The Financial Accounting Standards Board (FASB) released its exposure draft on changes to ASC Topic 815 Derivatives and Hedging on Sept. 8, 2016, a precursor for the first major update to hedging since Statements of Financial Accounting Standards No. 133 was issued in 1998. The exposure draft is a result of the overall financial instruments project, which was ultimately segregated into several separate projects. The financial instruments classification and presentation and credit losses projects were finalized earlier in 2016. Amendments to the hedging model were originally proposed in 2008 and 2010 as part of the more broad financial instruments projects, however, the changes proposed by those exposure drafts were placed on hold to address other FASB initiatives. The September 2016 exposure draft takes a targeted approach to amending the hedging accounting model in ASC 815. The overall goal of the FASB is to reduce the complexity involved in the current hedge accounting model and better align the hedge accounting with the risk management practices of the reporting entity. This is designed to also make it easier for financial statement users to evaluate the economic results of hedging activities. The proposed amendments would be a significant change to the current hedge accounting model, which entails a rules-based approach and can often result in a punitive financial reporting impact when applied inappropriately. The amendments focus on aspects of qualifying hedging transactions, documentation requirements, effectiveness and ineffectiveness assessment requirements, as well as presentation and disclosure clarifications.

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A publication of the Professional Standards Group
October 2016
Improvements to Hedging on the Horizon
The Financial Accounting Standards Board (FASB)
released its exposure draft on changes to ASC Topic
815 Derivatives and Hedging on Sept. 8, 2016, a
precursor for the first major update to hedging since
Statements of Financial Accounting Standards No.
133 was issued in 1998. The exposure draft is a result
of the overall financial instruments project, which was
ultimately segregated into several separate projects.
The financial instruments classification project and
the presentation and credit losses project were
finalized earlier in 2016.
Amendments to the hedging model were originally
proposed in 2008 and 2010 as part of the more broad
financial instruments projects, however, the changes
proposed by those exposure drafts were placed on
hold to address other FASB initiatives.
The September 2016 exposure draft takes a targeted
approach to amending the hedging accounting
model in ASC 815. The overall goal of the FASB is
to reduce the complexity involved in the current
hedge accounting model and better align the hedge
accounting with the risk management practices of
the reporting entity. This is designed to also make it
easier for financial statement users to evaluate the
economic results of hedging activities. The proposed
amendments would be a significant change to the
current hedge accounting model, which entails a
rules-based approach and can often result in a
punitive financial reporting impact when applied
inappropriately. The amendments focus on aspects
of qualifying hedging transactions, documentation
requirements, effectiveness and ineffectiveness
assessment requirements, as well as presentation
and disclosure clarifications.
Qualifying Transactions
Shareholders have previously raised concerns about
the limitations of hedging accounting when hedging
certain financial and nonfinancial risks. The exposure
draft proposes an amendment to the designation
and measurement guidance for component hedging
transactions, benchmark interest rates and aspects of
fair value hedging.
Component Hedging – Non-financial items
The existing requirements in ASC 815 limit the use of
component hedging on nonfinancial items to hedging
of the changes in cash flows of the entire contract,
which often leads to disqualification of the hedge
relationship. The amendments in the exposure draft
would permit entities to designate the variability in cash
flows attributable to changes in a specified contractual
component for a forecasted purchase or sale of a
nonfinancial asset. The hedged component must be
a contractually specified component in the contract.
For example, if a contract price to purchase clothing
is tied to cotton prices, an entity could designate the
changes in the cash flows of the purchase contract
related to only the cotton prices with a cotton futures
or forward contract.

