The Financial Accounting Standards Board (FASB) has finally implemented long-overdue relief(1) for certain private companies from some of the more onerous requirements of hedge accounting (see derivative accounting basics and/or, if you have the stomach, ASC 815-20-25). The new “simplified hedge accounting” (see ASC 942-320-50-1) is available for a very narrow but important band of hedging transactions called interest rate swaps that meet specific criteria including:
– The swap must be convert either forecasted interest payments or forecasted issuance(s) of variable-rate debt to fixed-rate debt;
– The swap and the related hedged debt instrument must be based on the same interest rate index and reset period (which may now be a non-benchmark rate – see ASC 815-20-25-6A);
– The swap must be a plain vanilla swap;
– Repricing and settlement dates of the swap and the related debt must match or be within a few days of each other;
– The swap’s value at inception must be zero and nearly zero (e.g., de minimus);
– The notional amount of the swap must match the principal amount of the debt, thought the amount of debt being hedged can be be less than the total amount borrowed;
– All variable-rate interest payments on the debt must be designated as hedged either in total or in proportion to the amount of dent designated as hedged.
An interest rate swap is a derivative instrument that is generally used to convert floating rate debt to variable rate debt. Previously under ASC 942, an entity entering into an interest rate swap had to meet strict requirements, including documenting the hedging relationship, at the time the swap was entered into. While this does not seem all that big of a deal, you must remember that most financings do not involve the accountants. In fact, accountants are often the last to know that something has taken place since, as historians, we spend most of our time looking in the rear view mirror. So, when the finance folks enter into floating rate debt then seek to convert that debt to a fixed rate with a swap, they often do so without any knowledge of the accounting rules governing hedge accounting.
Why does hedge accounting matter? Well, any instrument meeting the definition of a derivative, like a rate swap agreement, must be accounted for at fair value (under the old rules anyway…see below). This is also known as mark-to-market accounting. Basically, the fair value of the derivative is determined using one of a variety of methods and the carrying value is adjusted on each balance sheet date. Hedge accounting affects how the change in fair value from one period to another is reported by the entity. If the instrument qualifies for hedge accounting, then much or all of the change in fair value is reported in “other comprehensive income” in the equity section of the balance sheet. There is little or no effect, i.e., gain or loss, reported on the income statement. If hedge accounting is not applied, then the full gain or loss each period is reported in earnings and may cause significant fluctuations in net income or loss if interest rates swing significantly each period.
The new “simplified hedge accounting” removes much of the difficulty of qualifying for hedge accounting by allowing retrospective adoption of hedge accounting for an interest rate swap. Now the accountants can find out about the transaction after the fact and still have the derivative qualify for hedge accounting. Very cool! Additionally, the new rules allow the entity to assume full effectiveness of the hedge without performing rather complicated calculations each reporting period. So now a rate swap whose measurement dates are a few days from those of the related debt instrument can be assumed to be fully effective, i.e., no ineffectiveness.
One other important area of relief is the carrying value of the hedging instrument. Under the old rules, the instrument had to be reported at fair value. This required a valuation of the rate swap at each balance sheet date. Under the new rules, the carrying value is reported at the rate swap’s settlement value. Settlement value is basically the present value of the future net payments to be made under the terms of the swap agreement. Fair value, on the other hand, is similarly a present value calculation that also takes into account the probability of nonperformance by each party (the entity and the swap counterparty) as well. There are a number of methods for forecasting future net payments using published interest rate yield curves or yield curves implied by interest rates of various maturities. For example, a method know as bootstrapping will provide a rough yield curve by computing implied forward interest rates from published market interest rates. One good source of published market rates is the US Federal Reserve website.
Please note that an entity is still required to document the hedging relationship and that hedge accounting will be applied. The entity must also formally adopt the simplified method for the hedge in lieu of “normal hedge accounting”. As noted above, this can be done retrospectively. It should also be noted here that since public companies are not be eligible for simplified hedge accounting, an entity planning to go public in the near future would have to comply with the requirements of standard hedge accounting in its registration statement and in future filings.
The simplified hedge accounting method is elective and is effective for years beginning after December 15, 2014. This method may be adopted early and may be applied to 2013 calendar year financial statements if they have not already been issued at the time of adoption.
(1) Accounting Standards Update (ASU) 2014-03, Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps — Simplified Hedge Accounting Approach.