At its March 28, 2018, meeting, the FASB discussed a number of implementation issues related to ASU 2017-12¹ that arose from technical inquiries received by the FASB staff from various constituents. The staff shared with the Board its responses to those inquiries and questioned whether the Board agreed with the conclusions. The following issues were addressed:

Hedging Contractually Specified Components

Upon adopting ASU 2017-12, entities may designate the variability in cash flows attributable to changes in a contractually specified component (CSC) of a forecasted purchase or sale of a nonfinancial asset as the hedged risk in a cash flow hedge. At the meeting, the staff shared the following interpretations of how to apply the CSC hedging model:

• A hedging relationship must meet the criteria in ASC 815-20-25-22A and 25-22B to qualify for the CSC hedging model.
• When the CSC is explicitly referenced in supporting documents or sub-agreements (and not in the contract itself), the hedging relationship still must meet the requirement in ASC 815-20-25-22A.²
• An entity must analyze a not-yet-existing contract both (1) at hedge inception to determine whether it will meet the criteria in ASC 815-20-25-22A and (2) at the contract execution date to ensure the criteria were met.

The FASB staff acknowledged that an entity will need to exercise judgment to satisfy this requirement, for example, when it assesses whether a supporting document or not-yet-existing contract, or receipts in spot market transactions (1) would qualify for the normal purchases and normal sales scope exception or (2) will contain embedded derivatives that would need to be excluded from the analysis. However, the staff expects that practice will evolve and entities will be able to develop methods for making such assessments. The staff indicated that one acceptable approach might be to use a hypothetical contract to assess whether the criteria would be satisfied.

The staff noted that in CSC hedging relationships, when “an entity does not have a contract at hedge inception, it must develop an expectation . . . that when the transaction is entered into:

• i. The written agreement for a forecasted purchase or sale will contain an explicitly referenced [CSC].
• ii. The pricing formula that references the explicitly referenced [CSC] will determine the price of the nonfinancial item.
• iii. The requirements for cash flow hedge accounting will be met.
• iv. The agreement will be substantive.”

The staff also noted that, at hedge inception, an entity will need to exercise some level of judgment to develop its expectations about the contracts and transactions, and that it will be easier for an entity to develop such expectations if it has previous experience with the type of transaction that is anticipated.

In addition, the staff recommended monitoring implementation issues related to the CSC model through the creation of a project resource group composed of a cross-section of stakeholders.

The Board agreed with the staff’s conclusions and supported the formation of a project resource group to monitor implementation issues related to the CSC model and other topics if needed.

Multiple Partial-Term Fair Value Hedges of Interest Rate Risk in a Single Financial Instrument

The Board agreed with the FASB staff’s interpretation that the partial-term fair value guidance should apply to “simultaneous multiple partial-term hedging relationships for a single debt instrument (for example, consecutive interest cash flows in Years 1−3 and consecutive interest cash flows in Years 5−7 of a 10-year bond).” However, the staff cautioned that “this conclusion should not be analogized to the last-of-layer method until further research is conducted” for a multiple-layer hedging strategy under the last-of-layer method (see discussion below).

Last-of-Layer Method

The FASB staff received multiple inquiries related to the application of the last-of-layer (LoL) method, which allows an entity to designate the portion of a closed pool of prepayable assets not expected to be prepaid as the hedged item in a fair value hedge. The Board agreed with the staff’s recommendations to:

• Add a narrow-scope project to the Board’s agenda to address accounting for LoL basis adjustments and hedging multiple layers under the LoL method. In their discussion, Board members noted that ASU 2017-12 did not contemplate LoL hedging strategies that involved multiple layers.
• Exclude from the narrow-scope project any consideration of expanding the scope of the LoL to include prepayable liabilities or nonprepayable financial assets.

Changes in Hedged Risk in Cash Flow Hedges

ASU 2017-12 allows an entity to retain hedge accounting when the designated hedged risk in a cash flow hedge of a forecasted transaction changes if the derivative designated as the hedging instrument remains highly effective at achieving offsetting cash flows attributable to the revised hedged risk. To respond to various inquiries that it has received, the FASB staff recommended providing the following clarifications (i.e., potential Codification improvements) in the guidance on changes in the hedged risk:

• “The hedged forecasted transaction and hedged risk are distinct.”
• An entity may continue to apply hedge accounting when the hedged risk changes if the revised hedging relationship remains highly effective, even if the original hedge documentation did not distinguish between the hedged risk and the hedged forecasted transaction.
• “The hedged forecasted transaction may not be documented so broadly such that if a change in hedged risk occurs, it does not share the same risk exposure as the originally designated hedged forecasted transaction.”
• When the hedging relationship is no longer highly effective as a result of a change in the hedged risk, an entity must cease hedge accounting. Any amounts associated with the hedge will remain in accumulated other comprehensive income until the hedged forecasted transaction affects earnings, unless it becomes probable that the forecasted transaction will not occur.
• “Hindsight may be applied in identifying transactions as hedged transactions. However, an entity must first identify transactions as hedged transactions based on the originally documented hedged risk. Only when there are no transactions or insufficient transactions based on the originally documented hedged risk may the entity consider transactions based on other risks. If a transaction occurred in a prior reporting period, it may be retrospectively identified as a hedged transaction if it has not yet affected reported earnings.”

The Board directed the staff to solicit external review feedback on these proposed improvements.

See the meeting handout and summary of tentative Board decisions for additional information.

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1 FASB Accounting Standards Update (ASU) No. 2017-12, Targeted Improvements to Accounting for Hedging Activities.

2 Under ASC 815-20-25-22A, to qualify for CSC hedging, a contract to purchase or sell a nonfinancial asset must either be (1) a derivative in its entirety, to which the entity applies the normal purchases and normal sales derivative scope exception, or (2) not a derivative in its entirety, in which case the CSC must be a component remaining in the host contract after any embedded derivatives have been bifurcated from the contract to purchase or sell a nonfinancial asset.