Simplified accounting for private companies: Certain interest rate swaps

Transcription

1 Simplified accounting for private companies: Certain interest rate swaps Prepared by: Faye Miller, Partner, National Professional Standards Group, RSM US LLP Paige Kuroyama, Partner, Western Regional Professional Practice, RSM US LLP December 2014 (Updated May 2018) Background In January 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) , Derivatives and Hedging (Topic 815): Accounting for Certain Receive- Variable, Pay-Fixed Interest Rate Swaps - Simplified Hedge Accounting Approach. As background information, Topic 815 of the FASB s Accounting Standards Codification (ASC), Derivatives and Hedging (ASC 815), requires derivatives, such as interest rate swaps, to be recognized on the balance sheet at fair value, with changes in fair value recognized through the income statement unless the entity elects and qualifies for hedge accounting. It is not uncommon for lenders to require an entity desiring a fixed-rate borrowing to enter into a variable-rate borrowing with a separate interest rate swap agreement to economically obtain the desired fixed rate. While hedge accounting is generally desirable to avoid income statement volatility and to reflect the fixed rate of interest in the financial statements, the pre-existing provisions of ASC 815 to achieve hedge accounting are considered to be very complex. ASU provides certain private companies with an option to apply a simplified hedge accounting approach under ASC 815 for receivevariable, pay-fixed interest rate swaps used to convert variable-rate borrowings to fixed-rate borrowings. The benefits of an entity electing the simplified approach for qualified swaps and borrowings include: The ability to make the election on a swap-by-swap basis and assume no ineffectiveness with the hedge relationship The ability to elect to measure the swap at settlement value instead of fair value The extension of the date for which all documentation for the election is required to be in place to the date on which the annual financial statements are available to be issued This white paper provides additional information about the requirements to apply the simplified hedge accounting approach (hereafter referred to as the simplified approach), as well as other relevant information regarding the scope of the ASU, documentation considerations, disclosures and transition. In addition, Appendix A includes a sample of the documentation that could be prepared by an entity in connection with electing the simplified approach. Due to changes made in 2016, discussed later in the section, Effective date and transition, a private company may elect the alternative in any future reporting period. Additional information

2 about the effective date, as well as important points for private companies to consider before making a decision to elect the simplified approach, are provided later in this white paper. Scope The simplified approach is available to certain private companies, more specifically entities other than the following: (a) those that meet the definition of a public business entity (PBE) or not-for-profit entity as defined in the Master Glossary of the ASC, (b) employee benefit plans that fall within the scope of the related topics in the ASC (Topics 960, 962 and 965) and (c) financial institutions, which includes banks, savings and loans associations, savings banks, credit unions, finance companies and insurance entities. With the exception of the exclusion for financial institutions, this scope is consistent with the scope of the Private Company Decision-Making Framework. The Private Company Council (PCC) excluded financial institutions from the scope of the ASU under the belief that such entities generally use numerous derivative instruments and have adequate resources to comply with ASC 815. The FASB recently issued ASU , Definition of a Public Business Entity - An Addition to the Master Glossary, which added the definition of a PBE to the ASC. Entities who are considering electing the simplified approach should pay careful attention to this definition as it is broader than the terms public entity and publicly traded company used throughout the ASC. For additional information about the new definition, refer to our article, Q&A on the new public business entity definition. The simplified approach can be elected on a swap-by-swap basis for both existing swaps at the date of adoption and those entered into subsequent to adoption, as long as all relevant criteria are met. Simplified approach Under the simplified approach, an entity is able to assume no ineffectiveness for qualifying swaps and, as a consequence, record periodic interest expense as though it had entered into a fixed-rate borrowing as opposed to a variable-rate borrowing and interest rate swap. This approach can only be elected when all the following criteria are met: Both the variable rate on the swap and the borrowing are based on the same index and reset period (e.g., both are based on one-month London Interbank Offered Rate [LIBOR] or both are based on three-month LIBOR). The terms of the swap are typical (i.e., a plain vanilla swap), and there is no floor or cap on the variable interest rate of the swap unless the borrowing has a comparable floor or cap. The repricing and settlement dates for the swap and the borrowing match or differ by no more than a few days. The swap s fair value at inception (i.e., at the time the derivative was executed to hedge the interest rate risk of the borrowing) is at or near zero. The notional amount of the swap matches the principal amount of the borrowing being hedged. For this condition to be met, the amount of the borrowing being hedged may be less than the total principal amount of the borrowing. All interest payments occurring on the borrowing during the term of the swap (or the effective term of the swap underlying the forward starting swap) are designated as hedged (whether in total or in proportion to the principal amount of the borrowing being hedged). In establishing the preceding criteria, the PCC decided to limit the use of the simplified approach to a narrow set of circumstances that commonly pose practice issues for private companies. With regards to interest rate swaps and borrowings that contain caps or floors on the variable rate, the use of the word comparable in the second criterion does not necessarily mean equal. For example, assume an interest 2