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Benchmark Interest Rates
The amendments would allow reporting entities to
hedge the risk of variability in cash flows on variable
rate instruments attributable to changes in any
contractually specified index. This would eliminate the
requirement to designate the overall variability in cash
flows as the hedged risk in a cash flow hedge of a
variable rate instrument indexed to a nonbenchmarked
interest rate, which would often lead to a conclusion
the hedging relationship does not qualify as an
effective relationship or lead to a significant source of
ineffectiveness. Therefore, the amendment will likely
lead to hedging relationships qualifying for hedge
accounting treatment that would otherwise not have
been determined to be highly effective.
For fixed rate financial instruments, the current
definition of benchmark interest rates would remain
with the addition of the Securities Industry and the
Financial Markets Association Municipal Swap Index
(SIFMA).
Fair Value Hedges
Ineffectiveness results from differences in the tenor
of a fair value hedging relationship as the entire
contractual term of the hedged financial instrument.
If approved, the amendments would allow entities to
assess effectiveness using the tenor of the hedging
instrument rather than the hedged item. As a result,
entities may hedge only a partial time period of the
cash flows in a fair value hedge without resulting in
ineffectiveness, which will lead to more transactions
qualifying for hedge accounting treatment.
Under the existing requirements of ASC 815,
ineffectiveness will result from the requirement that the
entire coupon rate of an interest-bearing instrument
be used to determine the change in fair value. As
a result, the credit component, which is included
in the coupon rate, will affect the assessment, and
result in ineffectiveness as the credit component is
not also resident in the hedging instrument. Under
the proposed amendments, when the market yield
(coupon rate) of the hedged item at the hedging
transaction inception exceeds the benchmark interest
rate, entities will be able to measure the change in
the fair value of the hedged item based on only the
benchmark component of the contractual coupon
cash flows determined at hedge inception.
The amendments will allow entities hedging
prepayable financial instruments to consider only
how changes in the benchmark interest rate affect a
decision to settle a prepayable financial instrument
before its maturity date when calculating the change
in fair value attributable to interest rate risk.
Hedge Documentation
The exposure amends the current requirement that the
documentation be prepared before hedge accounting
treatment can be applied (i.e. contemporaneous with
the hedging transaction) to allow the initial quantitative
effectiveness testing to be performed before or at the
end of the three-month effectiveness-testing period
(i.e. before March 31 for a hedging transactions
entered into during the first quarter of a calendar
year). Other requirements of the preparation of hedge
documentation would not change.
The guidance also provides an accommodation
related to the use of the short cut method of hedge
accounting. Under the current requirements, an entity
that determined it inappropriately applied the short
cut method of accounting to a particular transaction
concluded the application of hedge accounting was
inappropriate for all periods, including prior periods,
and often leads to a restatement of the prior period
financial statements. This was often viewed as a
punitive result for unintended application errors of ASC
815. As a result, the FASB has proposed to amend
the guidance to permit an entity that applies the short
cut method of accounting to document, at the hedge
inception, how the entity would apply the long haul
method of accounting to the hedge relationship if it is
determined the short cut method was inappropriate.

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The information in this MHM Messenger is a brief summary and may not include all the details relevant to your situation. Please
contact your MHM auditor to further discuss the impact on your audit or audit report.
If under the long haul method, the hedge relationship
would have been effective since inception, the use of
the short cut method is not required to be considered
an error, and the long haul method would be applied
prospectively.
Effectiveness Testing
The highly effective threshold would remain in
place, however, after the initial quantitative testing
of effectiveness, entities may perform a qualitative
effectiveness assessment in future periods.
Subsequent quantitative effectiveness testing is
required only if it is determined significant facts and
circumstances have changed, which may affect the
hedging relationship’s qualification as highly effective.
This proposed change is designed to reduce the
complexity and effort required to perform each
quarterly assessment of the hedging transaction.
Presentation and Timing
ASC 815 currently specifies how entities that apply
hedge accounting should record the portion of the
change in the fair value of the hedging instrument
that is effective at hedging the identified risk and the
portion that is considered “ineffective.” Entities are
required to separate the amount by which the hedged
instrument does not offset the hedged risk, considered
the ineffective amount. This practice has proved
difficult for financial statement users to understand,
so the FASB proposed moving away from separately
reporting hedge ineffectiveness.
The change in fair value of the hedging derivative
would no longer be divided between the effective
and ineffective portions. For fair value hedges, if
the hedging relationship meets the highly effective
threshold, the entire change in the fair value of the
derivative would be recorded in the same income
statement line as the hedged item. For cash flow
hedges, if the hedging relationship meets the highly
effective threshold, the entire change in the fair value
of the derivative would be recorded in accumulated
other comprehensive income.
Amounts reclassified from Accumulated Other
Comprehensive Income (AOCI) would be presented
in the same income statement line items as the
hedged item.
Disclosure
Additional disclosures are also required by the
exposure draft, including disclosure of the cumulative
basis adjustments to fair value hedges, certain
tabular disclosures focusing on the impact of
hedge accounting on income statement line items,
and enhanced qualitative disclosures designed to
describe quantitative goals, if any, set to achieve
hedge accounting objectives.
Next Steps
The comment period on the exposure draft ends
on November 22, 2016. The FASB will consider
comments before setting the effective date for the
final standard.
If you have any specific comments, questions or
concerns about the changes to hedge accounting,
please contact Mike Loritz of MHM’s Professional
Standards Group. Mike can be reached at mloritz@
cbiz.com or 816.945.5611.