Hedge accounting: Simplifying the accounting for hedging activities

Hedge accounting: Simplifying the accounting for hedging activities The Dbriefs Financial Executives series Bob Uhl, Partner, Deloitte & Touche LLP Jon Howard, Partner, Deloitte & Touche LLP Bill Fellows, Partner, Deloitte & Touche LLP Chris Monteilh, Partner, Deloitte & Touche LLP May 22, 2018

Agenda ASU 2017-12 overview Beneficial Strategies Under ASU 2017-12 Implementation Hot Topics Industry Trends D. Q&A Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 2

Items to note Keep in mind: This webcast does not provide official Deloitte & Touche LLP interpretive accounting guidance. Check with a qualified advisor before taking any action. Learning Objective: To enhance participants understanding of important accounting issues pertaining to the new hedging standard. Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 3

Polling question #1 How would you describe your organization s current use (or prior to adoption of ASU 2017-12) of hedge accounting? Extensive users Moderate users Hardly use hedge accounting Don t know/not applicable Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 4

Overview of the new hedging standard The Financial Accounting Standards Board (FASB) issued ASU 2017-12, Targeted Improvements to Accounting for Hedging Activities ( new hedging standard ) on August 28, 2017. The ASU is effective for fiscal years beginning after December 15, 2018 with early adoption permitted. Why is the standard being issued? Pre-ASU guidance was restrictive and limited the scope of strategies which qualified for hedge accounting treatment The new standard will broaden the scope of instruments and strategies that can qualify for hedge accounting while also making it more operationally practical to designate hedges What instruments and strategies will benefit? Fair value hedging relief: Exclusion of credit spread in benchmark hedges Interest rate risk measurement for prepayable financial instruments Partial term hedges Portfolio hedges of prepayable assets Exclusion of cross currency basis spread in assessments Component hedging for nonfinancial assets and liabilities Hedges of non-benchmark variable rate instruments What are the key impacts? Simplified requirements to achieve hedge accounting Opportunities to further reduce financial statement volatility through expansion of hedging strategies Requirements to recognize hedging results with hedged items in financial statements Opportunities to potentially reclassify securities from Heldto-Maturity (HTM) to Availablefor-Sale (AFS) Improvements to the standard increase the ease of applying hedge accounting and provide a potential opportunity to reduce volatility that may currently exist in the financial statements Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 6

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 A number of disclosure requirements Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 7

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 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 8

Fair value hedges Portfolio hedging What s changed Who is impacted? Existing guidance Hedging portfolios of prepayable assets typically required operationally complex strategies that often included de-designations and redesignations to accommodate the constantly changing exposure profile. Banks Insurers New hedging standard An entity is able to FV hedge a portion of a closed portfolio of prepayable assets using a lastof-layer approach without having to consider prepayment or credit risk when assessing hedge effectiveness. GSEs Other financial institutions Existing Challenges The prepayment option held by borrowers in mortgage related products (MBS, MSRs) causes a convex relationship between interest rates and asset values. In order to hedge such exposures, financial institutions either had to purchase options or dynamically hedge using swaps. ASU 2017-12 provides significant relief for this issue through the last-of-layer approach Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 11

Example Fair value hedges of a portfolio of prepayable assets The last-of-layer approach will significantly reduce complexity in hedging prepayable assets Last-of-layer Approach An entity can enter into a fair value interest rate risk hedge of a stated amount of a portfolio that the entity does not expect to be affected by prepayments Prepayments or defaults, would first apply to the portion of the closed portfolio or beneficial interests that is not part of the hedged item At inception and on an ongoing basis, the entity must document its analysis that the hedged item would be outstanding at the assumed maturity date Similar assets test must still be applied, however, exclusion of prepayments will make it easier to demonstrate similarity Closed portfolio of MBS Portion not expected to be prepaid Portion expected to be prepaid Swap portfolio with matching notional can be used to hedge the last layer as if there is no prepayment risk. This significantly reduces hedging complexity. Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 12

Polling question #2 When does your organization expect to have ASU 2017-12 implemented? Already adopted either by the end of Q1 2018 or in 2017 In Q2-Q4 of 2018 In 2019 (or by the effective date) Don t know/not applicable Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 13

