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FASB continues redeliberations on targeted improvements to hedge accounting

Published on: 10 Mar 2017

At its March 8, 2017, meeting, the FASB continued its redeliberations on its 2016 proposed Accounting Standards Update (ASU), Targeted Improvements to Accounting for Hedging Activities, and made tentative decisions about whether (1) the “market yield” test should be retained in the proposed ASU and (2) the “last-of-layer” approach should be incorporated into the targeted improvements for fair value hedges of interest rate risk of prepayable instruments.

The Board tentatively concluded the following: 

  • Market yield test — The Board tentatively decided to remove the market yield test requirement for fair value hedges of interest rate risk under the proposed ASU. The proposal would have required entities to use the “full contractual coupon cash flows of the entire hedged item in calculating the change in the hedged item’s fair value attributable to changes in the benchmark interest rate” if the current market yield of the hedged item was less than the benchmark interest rate at hedge inception. As a result of the tentative decision, entities entering into fair value hedges of interest rate risk would be able to choose, at hedge inception, to use either the total contractual coupon cash flows or the benchmark interest rate component cash flows to determine the change in fair value of the hedged item attributable to changes in the benchmark interest rate.
  • Last-of-layer approach — The Board tentatively decided to incorporate a last-of-layer approach into the targeted improvements addressed by the current hedging project. This approach would allow entities to hedge interest rate risk in a closed portfolio of prepayable assets (e.g., residential mortgage loans) or a prepayable asset (e.g., a mortgage-backed security) by designating, at hedge inception, a “last dollar amount” as the hedged item. Under this approach, entities would assume that prepayments (if they occur) would first apply to the layer of the closed portfolio of prepayable assets or the prepayable asset that is not part of the designated hedged layer (i.e., the last dollar amount). Subsequently, whenever the entity assesses hedge effectiveness, it will also evaluate the expected performance of the asset(s) “to determine if the amount remaining at hedge maturity is still expected to exceed or be equal to the last of layer.”

Editor’s Note: The last dollar amount concept effectively eliminates prepayment risk from the hedging relationship as long as the entity can continue to assert that the last dollar amount will remain at the maturity of the hedging relationship. When an entity applies this concept in concert with its application of the Board’s other targeted improvements related to (1) permitting partial-term fair value hedges of interest rate risk and (2) enabling an entity to calculate the change in the fair value of the hedged item in a fair value hedge of interest rate risk by using the benchmark interest rate component of total contractual coupon cash flows, it would also “be able to apply the ‘similar assets’ test to [a] closed portfolio qualitatively and only at inception of the hedging relationship.”

Because the last-of-layer approach was not addressed in the proposed ASU, the FASB staff included draft last-of-layer approach guidance as part of the Board meeting handout.

Refer to the summary of tentative Board decisions for additional information.


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