, and would allow hedging of groups of items, like net exposures, Uhl says. “FASB in their exposure draft did not go that far.”

International Flair

HEDGE QUESTIONS

The International Accounting Standards Board is seeking comments on its hedge accounting proposal and has developed a list of questions surrounding the issue. Below is a sample of those questions:

(1) Do you agree with the proposed objective of hedge accounting? Why or why not? If not, what changes do you recommend and why?

(2) Do you agree that a non-derivative financial asset and a non-derivative financial liability measured at fair value through profit or loss should be

eligible hedging instruments? Why or why not? If not, what changes do you recommend and why?

(3) Do you agree that an aggregated exposure that is a combination of another exposure and a derivative may be designated as a hedged item? Why or why not? If not, what changes do you recommend and why?

(4) Do you agree that an entity should be allowed to designate as a hedged item in a hedging relationship changes in the cash flows or fair value of an item attributable to a specific risk or risks (ie a risk component), provided that the risk component is separately identifiable and reliably measurable? Why or why not? If not, what changes do you recommend and why?

(5) (a) Do you agree that an entity should be allowed to designate a layer of the nominal amount of an item as the hedged item? Why or why not? If not, what changes do you recommend and why?

(b) Do you agree that a layer component of a contract that includes a prepayment option should not be eligible as a hedged item in a fair value hedge if the option's fair value is affected by changes in the hedged risk? Why or why not? If not, what changes do you recommend and why?

(6) Do you agree with the hedge effectiveness requirements as a qualifying criterion for hedge accounting? Why or why not? If not, what do you think the requirements should be?

(7) (a) Do you agree that if the hedging relationship fails to meet the objective of the hedge effectiveness assessment an entity should be required to rebalance the hedging relationship, provided that the risk management objective for a hedging relationship remains the same? Why or why not? If not, what changes do you recommend and why?

(b) Do you agree that if an entity expects that a designated hedging relationship might fail to meet the objective of the hedge effectiveness assessment in the future, it may also proactively rebalance the hedge relationship? Why or why not? If not, what changes do you recommend and why?

(8)(a) Do you agree that an entity should discontinue hedge accounting prospectively only when the hedging relationship (or part of a hedging relationship) ceases to meet the qualifying criteria (after taking into account any rebalancing of the hedging relationship, if applicable)? Why or why not? If not, what changes do you recommend and why?

(b) Do you agree that an entity should not be permitted to discontinue hedge accounting for a hedging relationship that still meets the risk management objective and strategy on the basis of which it qualified for hedge accounting and that continues to meet all other qualifying criteria? Why or why not? If not, what changes do you recommend and why?

Source: IASB Proposal on Hedge Accounting.

IASB's plan also would change the income impact of hedge accounting, says Miller. Current rules under both U.S. GAAP and International Financial Reporting Standards require hedged items and the derivatives meant to offset them to be measured at fair value with changes flowing through the income statement. If the hedge is effective, the values are moving in opposite directions, so they will offset one another on their passage through net income, she says. IASB, however, is proposing to flush hedge accounting through equity, or “other comprehensive income,” rather than through net income, to further reduce volatility when a hedge is not effective.

FASB and IASB have also proposed different approaches for assessing the effectiveness of a hedge over its life, Miller says. FASB's current proposal would require a company to establish that a hedge is reasonably effective at the outset, then monitor its effectiveness going forward. If circumstances change such that the hedge is no longer effective, then it's no longer considered a hedge. IASB, on the other hand, proposes that companies take action to “rebalance” the hedge in order to keep it effective, says Miller. “If you get further out and it becomes ineffective, you would determine what you need to do to make it effective,” she says.

FASB says it hasn't yet studied the international plan itself, but the board wants U.S. constituents to react to it before any changes in U.S. rules are finalized. FASB says it will participate in the international deliberations based on international comments to the proposal and will hold deliberations of its own based on U.S. feedback.

Ed Grossman, a partner with accounting firm Crowe Horwath, says he's surprised it took FASB two months from the issuance of the IASB proposal to put it out for U.S. comment. It puts the board on a tight timeline to finish its financial instruments project by the mid-2011 target date to achieve a converged approach on some key differences between U.S. and international rules. The board is still working under that timetable, although it has acknowledged there are still many issues to resolve in a short period of time.

There are elements of both proposals that have merit, in Scoles' view. “I wish the two boards had worked together to come out with a single proposal,” he says. “It would have been easier for constituents to address if the boards had come to collective views issued in one proposal.” While there are differences today between GAAP and IFRS with respect to hedge accounting, the differences would be even more significant if the boards adopted their existing proposals, he says.