Foreign currency hedging creating synthetic foreign debt using net investment hedges What s changed Existing guidance Only FV changes resulting from fluctuations in the spot rate can be recognized in OCI when using the spot method to measure effectiveness. Other components must be recognized in earnings, including cross currency basis spread New hedging standard Spot Method mechanics effectively make cross currency basis spread an excludable component which can now be recognized in OCI. The excluded components will be recognized in earnings using a systematic and rational method over the life of the hedging instrument. Who is Impacted? All entities with net investments in non-functional USD subsidiaries Existing challenges Domestic entities seeking foreign debt issuance have historically been plagued with high transaction costs Options include direct issuance of foreign currency denominated bonds or entering a cross currency swap or series for FX forwards Direct foreign debt issuance may be more expensive than USD issuance swapped with cross-currency; however, cross-currency basis spread is not technically an excludable component on its own and has been a source of ineffectiveness and volatility since the Credit Crisis Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 15

Fair value hedges Portfolio hedging What s changed Who is impacted? Existing guidance Partial term hedging, such as stripping out and fair value hedging certain portions of a hedged item, was not previously permitted. This limited the flexibility that entities had in hedging their true economic exposures. Banks Insurers New hedging standard An entity is allowed to measure the change in fair value due to fluctuations in the benchmark rate of a partial term fair value hedge by assuming the hedged item has a term that reflects only the designated cash flows being hedged. Other Financial Institutions Entities with long term assets or liabilities (>15 years) Existing Challenges Mismatches in duration between the derivative and hedged item were a known source of ineffectiveness, often precluding the ability to apply hedge accounting. Longer term OTC products require greater customization and frequently have high transaction costs Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 17

Example: Partial term fair value hedge (Insurance) Scenario Insurer A holds a 50-year fixed-rate bond to match the profile of expected claims. For ALM purposes, the insurer would like to hedge its exposure to the loan over the first 30 years of the loan using a pay fixed, receive variable interest rate swap. Yield 10 20 30 40 50 Years The insurer has duration exposure for the first 30 years portion of the yield curve and would like to mitigate this risk. Prior to ASU 2017-12 Post ASU 2017-12 Hedged item Hedging Instrument Duration gap makes an effective partial term hedge difficult to achieve since changes in interest rates would have a larger impact on the 50-year loan. Entities can now assume that only the first 30 years of the 50-year bond are the hedged item for purposes of evaluating the effectiveness of the hedge. Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 18

Cash flow hedges of non-financial items What s changed Existing guidance Only the overall variability in cash flows or variability related to foreign currency risk could be designated as the hedged risk in a cash flow hedge of a nonfinancial item. New hedging standard For a cash flow hedge of a forecasted purchase or sale of a nonfinancial asset, an entity could designate as the hedged risk the variability in cash flows attributable to changes in a contractually specified component stated in the contract. Key takeaway Who is impacted? Energy companies Manufacturers Buyers/sellers of commodities Designating an effective hedging relationship for non-financial items proved difficult as entities were required to consider total price risk Existing Challenges Misalignment between an entity s hedge accounting results and its actual risk management objective Hedging portfolios of commodities, even when the portfolio was based on the same index Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 20

Example: Cash flow hedge of a contractually specified component Entity A desires to hedge the fuel price risk related to its barge contract. Entity A must structure its agreement to include the stated index in the contract in order to apply component hedging. Current Contract Entity A has a barge contract for which they must purchase fuel. The contract is a direct pass through for the price of fuel with no stated index. Because the index is not stated in the contract, the company can not separate and apply component hedging to the fuel component. Future Contract (meets ASU 2017-12 requirements) Assume the same fact pattern, except the agreement includes the following price formula: Price = $6,500/day + fuel adjustment based on the DOE Weekly Diesel Average Because the company structured the contract to include the index, it is allowed to hedge only the fuel adjustment portion, as a contractually specified component. Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 21

ASU 2017-12 Targeted improvements to hedge accounting Issues discussed at 2/14/18 FASB Meeting General technical inquiries received by Staff: Transition: Entities that elect to change existing designated risk to benchmark component of contractual coupon may also rebalance existing hedge relationship May rebalance the notional of the derivative or the amount of the hedged item May not involve new derivative or new hedged item No transition provided for switching from full-term to partial-term fair value hedge Fair value hedge basis adjustment disclosures intent was to disclose adjustments that do not impact future cash flows of hedged item: Basis adjustments that do impact future cash flows, such as foreign exchange risk basis adjustments are EXCLUDED from disclosures Hedged Available-For-Sale (AFS) security: carrying amount should be amortized cost, not fair value Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 23

