FASB s targeted improvements to hedge accounting: Smoother sailing ahead? The Dbriefs Financial Reporting series

FASB s targeted improvements to hedge accounting: Smoother sailing ahead? Robert Uhl, Partner, Deloitte & Touche LLP Mark Bolton, Managing Director, Deloitte & Touche LLP Jonathan Howard, Partner, Deloitte & Touche LLP William Fellows, Partner, Deloitte & Touche LLP Casey Fersch, Manager, Deloitte & Touche LLP September 7, 2017

Agenda Background and overview General hedging requirements Other hedging relief and cash flow hedges of nonfinancial assets Hedges of financial assets and liabilities Cash flow hedges of interest rate risk Disclosures Effective date, transition and controls Q&A Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 2

Keep in mind This webcast does not provide official Deloitte & Touche LLP interpretive accounting guidance. Check with a qualified advisor before taking any action. Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 3

Learning objective To enhance participants understanding of important accounting issues pertaining to the new hedging standard. Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 4

Polling question #1 Are you a financial statement preparer, user, auditor, or other interested party? Preparer User Auditor Other Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 5

Targeted improvements to accounting for hedging activities Background ASU 2017-12: Reasons for project Better align an entity s financial reporting with its risk management activities Improve relevance and depict a more faithful representation of hedging activities for investors Reduce complexity and costs Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 7

Targeted improvements to accounting for hedging activities What hasn t changed? Highly effective threshold for all hedges General documentation requirements Required prospective and retrospective hedge effectiveness assessments Ability to hedge components of financial items Concept of hedging the benchmark interest rate for fair value hedges of financial items Availability of shortcut and critical terms match methods Voluntary hedge dedesignations Simplified hedging approach Many disclosure requirements Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 8

Targeted improvements to accounting for hedging activities Overview Ineffectiveness Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 9

Overview Revised hedge accounting model P&L or OCI Effect Change in Fair Value of Hedging Instrument Component included in hedge effectiveness assessment Component excluded from hedge effectiveness assessment (option time value, foreign exchange forward points, crosscurrency basis spreads) Fair Value Hedge Cash Flow Hedge Net Investment Hedge All Hedge Types Systematic and Rational Amortization Initial Value Any FV change that differs from S & R amortization Recognize change in current earnings Current P&L OCI OCI (CTA) Current P&L OCI Current P&L Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 10

Targeted improvements to accounting for hedging activities Cross-currency basis spreads Issuers may exclude the portion of the change in fair value of a currency swap attributable to a cross-currency basis spread Has been a source of ineffectiveness and volatility since the Credit Crisis The spreads are present in the measurement of the hedging instrument, but not the hedged item Issuers that elect to exclude the crosscurrency basis spread will: Amortize the excluded component present at recognition Subsequent changes in the fair value due to changes in the cross-currency basis spread should be deferred in OCI Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 11

Polling question #2 Do you think companies will change how they account for excluded components? Yes No Don t know/not applicable Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 12

Targeted improvements to accounting for hedging activities Hedge effectiveness assessment Initial Prospective Quantitative Hedge Effectiveness Assessment The ASU requires an initial prospective quantitative assessment of hedge effectiveness in most circumstances: Entities required to complete the initial quantitative prospective assessment of hedge effectiveness by the end of the hedge inception reporting period: Up to 3 months for public companies and all financial institutions Nonpublic, nonfinancial institutions may be up to a year Quantitative assessments would use data as of hedge inception An initial quantitative assessment is not required if the hedge qualifies for the shortcut or critical terms match methods (or other methods that assume perfect effectiveness) Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 14

Targeted improvements to accounting for hedging activities Hedge effectiveness assessment Subsequent Qualitative Hedge Effectiveness Assessments Entities may elect to perform subsequent retrospective and prospective qualitative assessments of hedge effectiveness if: Initial prospective quantitative assessment demonstrates that the hedging relationship is highly effective The entity can, at hedge inception, reasonably support an expectation of high effectiveness on a qualitative basis in subsequent periods Documentation must specify: How qualitative assessments will be performed, and The alternative quantitative assessment that will be performed if the entity can no longer support a highly effective offset qualitatively Subsequent qualitative assessment election done on a hedge-by-hedge basis Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 15