3 rate swap has a variable rate based on LIBOR and the borrowing has a variable rate of LIBOR plus 2 percent. A 10 percent cap on the swap would be comparable to a 12 percent cap on the borrowing. Forward-starting swaps can also qualify for the simplified approach as long as the interest payments to be swapped are probable and all other criteria are met. For example, a two-year interest rate swap forward starting in three years could meet the required criteria if executed in the beginning of the first year of a five-year borrowing. In addition, a five-year interest rate swap forward starting in one year could meet the required criteria for a five-year borrowing forecasted to occur in one year. It is also evident from the ASU s Basis for Conclusions that borrowings with different options for the variable-rate index are eligible for the simplified approach if the required criteria are met at the inception of the interest rate swap agreement. If the borrower subsequently elects a different rate index or reset period that differs from the swap, the hedge would be disqualified or de-designated as elaborated on later in this white paper. While the preceding discussion constitutes a summary of the criteria that must be met to qualify for the simplified approach, it is important to keep in mind that pre-existing requirements in ASC 815 pertaining to cash flow hedge accounting in general also apply when the simplified approach is elected. This would include, for example, the requirement in ASC to consider the likelihood of the counterparty s compliance with the contractual terms of the swap on an ongoing basis. Documentation of election Entities have until the date on which the annual financial statements are available to be issued to complete the required documentation to elect the simplified approach. This is a significant concession from the general requirements of ASC 815, which mandates that prescribed documentation be in place at the inception of any hedge. Based on the PCC s outreach and comment letters to the related exposure draft, the documentation requirements of ASC 815 were challenging for private companies as they typically lack the expertise or staff to ensure the documentation is in place at the inception of hedges. The lack of documentation at inception of the hedge was typically one of the reasons why a private company could not apply hedge accounting in the past. It is important to note that while the documentation to elect the simplified approach does not need to be contemporaneous, it does need to meet the stringent and detailed requirements of ASC with regards to content. Additionally, while the ASU provides additional time for the election to apply the simplified approach to be made and documentation to be put in place, it would be prudent for reporting entities to not delay this process, particularly for new interest rate swaps. In the event the entity and (or) hedge does not meet the requirements to use the simplified approach, reporting entities who desired to apply hedge accounting would need to comply with the contemporaneous documentation and other requirements of the general provisions of ASC 815. Appendix A includes a sample of the documentation that an entity could prepare in connection with electing the simplified approach. Measurement If the simplified approach is elected for any swaps, the entity also has the option to record those swaps at settlement value rather than fair value. The primary difference between settlement value and fair value is that nonperformance risk is not considered in determining settlement value. Settlement value is typically estimated using a valuation technique that is not adjusted for nonperformance risk (e.g., a present value calculation of the swap s remaining estimated cash flows using a discount rate that represents a risk-free rate). De-designation or termination of hedge If any of the required criteria for applying the simplified approach subsequently cease to be met or the relationship otherwise ceases to qualify for hedge accounting, the general provisions of ASC 815 would apply at that date and on a prospective basis. For example, if the related variable-rate borrowing is 3

