No.

2015-41
1 July 2015

To the Point
FASB proposed guidance

FASB tries to make hedge accounting

easier to apply and understand

The FASB
tentatively decided
to make targeted
improvements
to its hedge
accounting model.

What you need to know

The FASB made a number of tentative decisions intended to make hedge accounting
easier for companies to apply and for users of the financial statements to understand.

The FASB tentatively decided to defer the recognition of ineffectiveness for cash flow
hedges until the hedged item affects earnings and allow companies to hedge
contractually specified components of nonfinancial items.

The FASB also tentatively decided to expand the types of interest rates that could be
designated as the hedged risk in cash flow and fair value hedges, relax certain hedge
effectiveness assessment requirements and address practice issues associated with
the long-haul method for fair value hedges of financial items.

The FASB plans to issue an exposure draft seeking comment on these proposals
during the fourth quarter of 2015.

Overview
The Financial Accounting Standards Board (FASB or Board) tentatively decided to make
certain targeted improvements to the hedge accounting model in Accounting Standards
Codification (ASC) 815 1 in an effort to make the accounting easier for companies to apply
and for users of the financial statements to understand.
The FASB had previously decided to make only targeted improvements to its hedge accounting
guidance rather than overhaul it completely. The targeted improvements the FASB tentatively
decided to make reflect feedback it received on hedge accounting proposals it issued in 2008 2
and in 2010 3 as part of its larger project on the accounting for financial instruments.

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The Boards tentative decisions cover a broad range of topics on hedge accounting for both
financial and nonfinancial items. The changes, if adopted, would reduce complexity for
companies that apply hedge accounting and provide financial statement users with better
insight into the hedging strategies companies use and their effectiveness.
The Board instructed its staff to begin drafting a proposed Accounting Standards Update
(ASU). The FASB plans to issue the proposed ASU in the fourth quarter of 2015.

Tentative decisions
Overall hedging model
In one of its most significant decisions, the Board tentatively decided to defer recognition of
ineffectiveness for cash flow hedges of both financial and nonfinancial items until the hedged
item affects earnings. This would mean that the entire change in the fair value of the hedging
derivative in a highly effective cash flow hedge would be deferred in accumulated other
comprehensive income (AOCI) and would be reclassified into earnings only when the hedged
item affects earnings (e.g., when interest expense is recognized, inventory is sold). At that
time, the relevant portion of AOCI (including both the effective and ineffective amounts)
would be released and presented in the same income statement line item as the hedged item.
For fair value hedges, the Board tentatively agreed that the entire change in fair value of the
derivative would also be presented in the income statement line item being hedged (e.g., interest
expense for a fair value hedge of fixed-rate debt).

How we see it
Under the Boards tentative decision, the effective and ineffective portions of a cash flow
hedge would be accounted for identically if the overall hedge relationship remains highly
effective. The FASB believes this approach would make the effect of hedging strategies
more transparent to users.

Nonfinancial hedging relationships

In another key decision, the FASB tentatively decided to allow companies to hedge
contractually specified components of nonfinancial items if it is probable they will have full
exposure to the component during the hedge relationship. Under current US GAAP,
companies are generally required to hedge the total price risk of nonfinancial items such as
commodities. This often results in the recognition of ineffectiveness, or even the failure to
achieve hedge accounting, because derivatives used to hedge these items are not typically
based on the total price risk of the nonfinancial items. Instead, the derivatives are based
solely on a market index related to the component being hedged.
This decision could increase the number of nonfinancial hedging strategies that would qualify
for hedge accounting as the underlying of the derivative would be more closely aligned with
the component being hedged.

How we see it
Current US GAAP allows entities to hedge the benchmark interest rate risk associated with
financial instruments. Companies that hedge commodity risk believe this is akin to hedging
a component of a nonfinancial item, which is currently not permitted. Allowing companies
to hedge contractually specified components of nonfinancial items would eliminate this
inconsistency in the hedging guidance.