Targeted improvements to accounting for hedging activities Hedge effectiveness assessment Timing of documentation of assessment Public companies and all financial institutions Hedge documentation timing requirement did not change (i.e., at inception) As previously noted though, completion of effectiveness assessment can be deferred up to 3 months Private companies that are not financial institutions as well as not-for-profit entities Must prepare only a statement of intent to hedge at hedge inception Not required to perform and document all initial and subsequent hedge effectiveness assessments (whether quantitative or qualitative) until their next set of interim (if applicable) or annual financial statements is available to be issued Note Relief relates only to timing of performance and documentation of effectiveness assessments, not to the documentation s content or frequency of effectiveness assessments Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 16

Polling question #3 For public companies and private companies that are financial institutions, what is the maximum amount of time the entity can defer its initial quantitative prospective hedge effectiveness assessment? A Up to 3 months from hedge inception, but before its interim or annual financial statements are available to be issued B Up to one year from hedge inception, but before its annual financial statements are available to be issued C The initial quantitative prospective hedge effectiveness assessment cannot be deferred; that is, it must be completed concurrently with the hedge documentation required at hedge inception Don t know/not applicable Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 17

Targeted improvements to accounting for hedging activities Loosening the reins on critical terms and shortcut Critical terms match for a CF hedge of a group of forecasted transactions if the transactions occur and the hedging derivative matures within the same 31-day period or fiscal month Back-up long-haul method for certain hedges designated as shortcut if: The hedge was highly effective The entity documented at hedge inception which long-haul methodology it would use to measure hedge ineffectiveness as a back-up Shortcut criteria would be amended to allow partial-term fair value hedges of interest risk to qualify for the shortcut method Codifies certain practices related to the change in variable cash flows method and hypothetical derivative methods for cash flow hedges Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 18

Targeted improvements to accounting for hedging activities Component hedging not just for financial transactions anymore Nonfinancial purchases and sales Purchases/sales of nonfinancial assets containing a contractually specified component, may be eligible for component hedging if: The exposure related to variability in cash flows attributable to the component exists throughout the life of the hedge Hedges for longer than the contractual term or for a not-yet-existing contract are permissible if certain criteria are met Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 20

Targeted improvements to accounting for hedging activities What does specified really mean? Nonfinancial purchases and sales Sometimes a contractually specified component is not explicitly referenced in the executed contract, but other agreements exist to support the price at which the nonfinancial asset will be purchased or sold such as: Purchases in the spot market that have demonstrable agreements noting that the spot price is based formula that incorporates a specific index and a basis Certain pre-execution agreements Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 21

Targeted improvements to accounting for hedging activities Non-financial component example Entity A purchases aluminum delivered at their factory under a 3 year agreement with the following price formula: Price = $1000/ton + Platt's US Midwest Basis Adjustment + a fuel adjustment based on the DOE On-highway Weekly Diesel Average Entity A enters into Diesel swaps that settle against the DOE On-highway Weekly Diesel average to fix the transportation component of its raw aluminum purchases. Current hedge accounting standard New hedge accounting standard Entity A s only designation option is to hedge the total price risk associated with the forecasted aluminum deliveries. As the total price will fluctuate based on a regional aluminum basis and diesel prices, the Diesel hedge alone may not be effective. Under the new standard, Entity A will be able to designate the Diesel swap as a hedge of the Diesel component of the aluminum forecasted purchase. Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 22

Polling question #4 Do you expect that your company will use component hedging for nonfinancial hedging? Yes No we will continue our nonfinancial hedging program as is Not applicable we don t have these exposures to hedge Don t know Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 23

Targeted improvements to accounting for hedging activities Changes to hedges of financial assets/liabilities Acceptable designated risks for fair value hedges of interest rate risk have increased. New FV hedging strategies include: Benchmark interest rate component of coupons New benchmark component for FV hedges: SIFMA Partial-term hedging Prepayable debt may consider only how changes in benchmark interest rate impact decision to prepay Last of layer approach hedging closed portfolio of prepayable assets (or beneficial interest in portfolio of prepayable assets) Cash flow hedging: Benchmark interest rate replaced with contractually specified rate Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 25

Targeted improvements to accounting for hedging activities Benchmark component of coupons Example: Company ABC issues 10-year fixed-rate debt Principal: $100 million Interest: 7% per annum, payable semi-annually 10-year $100 million notional swap Pay variable: 6-mo LIBOR Receive fixed: 4.5% per annum Benchmark component of coupons Net settles every 6 months Hedged item for purposes of measuring change in FV: 10-year fixed-rate debt Principal: $100 million Interest: 4.5% per annum, payable semi-annually Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 26