4 prepaid without terminating the swap, the amount in accumulated other comprehensive income associated with the swap would immediately be reclassified into earnings in accordance with ASC Additionally, unless designated under a new hedge under the general provisions of ASC 815, the swap would be subsequently measured at fair value with the changes in fair value recognized in earnings on a prospective basis as those changes occur. Conversely, if the swap is terminated early without the related variable-rate borrowing being prepaid, the gain or loss on the swap in accumulated other comprehensive income would generally be reclassified into earnings in the same period or periods over which the hedged transactions (variable interest payments on the borrowing) affect earnings. Disclosure The disclosure requirements under ASC 815 continue to apply for swaps for which the simplified approach is elected, as do the fair value disclosures required by ASC 820, Fair Value Measurement. If an entity elects to use settlement value instead of fair value as the measurement basis, settlement value is replaced for fair value in the disclosures, with amounts recorded at settlement value disclosed separately from amounts recorded at fair value. The ASU may also make it possible for more entities to be exempt from the fair value disclosure requirements in ASC 825, Financial Instruments, as it relates to all their other financial instruments. Swaps for which the simplified approach is applied are not considered to be accounted for as derivative instruments under ASC 815 for purposes of the exemption outlined at ASC Therefore, if an entity has less than $100 million in total assets and previously its only derivative instruments were interest rate swaps for which it has now elected the simplified approach, the entity will no longer have to provide the additional fair value disclosures. Finally, entities should disclose the accounting policy for its derivatives, including those swaps for which the simplified approach is elected, as well as the required disclosures regarding the change in accounting principle for the year of adoption. Effective date and transition In 2016, the FASB issued ASU , Intangibles - Goodwill and Other (Topic 350), Business Combinations (Topic 805), Consolidation (Topic 810), Derivatives and Hedging (Topic 815): Effective Date and Transition Guidance (a consensus of the Private Company Council). ASU removes the effective dates of ASU and the other three private company ASUs issued in ASU allows a private company to elect the simplified hedge accounting alternative in any future accounting period without establishing preferability under Topic 250, Accounting Changes and Error Corrections. ASU also eliminates the requirement for a private entity electing a private company accounting alternative to retrospectively apply a change in accounting principle to all periods presented a requirement under Topic 250 generally applicable to accounting changes. Regarding transition, the amendments in ASU indefinitely extend the transition guidance in all private company alternatives. For the simplified hedge accounting alternative, elimination of its effective dates and extension of its retrospective transition guidance means that a private company voluntarily electing to adopt ASU will be allowed to apply the simplified hedge accounting approach to existing swaps upon initial election of the simplified hedge accounting approach. A private company will choose either the modified retrospective method or the full retrospective method to apply the approach as of the beginning of the first fiscal year in which it is elected. Under a modified retrospective approach, offsetting adjustments are made to the assets, liabilities and opening balances of accumulated other comprehensive income and retained earnings of the current period presented to reflect the application of the simplified approach from the date the swap was entered into or acquired by the entity. Under a full retrospective approach, the financial statements for each prior period presented are adjusted to reflect the application of the simplified approach to each period from the date the swap was entered into or acquired by the entity, with offsetting adjustments to the assets, liabilities and opening balance of the appropriate components of equity of the earliest period presented, If 4

5 an entity elects to apply the simplified approach to an existing swap, the condition that the swap s fair value at the time of application of this approach is at or near zero need not be considered. Instead, as long as the fair value of the swap was at or near zero at the time the swap was entered into, the entity may apply the simplified approach, assuming all other requirements are satisfied. The simplified approach may be elected for any qualifying swap, whether existing at the date of adoption or entered into after that date. The election to apply the simplified approach to an existing swap should be made upon the adoption of the ASU. After electing to apply the simplified approach to identified swaps, no further retrospective applications to existing swaps (full or modified) are permitted. In addition, a private company is only permitted to apply the simplified approach to existing swaps the first time the accounting policy election is made. Considerations related to election of the accounting alternative A private company should carefully consider whether electing the simplified approach makes sense in its facts and circumstances. Factors to consider in this regard include: Status as a PBE. As indicated earlier, the new definition of a PBE, which is integral in determining the entities that can apply the simplified approach, is broader than the terms public entity and publicly traded company used throughout the ASC. For additional information about the new definition, refer to our article, Q&A on the new public business entity definition. Given that the new definition is broader, careful consideration should be given to whether an entity falls within that new definition. In addition, if a business entity concludes that it is eligible to elect the simplified approach because it is not a PBE, it should consider whether there is a reasonable possibility that it may go public in the future or be acquired by a public business entity in the future. If a private company goes public after it has elected the simplified approach, it would have to discontinue that election. A private company would also have to discontinue an election to apply the simplified approach if it is acquired by a PBE that is required to include the private company s financial statements (prepared in accordance with U.S. generally accepted accounting principles applicable to a PBE) in a filing with the Securities and Exchange Commission (SEC). In this situation, absent additional standard setting, the private company would be required to retrospectively restate their financial statements and apply the general provisions of ASC 815. It is possible that the FASB or SEC could issue supplemental guidance that would provide a transition method other than retrospective application; however, we are not aware of plans on the part of either the FASB or SEC to provide such guidance. Criteria to use the simplified approach no longer being met. One factor that should be considered related to electing the simplified approach, is the likelihood that the hedged debt will be modified or prepaid or any other circumstances will occur that would result in the criteria to use the simplified approach no longer being met. If circumstances occur that result in the criteria to use the simplified approach to no longer be met, the hedge would terminate. This may be the case, for example, if the private company makes unscheduled paydowns on the debt such that the notional amount of the swap exceeds the amount of debt outstanding at any given point in time. Another example would be if the private company has the option to choose different variable-rate indices or reset frequencies on the debt and elects an option that no longer matches the variable-rate index or reset dates of the swap. In the event these or other circumstances result in the termination of the hedge, if the private company does not elect or does not qualify for a new hedge election under the general provisions of ASC 815, future changes in the fair value of the swap would be recognized directly through the income statement. The ability to make a new hedge election under the general provisions of ASC 815 would be complicated by the fact that the swap would be out of market, which introduces ineffectiveness into the hedge relationship. For these reasons, unless a private company is confident it will continue to meet the requirements to apply the simplified approach through the entire term of the swap, it may be prudent for it to continue to apply the general provisions of ASC 815 and elect what is referred to as a long-haul approach to hedge accounting. 5

