By Rich Daisley, CPA
In its recent issuance, ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, the FASB both simplified certain elements of hedge accounting under Topic 815 as well as increased the types of effective risk management strategies for which hedge accounting treatment would be applicable. In responding to demands from stakeholders that the current voluminous rules often resulted in a financial statement mismatch between effectively hedging risk and reporting on these hedges, the amendments in ASU No. 2017-12 are welcomed by the often big entities that use derivatives as part of their risk management strategy today.
However, smaller entities, including those that don’t currently use derivatives to hedge financial statement risk, may be wondering what is the impact of ASU No. 2017-12? They should assess the impact of this new standard to determine if now is the time to begin using derivative financial instruments to help manage their financial risks.
Often the financial risks due to changes in expected cash flows or the fair value of assets and liabilities are the same for smaller entities as they are for larger ones. The biggest difference is the overall size of the exposure. Many smaller entities shied away from employing derivatives due to the costs of complying with the complex accounting guidance of ASC 815. As a result, these entities, while maintaining simplified accounting, risked reducing the value of their entities. While this risk may have been manageable in the low interest rate, low inflation economic environment of the past few years, these risks are rapidly growing, given the expectations of both higher interest rates and inflation. The changes in this environment could result in a change in the cost-benefit analysis which supported an entity’s decision to not engage in derivatives in order to protect the value of its assets and liabilities.
ASU No. 2017-12 makes a variety of changes to the rules governing cash flow and fair value, as well as all hedges, with the net effect being that it should be easier to achieve hedge accounting treatment for more types of derivatives. However, the changes most likely to benefit smaller entities deal with the timing of the required documentation to support hedge accounting treatment.
Currently, all such documentation, including discussions of the entity’s overall hedging strategy, risks being hedged and its original assessment of hedge effectiveness must be performed contemporaneously with the entities entering into the hedging relationship. Under ASU 2017-12’s revisions, the documentation of original hedge effectiveness must be completed by the date of the non-public entity’s first financial statements following the transactions, though the other documentation must still be completed at the date of the hedging transaction. Additionally, entities can perform ongoing effectiveness testing on a qualitative basis, if certain conditions are met, as opposed to the ongoing quantitative assessment currently required. Lastly, the accounting for the ongoing changes in fair value of the hedging derivative has also been simplified for cash flow hedges. Under the new model, entities no longer need to compute and separately report the change in fair value of the ineffective portion of an overall effective cash flow hedge.
Collectively, these changes could make hedging transactions more appealing to smaller entities, who generally avoided such transactions due to the complexity of their accounting. However, for an entity with variable rate debt or one that has large requirements of commodity-based raw materials, the benefits of locking in their cash flows–whether they be for interest expense or for future purchases or sales of materials–may be sufficient to change the cost-benefit equation.
If you haven’t already, now is the time to take a look at these transactions, assess any value that is currently being leaked or will be in the future due to changes in cash flows, and re-run that cost-benefit equation in light of this new Update. My guess is that you may get a different answer under these new set of rules. Be sure to watch my schedule of upcoming live CPE webinars for more on this topic.
Rich Daisley is Senior Director, Accounting and Financial Reporting Content for Surgent CPE. With over 26 years of experience in the accounting and auditing field, Mr. Daisley has worked in both the client service setting, mainly for PwC’s Capital Markets and Accounting Advisory Services Group and for PECO Energy’s Merger and Acquisition Group, and in the internal capacity setting as a course developer and facilitator creating leading training courses for PwC and Surgent. Rich lives in suburban Philadelphia.