Yesterday, the FASB held its first decision-making meeting in connection with its project on targeted improvements to hedge accounting. At the meeting, which followed several educational sessions held earlier in the year, the FASB made a number of tentative decisions that, if ultimately adopted, would significantly modify certain aspects of the existing hedge accounting model. The Board hopes to issue a proposed Accounting Standards Update (ASU) reflecting these tentative conclusions by the end of the year.

Specifically, the FASB discussed three “decision packages” proposed by its staff, which covered aspects of (1) the overall hedging model, (2) financial hedging relationships, and (3) the shortcut method. Highlights of these packages are discussed below.

Overall Hedging Model

The FASB tentatively decided to retain (1) the highly effective threshold used to qualify for hedge accounting under current U.S. GAAP for both cash flow and fair value hedges and (2) the current guidance allowing an entity to voluntarily dedesignate a hedging relationship. Under the tentatively approved model, quantitative assessments of hedge effectiveness would be required only at hedge inception (unless the criteria for use of the shortcut or critical-terms-match methods are met, in which case quantitative assessments are not required at all); subsequent quantitative assessments would be required only when facts and circumstances change. An entity would still need to document at hedge inception its method for quantitatively assessing hedge effectiveness; however, it would not have to complete its initial quantitative prospective assessment of hedge effectiveness until the end of the reporting period during which it designated the hedge (i.e., up to three months). For nonfinancial items, the model also would permit an entity to designate a contractually specified component or ingredient that is linked to a contractually stated rate or index as a hedged item.

The Board also tentatively decided to eliminate the traditional concept of hedge ineffectiveness. For highly effective hedging relationships, all changes in the fair value of the hedging derivative would be recorded in (1) other comprehensive income until the hedged item affects earnings for cash flow hedges and (2) the same line item of the income statement for fair value hedges. In the income statement, the entire change in the fair value of the hedging derivative would be recorded in the line item that is being hedged (either immediately, for fair value hedges, or upon reclassification from accumulated other comprehensive income, for cash flow hedges).

Further, the FASB tentatively decided to require additional disclosure about (1) cumulative basis adjustments for fair value hedges, and (2) the effect of hedging on individual income statement line items. It also tentatively decided to require expanded qualitative disclosures about the quantitative goals, if any, that an entity set to achieve its hedging objectives.

Financial Hedging Relationships

For hedges of financial items, the FASB tentatively decided to (1) allow the contractually specified index rate in a variable-rate hedged item to be the designated interest rate risk,¹ (2) retain the existing benchmark interest rate definition for fixed-rate hedged items with minor modifications to eliminate inconsistencies, and (3) designate the SIFMA² Municipal Swap index as a permitted benchmark interest rate. In addition, the tentative decisions would allow an entity to:

• Designate the change in only the benchmark component of total coupon cash flows attributable to changes in the benchmark interest rate as the hedged risk in a hedge of a fixed-rate financial asset or liability.
• Consider only the effects of the designated hedged risk (e.g., interest rate risk) on a prepayment option when determining the change in the value of the debt for hedges of callable debt.
• Designate as the hedged risk only a portion of the hedged item’s term (e.g., compute the change in the hedged item’s fair value by using the same term as that of the hedging derivative).

Shortcut Method

The FASB tentatively decided to retain the existing shortcut method model but also allow an entity to document at hedge inception the long-haul method it would use to measure hedge ineffectiveness if the shortcut method could not be applied. If the entity later determines that continued use of the shortcut method is inappropriate, it can continue the hedging relationship by using the long-haul method designated at inception as long as the hedging relationship has been highly effective since inception. Moreover, an entity would need to assess whether the difference between applying the shortcut method and applying the long-haul method was material to determine whether restatement is required.

Next Steps

The FASB staff will (1) develop a staff draft reflecting the Board’s decisions; (2) analyze the costs, benefits, and potential complexity of the tentative decisions; and (3) identify any issues that need to be brought back to the Board for a vote. In addition, the FASB will need to address transition and the comment period of the proposed ASU.

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1 The benchmark rate definition in ASC 815-20 will not apply to these hedging relationships. (For titles of FASB Accounting Standards Codification (ASC) references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”)

2 Securities Industry and Financial Markets Association.