6 Hedge documentation timing. Another factor to consider relates to the timing of hedge documentation. Under the simplified approach, a private company is permitted to take up to the date on which the annual financial statements are available to be issued to put in place the formal documentation to elect and qualify for the simplified approach. However, it would be prudent for the private company to fully evaluate whether or not it qualifies for this approach and desires to elect it at the inception of the hedge. In the event the private company delays this analysis and determines that it does not want to elect the simplified approach or does not qualify for it, the private company would need to recognize changes in the fair value of the swap directly through the income statement unless, or until, it qualifies for hedge accounting under the general provisions of ASC 815, which would be further complicated by the swap no longer having a zero fair value. Subsequent improvements for all entities: In 2017, the FASB issued ASU , Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, to ease the hedge accounting requirements for all entities. Amongst other changes, the amendments permit hedge effectiveness to be assessed qualitatively in certain circumstances and allow additional time for private companies (other than financial institutions and certain not-for-profit entities) up until the date on which the next interim (if applicable) or annual financial statements, including footnotes are available to be issued to (a) select the method that will be used to assess effectiveness and (b) perform any required initial and quarterly effectiveness assessments. The amendments are effective as of January 1, 2019 for calendar year PBEs, including interim periods within that period and calendar year 2020 for all other entities. Early adoption is permitted for existing relationships on the date of adoption. The effects of adoption should be reflected as of the beginning of the first fiscal year of adoption. For additional information on ASU , see our article, Highly anticipated improvements to hedge accounting. For additional information about the simplified approach and assistance in the evaluation of your specific facts and circumstances, contact your RSM professional. 6

7 Appendix A Sample hedge election documentation 1 Date: [INSERT DATE] 2 To: Accounting File From: Private Company CFO RE: Hedge designation of interest rate swap under the private company simplified hedge accounting approach Hedging relationship, risk management objective and strategy Private Company LLC (the Company) entered into a $10.5 million notional amount interest rate swap agreement on September 29, 2014 with XXX Institution. The agreement and hedging relationship were undertaken as a cash flow hedge of interest rate risk, specifically of the variable interest payments associated with a corresponding amount of variable rate borrowings. Description of the hedging instrument: The hedging instrument is a pay-fixed, receive-variable interest rate swap agreement with a beginning notional amount of $10.5 million. The term of the swap agreement begins on October 1, 2014 and expires on September 30, Description of the hedged transaction: The hedged transactions are each of the first quarterly interest payments on the amount of outstanding three-month LIBOR borrowing equivalent to the then notional amount of the swap during the term of the swap. (Specifically, this LIBOR borrowing is the note currently outstanding with XXX Institution or its replacement with similar qualifying terms.) Nature of the risk being hedged: There is a risk of variations in interest rate payments due to changes in the variable interest rate outlined in the note agreement. The Company s objective is to hedge against these variations by fixing the interest rate on a portion of the principal outstanding. Assessment of the hedging instruments effectiveness: Under the simplified hedge accounting approach, the Company can assume no ineffectiveness for qualifying interest rate swaps. Use of the simplified hedge accounting approach is appropriate for certain private companies provided certain conditions are met. The Company considered the following conditions (as provided in ASC D) when concluding it was appropriate to apply the simplified hedge accounting approach to its cash flow hedge of the variable-rate borrowing: 1 This sample provides one approach related to how an entity may document its election of the simplified approach. While the documentation prepared by an entity does not have to follow this format, it does need to meet the requirements of ASC When applying the simplified approach, this documentation must be completed by the date on which the first annual financial statements are available to be issued after hedge inception. 7

