The FASB updates for ASC-815 aren’t required to be implemented until the new year beginning after December 15, 2018, but early adoption efforts are well underway and offer a glimpse into the impact the new rules will have on everything from accounting processes to hedge strategies as a whole.
Moving toward more democratized margin protection
The biggest change that comes with the updates to ASC-815 is a new recognition that hedging is critical to many businesses where margins are at risk due to volatility.
It is no secret that the FASB rules for hedging had become so prohibitive that only exceptionally large corporations felt confident navigating and managing compliance efforts. While the original FAS133 undoubtedly eliminated derivatives executed ignorantly or speculatively, the FASB rule was so onerous, companies that really needed to hedge and needed to show that margin protection at work with special hedge accounting–especially with commodities–were just unable to comply. Even straightforward currency risk hedging was frequently avoided as auditors cautioned companies away from the audit risk associated with hedge accounting.
Non-GAAP reporting became “the tool” that financial statement readers came to rely on to evaluate whether hedge programs were protecting margins. That was working effectively for the readers until the SEC discovered some preparers were manipulating the non-GAAP contract settlements to further enhance results.
This update to ASC-815 levels the playing field and makes great strides toward democratizing special hedge accounting. It also sets expectations for a shift in auditor focus from targeting and punishing companies for hedging to ensuring companies are doing it well and effectively.
Profile of early adopters
With special hedge accounting now more accessible, it is not surprising to see a wide range of companies early adopting. They essentially fall into three categories:
- Companies that, to date, have been reporting ineffectiveness in their hedge programs because they couldn’t prove a perfect hedge relationship. They already have processes or systems and are eager to take advantage of the hedge accounting simplifications offered by the new guidance.
- Companies with hedge programs in transition. Maybe they have FX hedges but are eager to apply the new rules to hedge commodity or interest rate volatility that is threatening their financial results. Treasuries with an unusual or new type of transaction are wisely choosing to simply begin their program within the new rule.
- Companies that have made an acquisition or are just starting a hedge program are starting them under the new guidance. The new accounting rules are simpler–and why implement or two different programs, then turn around and implement again within a year.
The early adoption bell curve
While we had anticipated (and experienced) a flood of early adopters when the rules came out in August, it appears two drivers have dampened adoption:
Revenue recognition guidance has also changed and is core to every business. Since hedging is core to only a very few, the updates to ASC-815 are competing with rev rec for mind share. In this climate, hedging changes are often considered “nice to haves” rather than “must haves”.
Key decision makers in adopting new guidance are often not involved in accounting for derivatives. Many Treasury organizations are preparing the journal entries and just as frequently the disclosures for hedge accounting resulting in a responsibility gap. Essentially, those who have the power to enable early adoption are not necessarily those who benefit.
Not surprisingly, many companies are still evaluating early adoption rather than jumping right in. Once the decision is made, however, implementation is usually fast and painless. We expect to see additional early adopters once the Q1 financials are issued and accounting organizations, especially among those with commodities hedging programs.
Highlights of ASC-815 Update Impacts
Looking back at the early adoptions that have already been or are being implemented, we can make the following observations:
- Companies that have been reporting perfect hedge relationships will likely see no change as the new rules still allow the accounting of derivatives as perfect. This will also reduce the audit risk for those companies that have been designating and reporting on hedge relationships as perfect and that have not met the rigorous historical requirements for critical terms match relationships.
- For companies reporting ineffectiveness, the update will serve to simplify their accounting efforts and allow them to eliminate the no-value add calculations previously required to record and report ineffective amounts—the new guidance provides for reporting 100% of the derivative’s gain or loss to OCI for cash flow hedges. For fair value hedges there may be ineffectiveness “fall-out” in earnings as both the hedged item and derivative are fair valued and impact earnings.
- Changes to the geography of Gains and Losses reporting have been one of the more disruptive elements for early adopters. The new rule mandates where gains and losses have to go for all components of the derivative. While this doesn’t really affect interest rate hedging programs, in Currency, companies have gotten used to a level of flexibility that no longer exists. The rule requires companies to follow the income statement geography of the defined hedge items which doesn’t always reflect what they’re trying to do economically. This will be an adjustment for all implementations early or otherwise and requires companies to carefully consider how to position, communicate and manage this change both with internal management and investors or other stakeholders.
- A new table has been added to the ever-growing disclosure requirements associated with hedging, but no new information is required in these disclosures. We have been encouraging companies to take this as an opportunity to review and refresh their derivative and hedging disclosures as a whole. The update gives companies an excuse to revisit their disclosures make sure they are substantive and specific, meeting all the requirements.
- Including rather than excluding time value will now simplify the accounting process. Historically companies excluded time value to simplify the application of ASC815. Now including time value in hedge relationships is likely to simplify the calculations. Those who chose to exclude will benefit from the new rules enabling companies to straight-line the time value through income. If companies want to exclude and do not want to change their current practice of recording the market amortization of time value they will need to make and disclose that election.
A Few Predictions
Looking forward, we expect to see the following shifts in the industry as the FASB update to ASC-815 is fully implemented across the board:
- The impact of hedge programs on the hedged items in the income statement will become transparent and increasingly relevant due to the new restrictions on where gains and losses are reported.
- Treasury and Accounting personnel will be able to focus on exposure identification and quantification as most hedge programs will use simple instruments to hedge simple exposures, bypassing the need for statistical analysis.
- Audit scrutiny should shift from policing and disciplining to understanding the mechanics of the hedging relationships and ensuring accurate representation in the financial statements.
- Companies will be motivated to update their hedging processes and systems as they discover inflexibility or limitations during their efforts to comply to the new rule.
- There will be an increased interest in starting hedging programs as companies realize how the rule change eliminates barriers to special hedge accounting and they can safely protect their margins.