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Financial hedging relationships

The Board made the following tentative decisions on hedging benchmark interest rates in
financial items:

Variable-rate hedged items The Board tentatively decided to eliminate the requirement
that only specified benchmark interest rates could be hedged for these items. Instead, the
Board decided to allow companies to designate any contractually specified index rate as
the hedged risk (e.g., the prime rate at a particular financial institution).

Fixed-rate hedged items The Board effectively decided to retain the benchmark interest
rate requirement for these items but add the Securities Industry and Financial Markets
Association (SIFMA) municipal swap rate to the list of permitted benchmark interest rates.

The Board also tentatively decided to simplify the application of the long-haul method for fair
value hedges of financial items by allowing companies to:

The tentative
decisions would
reduce some of
the ineffectiveness
currently recognized
when the long-haul
method is used for
fair value hedges.

Measure and assess changes in the fair value of the hedged item using only the portion of
the contractual cash flows related to the benchmark interest rate, not the entire coupon

Consider the effect of a prepayment option in callable debt only as it relates to the risk
being hedged (e.g., benchmark interest rate risk)

Assume that the principal amount of the hedged item is due at the derivatives maturity
date when designating a partial-term hedge

In addition to simplifying the application of the long-haul method, these tentative decisions
would reduce ineffectiveness recognized in the income statement.

Shortcut method
The Board tentatively agreed to retain the shortcut method but address concerns about
restatement risk. The Board tentatively decided to allow an entity to apply the long-haul
method if a company inappropriately used the shortcut method. A company would have to
demonstrate that the hedge relationship is highly effective under the long-haul method and
have documented this alternative at inception.

How we see it
Under existing guidance, an entity that inappropriately applied the shortcut method has to
assess the materiality of the misstatement based on the reported results as if no hedge
accounting had been applied. Allowing an entity to retroactively apply the long-haul
method (if the hedge would have been effective under this method) would often reduce the
size of the correction and would therefore reduce the risk of restatement.

Other tentative decisions

While companies would still have to perform initial quantitative effectiveness testing (unless
the hedges qualify for the shortcut or critical terms match methods), the Board tentatively
decided to reduce the administrative burden of applying hedge accounting by:

Requiring subsequent quantitative testing only if facts and circumstances change

Allowing the quantitative portion of the hedge assessment to be performed up to the end
of the quarter within which it was designated

3 | To the Point FASB tries to make hedge accounting easier to apply and understand 1 July 2015

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To help users of the financial statements better understand the effects of hedge accounting,
the Board tentatively decided to require the following disclosures:

Disclosure of the cumulative basis adjustment to the hedge item in fair value hedges

Tabular disclosure that shows the effect of hedge accounting on the income statement
(e.g., for each applicable line item, separate presentation of the amount recognized for
the hedging instrument as well as the hedged item)

Qualitative disclosure to describe any quantitative goals for the hedging program
(e.g., the entity aims to hedge 90% of its exposure to a certain risk for up to 12 months)

Finally, consistent with existing guidance, the Board tentatively decided that entities may
voluntarily dedesignate their hedge relationships.

How we see it
How much relief the proposed limit on performing subsequent quantitative effectiveness
testing will provide depends on how broadly the FASB describes a change in facts and
circumstances in the proposed ASU.

Whats next
The FASB will discuss the transition approach and comment period before the proposed ASU is
issued. During the drafting process, the staff may identify other issues for the Board to address.
Endnotes:
1
2
3

EY | Assurance | Tax | Transactions | Advisory

2015 Ernst & Young LLP.
All Rights Reserved.
SCORE No. BB3007

ey.com/us/accountinglink

ASC 815, Derivatives and hedging.

Exposure Draft, Accounting for Hedging Activities.
Proposed Accounting Standards Update (ASU), Accounting for Financial Instruments and Revisions to the
Accounting for Derivative Instruments and Hedging ActivitiesFinancial Instruments (Topic 825) and Derivatives
and Hedging (Topic 815).

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