ASU 2017-12 Targeted improvements to hedge accounting Issues discussed at 2/14/18 FASB Meeting Definition of prepayable Qualification for last of layer approach What can be reclassified from HTM upon adoption? Measurement of the hedged item Financial instruments meet the definition of prepayable include the following: Instruments that are currently exercisable or prepayable at any time Instruments with certain contingent prepayment features: Passage of time Occurrence of specified event Movement of an interest rate Instruments with conversion features Does NOT include acceleration due to credit Subsequent sale of HTM securities reclassified to AFS do not taint Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 24

ASU 2017-12 Targeted improvements to hedge accounting Issues discussed at 2/14/18 FASB Meeting Net investment hedge with a cross-currency interest rate swap: Cross currency basis spread is not technically an excludable component on its own, but spot method mechanics essentially exclude them Transition from forward to spot method (must de- and re-designate): Improved method of assessment Off-market swap at time of re-designation Methodology should result in only changes in spot rate in cumulative translation adjustment at end of hedge Choose a systematic and rational approach Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 25

Polling question #3 What do you expect will be the biggest benefit to your organization in adopting the new standard? Better alignment with current risk management Decreased operational burden Opportunities related to adoption of new hedge accounting strategies Other Don t know/not applicable Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 26

ASU 2017-12 Targeted improvements to hedge accounting Issues discussed at 3/28/18 FASB Meeting Changes in the hedged risk of a forecasted transaction: Hedge accounting may continue when the hedged risk is modified, so long as the new hedging relationship remains highly effective Potential technical corrections necessary to clarify this determination: Distinction between hedged risk and the hedged forecasted transaction Application of hindsight when identifying hedge transactions Accounting for ineffective hedges resulting from a change in the hedged risk Specificity of hedged forecasted transactions Clarification that the original hedged risk and forecasted transaction need not be distinguished to revise the hedging relationship Hedging contractually specified components: Emphasis on judgment to satisfy requirements set forth in the guidance, specifically when assessing whether underlying contracts : Qualify for the normal purchase / normal sales scope exception Contain embedded derivatives required to be excluded from the analysis Project Resource Group Address spot transactions and not-yet-existing contracts Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 27

ASU 2017-12 Targeted improvements to hedge accounting Issues discussed at 3/28/18 FASB Meeting Multiple partial-term fair value hedges of interest rate risk: Entities are allowed to apply simultaneous multiple partial-term hedging relationships to a single debt instrument This concept is not to be analogized to last of layer hedges 00 01 02 03 04 05 Hedged item Hedging Instrument Entities may now hedge consecutive interest cash flows in Years 1-2 and interest cash flows in Year 5 of a 5-year bond Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 28

ASU 2017-12 Targeted improvements to hedge accounting Issues discussed at 3/28/18 FASB Meeting Last of layer method: Addition of a narrow-scope project to address: Basis adjustments Multiple layers ASU 2017-12 did not contemplate strategies involving multiple layers Explicitly excluded from this project is the consideration of whether prepayable liabilities and nonprepayable financial assets are within the scope of last of layer guidance Vertical Horizontal Amortizing Outstanding Balance Outstanding Balance Outstanding Balance $200M $200M $200M $100M $100M $100M 4 years 8 years Time 4 years 8 years Time 4 years 8 years Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 29

Banking Top 25 Largest Banks by Total Assets Common derivative and hedge strategies employed include fair value hedges of fixed-rate debt, cash flow hedges from variable-rate debt, and net investment hedges associated with fluctuations in foreign currency exchange rates. 96% are active derivative and hedge users 88% of active users early adopted 33% disclosed cumulative retrospective adjustments 96% 88% 33% Key Observation: All banks use derivatives and hedging and most early adopted: the banks early adopted to take advantage of improvements related to fair value hedges; another benefit of early adoption was the ability to transfer securities from HTM under certain conditions. Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 31