Targeted improvements to accounting for hedging activities Partial-term hedging Example: Company ABC issues 10-year fixed-rate debt Principal: $100 million Interest: 7% per annum, payable semi-annually 5-year $100 million notional swap Pay variable: 6-mo LIBOR Benchmark component of coupons Receive fixed: 3.5% per annum Net settles every 6 months Hedged item for purposes of measuring change in FV: 5-year fixed-rate debt Principal: $100 million Interest: 3.5% per annum, payable semi-annually Combination of benchmark component and partial term Qualifies for shortcut method! Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 27

Targeted improvements to accounting for hedging activities Prepayments due to benchmark Example: Company ABC issues 10-year fixed-rate debt Principal: $100 million Interest: 8% per annum, payable semi-annually Callable at par by issuer after 5 year anniversary 10-year $100 million notional swap, settles semi-annually Pay variable: 6-mo LIBOR Receive fixed: 5.5% per annum Counterparty may terminate after year 5 Benchmark component of coupons Hedged item for purposes of measuring change in FV: 10-year fixed-rate debt, callable after year 5 Principal: $100 million Interest: 5.5% per annum, payable semi-annually Issuer s decision to call debt is based on LIBOR swap rate + 2.5% Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 28

Targeted improvements to accounting for hedging activities Strategies available for callable debt Example: Company ABC issues 10-year fixed-rate debt Principal: $100 million Interest: 8% per annum, payable semi-annually Callable at par by issuer after 5 yr anniversary Derivative/Hedging Options: Today: 10-year swap, terminable after year 5 Same derivative ineffectiveness of credit spread can be ignored: Component of coupon Benchmark impact on prepayments Partial-term hedge: Swap up to 5 years can ignore prepayment risk Swap beyond 5 years needs to consider termination option in swap Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 29

Targeted improvements to accounting for hedging activities Additional benefits of new identifiable risks Portfolio hedging Example: Insurance Co XYZ holds $200 million of fixed-rate corporate bonds Interest rates vary benchmark component of coupons makes them all similar Maturities vary partial-term hedge makes them similar Callable bonds combination of strategies may make them similar Mix callable and non-callables? What about convertible debt? Example: Company EGC issues 10-year convertible notes: Principal: $100 million Interest rate: 2% Convertible at option of holder at $10/share Callable by issuer after year 5 Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 30

Targeted improvements to accounting for hedging activities Last of layer approach Example: Bank MSG holds $200 million of fixed-rate residential mortgages Interest rates: range from 3-8% per annum Remaining maturity dates: ranging from 28 30 years Bank MSG is confident that $150 million of mortgages will remain in 3 years Swap: Notional: $150 million Term: 3 years Pay fixed: 4% per annum Receive variable: 3-month LIBOR Net settles every 3 months Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 31

Targeted improvements to accounting for hedging activities Last of layer approach Criteria: Closed portfolio of similar items Prepayable financial assets or beneficial interest(s) in portfolio of prepayable financial assets Probable that bottom layer will remain throughout hedge ($150 million in example) Requires partial-term hedging election Effect: Prepayments and defaults are applied to top layer first ($50 million in example) Partial dedesignation required if portion no longer expected to be outstanding If last of layer is impacted before dedesignation, hedge accounting ceases Dedesignations result in allocation of basis adjustments to individual assets - Basis adjustments are proportional to amount de-designated Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 32

Targeted improvements to accounting for hedging activities Cash flow hedges of interest rate risk Definition of interest rate risk changed Preadoption GAAP The risk of changes in a hedged item s fair value or cash flows attributable to changes in the designated benchmark interest rate ASU 2017-12 For recognized variable-rate financial instruments and forecasted issuances or purchases of variable-rate financial instruments, interest rate risk is the risk of changes in the hedged item s cash flows attributable to changes in the contractually specified interest rate in the agreement Eliminates the benchmark interest rate concept for variable-rate financial instruments, now allowing an entity to hedge a contractually specified rate Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 33

Polling question #5 What do you regard as the primary barriers to early adoption of the FASB hedging standard? Competing deadlines with other accounting standards Establishing appropriate processes, systems and internal controls Lack of internal resources Not a priority Don t know/not applicable Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 34

