[IMGCAP(1)][IMGCAP(2)]Since the advent of Financial Accounting Standard 133 in 1998, financial statement preparers have been dealing with the onerous and complex requirements of hedge accounting, arguably one of the most complex statements that the board has promulgated.
Much of the complexity related to this statement can be attributed to the rapid rise of the derivative markets at the end of the last century and an accounting industry that was grappling with how to handle this change. More recently, the accounting industry has been seeing a trend towards moderating the hedge accounting regulations, a trend which is very welcome by preparers and users alike.
There are multiple reasons to support this moderation in approach. This can be attributed to factors such as the complexity of hedge accounting requirements, a changing regulatory environment, the usefulness of the data and convergence with International Financial Reporting Standards.
The most notable proof of this change is evident when reviewing the Financial Accounting Standards Board’s Web site. A quick look at the agenda of some of the more recent meetings reveals that FASB has started to address topics related to fair value and hedge accounting on a more consistent basis, and the outcomes have been more moderate in tone. One such example is the recent Emerging Issues Task Force meeting on June 18, 2015, which focused on three hedge accounting-related items. Of the three topics discussed, the most notable was EITF Issue No. 15-D, which relates to the effects of derivative contract novations on existing hedge accounting relationships.
To provide some background, a novation is a common legal term that entails replacing a party to an agreement with a new party, thereby transferring all the rights and obligations from the exiting party to the new party. In more simple terms, the new party is stepping into the position of the exiting party, usually with no other changes in any of the existing contract terms.
There are many reasons why this type of transaction occurs in business. The most obvious reasons are related to a merger involving one of the counterparties, a change in the legal entity name of one of the parties, a change in a financial relationship between the parties and regulatory changes. These are but a few of the many instances whereby a novation may occur.
Prior to the most recent EITF meeting, the guidance in Accounting Standards Codification Topic 815 was not explicitly clear on how to treat this type of occurrence. The accounting industry’s accepted interpretation was that a novation is a change in a significant (or “critical”) contract term, and as a result, the accounting treatment related to either of the contract parties that was utilizing that contract in a hedging relationship would be to terminate hedge accounting. In hedge accounting terminology, it would require the de-designation of that existing hedge accounting relationship.
This could impact the company in many ways, such as increasing the volatility in earnings as a result of losing hedge accounting or possibly violating a banking covenant. In addition, there is the added burden of determining the accounting treatment and fair value for these de-designated hedges and making changes to the recording, reporting and disclosures going forward. This usually requires the assistance of a valuation specialist because the client is now dealing with a change in variables that must be modeled appropriately.
If the company wanted to re-designate the instruments into new hedging relationships, this would require an even more complicated set of calculations be performed because the instruments are now considered to be off market, which means the hedge effectiveness testing would require additional considerations in order to qualify for hedge accounting.
During the June 18 meeting, the EITF reached a consensus that a change in one of the parties to a derivative contract that is part of an existing hedge accounting relationship does not, in and of itself, require the de-designation of that hedge accounting relationship.
Proponents of this alteration in approach argued that a change in name only to a party of the contract does not signify a termination, as the derivative is largely unchanged. In addition, they cited guidance whereby the context of a critical term refers to a factor that affects the amount and timing of the contractual cash flows. They stated that a change in the counterparty and other non-critical terms may affect the probability of performance, but not the amount or the timing of the cash flows.
Proponents viewed a change in a counterparty as a change in “facts and circumstances” and not a change in a critical term.
The other reasons cited by advocates for this approach were as follows:
The previous accounting treatment, involving the de-designation of an existing hedging relationship, does not provide financial statement users with additional relevant information;
The previous treatment increases the complexity of trying to re-establish hedge accounting treatment as well as the cost and effort associated in maintaining hedge accounting going forward; and
There were inconsistencies in the treatment of hedge accounting versus other similar types of transactions, whereby an extinguishment would not be recorded.
No guidance was changed or provided related to the estimation of fair value; however, companies will need to consider the impact a novation may have on the underlying credit risk of a contract. Although there were other alternatives presented, the board reached a consensus that this more moderate approach was advisable and they reiterated that by ratifying the decision at the more recent July 9 EITF meeting. This change is expected to be based on a prospective transition for all existing hedge accounting relationships in effect at the novation date, which is subsequent to the effective date of the proposed guidance.
In closing, this is but one example of several that have occurred recently, many of which are moderating the stance of hedge accounting going forward. Companies are going to need to stay abreast of such changes as they occur and be ready to implement changes accordingly in order to avoid some potential pitfalls. We are all anxious to see where these changes may lead us.
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