Banking Top 25 Largest Banks by Total Assets Disclosed adjustments and changes to hedging strategies Example disclosures: The primary impact to Key at adoption was the election to measure the change in fair value of hedged items in fair value hedges on the basis of the benchmark interest rate component of contractual coupon cash flows. This change has resulted in a reduction of hedge ineffectiveness for impacted fair value hedges. (Keycorp) The Company early adopted ASU 2017-12 and modified its measurement methodology for certain hedged items designated under fair value hedge relationships. The Company elected to perform its subsequent assessments of hedge effectiveness using a qualitative, rather than a quantitative, approach. (SunTrust) Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 32

Banking Transfers of securities from HTM to AFS eligible to be hedged under the last-of-layer method SEC registrants that disclosed their transfers of HTM BNY Mellon 2.7 Capital One 31.0 Citigroup 7.5 Huntington 30.8 JPMorgan Chase 47.0 US Bancorp 3.4 % of HTM portfolio transferred Key Observations: The guidance permits a one-time reclassification of debt securities eligible to be hedged under the last-of-layer method from held to maturity to available for sale upon adoption For a closed pool of pre-payable financial assets, entities are able to hedge an amount that is not expected to be affected by prepayments, defaults and other events Banks early adopted the guidance to optimize their investment portfolio management for capital and risk management considerations, by making a one-time election to transfer held to maturity securities eligible to be hedged under the last-of-layer method to the available for sale category Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 33

Energy and Resources 36 of 50 sampled SEC registrants are active derivative and hedge users 24 of 36 early adopted 13% of early adopters introduced new hedging programs 6 of 14 non-users are evaluating the impact and considering the benefits of hedging programs Evaluating 22% Not disclosed 11% Early adopted 67% Consumer & Industrial Products and Technology, Media & Telecommunications Amongst 25 of the largest multinational companies in these industries (e.g., Apple Inc, Caterpillar, Twenty-First Century Fox), we have seen early adoption to take advantage of new hedging opportunities. For example, to manage the risks of foreign exchange in international business and prevent major earnings swings, companies have revised their hedging strategies to include nonfinancial hedges of commodities, update hedge effectiveness assessment methodology to the spot rate method, and isolate foreign-exchange-related risk for hedging purposes. Evaluating 52% Not disclosed 4% Early adopted 44% Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 34

Polling question #4 What do you expect will be the biggest obstacle to implementation? Developing an efficient process for reviewing existing hedging instruments, strategies and contracts across the organization and evaluating them against the new standard Navigating the gray areas of the standard, such as how to hedge assets without contractually-specified terms Education (for example, this is my organization s first time using hedging strategies and there is a significant learning curve) Other Don t know/not applicable Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 35

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Contact information Bob Uhl Partner Deloitte & Touche LLP ruhl@deloitte.com Connect with me on LinkedIn Jon Howard Partner Deloitte & Touche LLP jonahoward@deloitte.com Connect with me on LinkedIn Bill Fellows Partner Deloitte & Touche LLP bfellows@deloitte.com Connect with me on LinkedIn Chris Monteilh Partner Deloitte & Touche LLP cmonteilh@deloitte.com Connect with me on LinkedIn Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 38

Acronyms used in presentation AFS Available For Sale ALM Asset and Liability Management ASU Accounting Standards Update CTA Cumulative Translation Adjustment DOE Department of Energy FASB Financial Accounting Standards Board FV Fair Value FX Foreign Currency HTM Held-To-Maturity MBS Mortgage-Backed Securities MSRs Mortgage Servicing Rights MTM Mark-to-Market NYMEX New York Mercantile Exchange OCI Other Comprehensive Income OTC Over The Counter P&L Profit & Loss PBEs Public Business Entities SEC Securities & Exchange Commission Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 39

Resources Heads Up FASB Issues Standard Bringing Targeted Improvements to Hedge Accounting Deloitte Accounting Journal - FASB Discusses Feedback on Key Implementation Issues Deloitte Derivatives and Hedging Advisory Services Roadmap A Roadmap to Foreign Currency Transactions and Translations Roadmap A Roadmap to Applying the new Leasing Standard Roadmap Series Copyright 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 40

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 2018 Deloitte Development LLC. All rights reserved. Hedge accounting: Simplifying the accounting for hedging activities 41

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