Targeted improvements to accounting for hedging activities Disclosure requirements No longer required to disclose amounts of hedge ineffectiveness New Requirements: Tabular disclosure of FV or CF hedging activity effects on individual income statement line items, as well as the total amounts reported for those line items affected by hedging activity For FV hedges carrying amounts and cumulative basis adjustments of items designated and qualifying as hedged items Frequency Every annual and interim reporting period for which a balance sheet and income statement are presented Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 36

Polling question #6 The hedging standard is effective for public business entities beginning after December 15, 2018 and interim periods therein, for all others the standard is effective for fiscal years beginning after December 15, 2019 and interim periods within fiscal years after December 15, 2020. Early adoption is permitted during any interim or annual period. When do you expect your company will adopt the standard? 2018 2019 2020 Don t know/not applicable Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 37

Targeted improvements to accounting for hedging activities Effective date and transition Effective Dates: PBEs: Fiscal years beginning after 12/15/18 and interim periods therein All others: Fiscal years beginning after 12/15/19, interims within fiscal years after 12/15/20 Early adoption is allowed during any interim or annual period: If adopted during an interim period transition adjustments as of beginning of fiscal year Also must complete all transition elections by end of quarter of adoption Transition: Modified retrospective approach to existing hedging relationships Cash flow and net investment hedges: adjust OCI for prior ineffectiveness Effects of any modified hedge relationships also in cumulative-effect adjustment Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 39

Targeted improvements to accounting for hedging activities Transition elections One-time elections: Reclassify debt securities eligible for last of layer approach from HTM to AFS Existing hedges: Modify hedge documentation: Shortcut add fallback methodologies for longhaul Change hedge assessment to qualitative Fair value hedges modify relationships: Apply benchmark component (may also de-designate a portion) Apply benchmark impact on prepayment options Exclude cross-currency basis spread from hedge assessment and amortize into earnings Change method for excluded components to amortization approach Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 40

Targeted improvements to accounting for hedging activities Transition elections (cont.) One-time elections: Existing hedges: Cash flow hedges: Modify risk to contractually specified component or interest rate Change method for excluded components to amortization approach Net investment hedges Change method for excluded components to amortization approach Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 41

Targeted improvements to accounting for hedging activities Early adoption considerations Early adoption allowed during interim periods Existing hedges: Modification of any existing hedges must be done by end of quarter of adoption Cumulative effect of adoption is as of beginning of fiscal year Similar hedges similar assessments (exception for pre- and post-adoption) Transfers from HTM ICFR over hedge accounting: Process for qualitative assessments Change in designated risks may require different data for quantitative assessments Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 42

Polling question #7 How will the new FASB hedge accounting standard impact your company s business strategy? Significant positive impact Moderate positive impact No Impact Significant negative impact Moderate negative impact Don t know/not applicable Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 43

Join us September 19 at 2 p.m. ET as our Financial Executives series presents: Quarterly accounting roundup: An update on Q3 2017 important developments Copyright 2017 Deloitte Development LLC. All rights reserved. 45

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Contact information Robert Uhl Partner Deloitte & Touche LLP ruhl@deloitte.com Mark Bolton Managing Director Deloitte & Touche LLP mbolton@deloitte.com Jonathan Howard Partner Deloitte & Touche LLP jonahoward@deloitte.com Connect with me on LinkedIn Connect with me on LinkedIn Connect with me on LinkedIn William Fellows Partner Deloitte & Touche LLP wfellows@deloitte.com Connect with me on LinkedIn Casey Fersch Manager Deloitte & Touche LLP cfersch@deloitte.com Connect with me on LinkedIn Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 47

Acronyms used in presentation AFS Available For Sale CTA Cumulative Translation Adjustment DOE Department of Energy FASB Financial Accounting Standards Board FV Fair Value GAAP Generally Accepted Accounting Principles HTM Held To Maturity LIBOR London Interbank Offered Rate OCI Other Comprehensive Income P&L Profit & Loss SIFMA Securities Industry and Financial Markets Association S&R Systematic & Rational Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 48

Resources Heads Up FASB Issues Standard Bringing Targeted Improvements to Hedge Accounting Roadmap A Roadmap to Foreign Currency Transactions and Translations Roadmap A Roadmap to Distinguishing Liabilities from Equity Roadmap A Roadmap to Accounting for Noncontrolling Interests Copyright 2017 Deloitte Development LLC. All rights reserved. FASB s targeted improvements to hedge accounting: Smoother sailing ahead? 49

This presentation contains general information only and Deloitte is not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this presentation. Copyright 2017 Deloitte Development LLC. All rights reserved. 50

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