8 Condition Swap Borrowing Condition met Variable rates are based on same index and reset period The terms of the swap are typical 3 Repricing and settlement dates differ by no more than a few days: Three-month LIBOR While the borrowing has various interest rate options, three-month LIBOR is what the Company selected. Repricing dates First day of the quarter First day of the quarter Y Settlement dates Last day of the quarter Last day of the quarter Y Fair value of swap is at or near zero at its inception Notional amount of swap matches principal amount of borrowing being hedged (which does not need to be full amount of borrowing) All interest payments occurring on the borrowing during the term of the swap (or the effective term of the swap underlying the forward starting swap) are designated as hedged whether in total or in proportion to the principal amount of the borrowing being hedged. If the swap is forward starting, the occurrence of forecasted interest payments is probable. Swap fair value was zero on September 29, $10.5 million, amortizing The total borrowing is $20 million and amortizes in such a manner that at all times the outstanding principal amount of it or its replacement will equal or exceed the notional amount of the swap. Term is October 1, 2014 to September 30, The hedged item is designated as all interest payments on the amount of outstanding borrowing equivalent to the notional amount of the swap during the term of the swap. N/A N/A N/A The Company will assess on an ongoing basis whether the preceding conditions for applying the simplified hedge accounting approach continue to be met and will assess the likelihood of the counterparty s compliance with its obligations under the interest rate swap agreement. Y Y Y Y Y 3 ASC 815 does not elaborate on what constitutes typical terms other than to state that such a swap is generally considered to be plain-vanilla and have no floor or cap on its variable interest rate unless the borrowing has a comparable floor or cap. An example of a swap terms sheet that we believe to be typical follows this sample hedge election documentation. 8

9 Method of measuring ineffectiveness: Ineffectiveness will be assumed to be zero if the aforementioned conditions are met as provided for in ASC A. The carrying amount of the swap asset or liability will be adjusted to its current settlement value at each reporting period end through other comprehensive income or loss. Amounts in other comprehensive income or loss will be reclassified into interest expense as interest accrues on the debt to result in an overall fixed rate of interest. If the preceding conditions are no longer met or the likelihood that the counterparty will not default ceases to be probable as elaborated on beginning at ASC , the relationship will no longer qualify for the simplified hedge accounting approach. Upon failing to qualify, the hedge will be de-designated with the gain or loss on the swap in accumulated other comprehensive income reclassified to earnings in accordance with paragraphs ASC to 6. Ineffectiveness will be measured using the hypothetical derivative method as described beginning at ASC The swap will be measured at fair value on the date of de-designation with subsequent changes in fair value reported in earnings. Measurement election Under the simplified hedge accounting approach, as provided in ASC A, the Company has elected to measure the interest rate swap at settlement value rather than fair value. 9

10 Sample abbreviated interest rate swap terms sheet Trade date: September 29, 2014 Notional amount: Initially $10.5 million, amortizing in accordance with a supplemental schedule Effective date: October 1, 2014 Termination date: September 30, 2019 Fixed payments Fixed rate payer: Fixed rate: Private Company LLC 4.75 percent Period end/payment dates: Quarterly, beginning the last day of each December, March, June and September commencing December 31, 2014, through and including the termination date Floating payments Floating rate payer: Floating rate index: Spread: Reset dates: XXX Institution Three-month LIBOR percent First day of each quarter Period end/payment dates: Quarterly, beginning the last day of each December, March, June and September commencing December 31, 2014, through and including the termination date 10

11 rsmus.com This document contains general information, may be based on authorities that are subject to change, and is not a substitute for professional advice or services. This document does not constitute audit, tax, consulting, business, financial, investment, legal or other professional advice, and you should consult a qualified professional advisor before taking any action based on the information herein. RSM US LLP, its affiliates and related entities are not responsible for any loss resulting from or relating to reliance on this document by any person. Internal Revenue Service rules require us to inform you that this communication may be deemed a solicitation to provide tax services. This communication is being sent to individuals who have subscribed to receive it or who we believe would have an interest in the topics discussed. RSM US LLP is a limited liability partnership and the U.S. member firm of RSM International, a global network of independent audit, tax and consulting firms. The member firms of RSM International collaborate to provide services to global clients, but are separate and distinct legal entities that cannot obligate each other. Each member firm is responsible only for its own acts and omissions, and not those of any other party. Visit rsmus.com/aboutus for more information regarding RSM US LLP and RSM International. RSM and the RSM logo are registered trademarks of RSM International Association. The power of being understood is a registered trademark of RSM US LLP RSM US LLP. All Rights Reserved.