Accounting for hedging activities has never been easy, but by year’s end, if a proposal from the Financial Accounting Standards Board meets approval, it might get a little simpler.FASB has proposed an amendment to Statement 133, Accounting for Derivative Instruments and Hedging Activities. The proposed statement, Accounting for Hedging Activities, issued as an exposure draft, would eliminate most of the many methods of hedge accounting. The result: financial statements that are simpler, more transparent and more comparable.

“The board was dealing with a lot of implementation issues around hedge accounting, and a lot of users of financial statements were concerned that results relating to hedge accounting weren’t as transparent as they could be,” explained FASB assistant director of technical activities Kevin Stoklosa. “The board identified a number of areas that were causing the complexity and financial reporting issues, and they focused in on those.”

The board hammered out an amendment that grapples with three main areas: how to qualify for hedge accounting, elimination of the shortcut method and critical terms matching, and bifurcation by risk.

The proposal simplifies qualifying for hedge accounting by modifying the effectiveness threshold from “highly effective” to “reasonably effective.”

Stoklosa said that the change should alleviate a lot of quantitative testing that preparers of financial statements had to perform. Often a pre-inception qualitative test would suffice. Quarterly testing for effectiveness would be required only when circumstances suggest that the hedging relationship is no longer effective.

With elimination of the shortcut method, an entity would no longer be able to assume a hedging relationship is highly effective and recognize no ineffectiveness in earnings during the term of the hedge. Entities would have to determine changes in fair value of the hedged item for value hedges and the present value of the cumulative change in expected future cash flows.

Stoklosa said that eliminating the shortcut method would require all entities to perform hedge accounting the same way, producing comparable results.

SPOT THE RISK

The proposal would eliminate the current option to designate individual risks as the hedged risk in a fair value or cash-flow hedge. Statements would reflect information about risks in the hedged item or transaction that an entity chooses to manage and not manage as part of a given hedging relationship.

The exposure draft specifically asks whether the statement should allow two exceptions. Entities may designate as individual risks any interest rate risk related to issued debt (if hedged at inception), and foreign currency exchange risk.

“Under this amendment, when you mark your hedged item to market, you have to mark it for all changes to fair value,” Stoklosa explained. “This way, the seer can understand not only what risks the company is hedging, but what it’s not hedging.”

The exposure draft asks whether Statement 133 should be amended to prescribe the presentation of gains and losses associated with merging instruments, including the effective and ineffective portions and any amounts excluded from the evaluation of effectiveness.

The hedge fund industry and corporations involved in hedging activities are still assessing the potential impact if the proposal becomes a formal FASB statement as presented.

David Friedland, president of Magnum U.S. Investments and president of the Hedge Fund Association, expressed tentative support as the HFA began analyzing the changes to current practice. “The Hedge Fund Association is pleased to see the FASB’s continued efforts for simpler, more transparent accounting for hedging activities,” he said. “Such efforts should be in the interests of hedge fund managers, investors and service providers alike.”

The board hopes to issue a final statement by Dec. 15, 2008. If it manages to, the new standard would have to be applied for financial instruments issued for fiscal years after June 15, 2009. Comments are requested by Aug. 15, 2008. A copy of the exposure draft is available at www.fasb.org.

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