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How can the FASB’s new hedge accounting guidance reduce income statement volatility? Watch our latest video for more info.
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We will discuss changes made to the accounting for components excluded from the assessment of hedge effectiveness. Consistent with previous accounting, the new guidance permits companies to exclude certain elements of a derivative instrument’s change in fair value from the assessment of hedge effectiveness. These elements are referred to as “excluded components”. However, the new guidance expands the previous allowable exclusions and changes the recognition of excluded components.
What components are eligible for exclusion from the assessment of effectiveness? Under previous guidance, an entity may exclude the time value of an option, or certain portions of it, when determining the change in fair value of the derivative instrument. An entity may also exclude the change in the fair value of a derivative contract related to the difference between the spot price and the forward or futures price, referred to as “forward points”, when determining the change in fair value of a forward contract.
The new guidance continues to allow exclusion of these components and also permits companies to exclude the portion of the change in fair value of a cross-currency swap due to the cross-currency basis spread. The cross-currency basis spread is embedded in a cross currency interest rate swap.
Under previous guidance, that was a source of income statement volatility because it was part of the valuation mechanics of the currency swap but not part of the valuation mechanics of the hedged item. As a result, being able to exclude it from the effectiveness assessment should improve the effectiveness of the hedge.
Now that we’ve discussed which components are eligible for exclusion from the assessment of effectiveness, how should excluded components be recognized in the financial statements? Previous guidance required a mark-to-market approach for recognition of excluded components. This requirement could be a source of income statement volatility in each period. Under the new guidance, a reporting entity may elect an accounting policy to use either a mark-to-market approach or an amortization approach. This election must be consistently applied for similar hedges.
Under the newly-allowable amortization approach, the initial value of the components excluded from the assessment of hedge effectiveness is recognized in earnings using a systematic and rational method over the life of the hedging instrument. Any difference between the change in fair value of the excluded component and amounts recognized in earnings under that systematic and rational method would be recognized in other comprehensive income. While both methods produce the same cumulative result, the amortization approach provides for more predictable results.
What is the accounting treatment for excluded components upon discontinuance of a hedge? When a hedge is discontinued, if the company recognizes the excluded component through the amortization approach, the company is required to release amounts remaining in Accumulated Other Comprehensive Income, or AOCI, as follows:
For a cash flow hedge in which the forecasted transaction is still probable of occurring, an entity would release amounts from AOCI when the forecasted transaction impacts earnings. However, if the forecasted transaction is probable of not occurring, an entity would release amounts from AOCI to earnings in the current period.
For a fair value hedge, an entity would release amounts from AOCI consistent with how fair value hedge basis adjustments are recognized in earnings for the related hedged item.
For a net investment hedge, any amounts that have not been amortized into income should remain in the entity’s cumulative translation adjustment account until the hedged net investment is sold or substantially liquidated.
The new hedging guidance, including new guidance around excluded components, allows entities to better align their risk management activities with their hedge accounting. Entities should be aware that transition relief is provided related to these changes, if elected at adoption. In addition, there are amended disclosure requirements associated with excluded components.