Memo No. Issue Summary No. 1 Memo Issue Date June 4, 2015 Meeting Date(s) EITF June 18, 2015 Contact(s) Nicholas Milone Lead Author 203-956-5344 Jennifer Hillenmeyer EITF Coordinator 203-956-5282 Matthew Esposito Assistant Director 203-956-5377 Bret Dooley Liaison Project Project Stage Dates previously discussed by EITF Previously distributed Memo Number EITF Issue No. 15-D, Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships Initial Deliberations May 14, 2015 EITF Educational Meeting None Purpose of This Memo 1. The purpose of this memo is to assist the Task Force in determining whether the novation of a derivative instrument that is part of an existing hedge accounting relationship under Topic 815, Derivatives and Hedging, results in a requirement to dedesignate that hedge accounting relationship and therefore discontinue the application of hedge accounting. Background Information 2. As it relates to derivative contracts, the term novation refers to replacing one party to the derivative contract with another. For example, Reporting Entity A enters into an interest rate swap with Counterparty B. At some point during the life of the interest rate swap, a novation occurs to move the swap from Counterparty B to Counterparty C, thereby transferring all of the rights and obligations of the interest rate swap contract from Page 1 of 26
Counterparty B to Counterparty C. That is, Counterparty C effectively steps into the shoes of Counterparty B, becoming Reporting Entity A s new counterparty to the swap. Novations generally require the consent of the remaining party to the contract (Reporting Entity A in this example). 3. In practice, derivative contract novations may occur for a variety of reasons, including, but not limited to: a. Financial institution mergers A financial institution merges with and into a surviving entity that assumes the same rights and obligations that existed under a pre-existing derivative instrument of the merged entities. b. Intercompany novations The derivatives of one consolidated legal entity are assumed by another consolidated legal entity (for example, a broker/dealer that is downgraded novates derivatives to an FDIC insured bank entity that is rated investment grade at the request of the financial institution s counterparties). c. Exiting a particular derivatives business or relationship A financial institution may decide (voluntarily or as a result of regulatory requirements) to exit a particular derivatives business or customer relationship, or an end user of derivatives may seek to exit a banking relationship. As a result, derivative contracts related to that business or relationship are novated to effect that exit. Similarly, derivatives may be novated to others if a financial institution or an end user wishes to decrease its exposure to a particular derivative market or relationship (while not completely exiting that market or relationship). d. Internal credit limits A financial institution or an end user of derivatives may seek to limit or reduce its exposure to a particular derivative counterparty to manage against internal credit limits. As a result, derivative contracts may be novated to manage against those limits. e. Regulatory requirements Derivative contract novations resulting from regulatory requirements. For example, to effect the central clearing of certain over-the-counter (OTC) derivative transactions. Page 2 of 26
Issue 1: Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships 4. The derivative instrument that is the subject of a novation may be the hedging instrument in a hedge accounting relationship that has been designated under Topic 815. The issue is whether the novation of a derivative instrument that is part of an existing hedge accounting relationship under Topic 815 results in a requirement to dedesignate that hedge accounting relationship and therefore discontinue the application of hedge accounting. Using the example in paragraph 2 above, the question arises as to whether Reporting Entity A would be required to dedesignate an existing hedge accounting relationship solely as a result of the change in the interest rate swap counterparty from Counterparty B to Counterparty C? 5. The scope of this Issue relates to whether a change in one of the parties to a derivative contract that is part of an existing hedge accounting relationship, in and of itself, requires the dedesignation of that hedge accounting relationship. For those novations in which certain contractual terms change (for example, the maturity date or terms that impact the contractual cash flows on the derivative), the staff understands that practice is in agreement that such changes would require the dedesignation of an existing hedge accounting relationship. Likewise, for certain other changes (for example, the addition of or an amendment to a credit support annex that governs the collateral arrangement between the parties to the derivative contract), the staff understands that practice is in agreement that such changes would not require the dedesignation of an existing hedge accounting relationship. The staff believes that the scope of this Issue can be focused on the effect, if any, of a change in one of the parties to the derivative contract. 6. If dedesignation of the existing hedge accounting relationship is required, Topic 815 would allow the reporting entity to then attempt to redesignate a new hedge accounting relationship (assuming that all of the criteria for hedge accounting are met). However, that newly redesignated hedge accounting relationship may have incremental amounts of hedge ineffectiveness to be recorded (or it may fail to meet the highly effective threshold to qualify for hedge accounting) as a result of the hedging instrument being off-market (that is, having a non-zero fair value) upon redesignation. See Appendix A and Exhibit A Page 3 of 26
in the materials from the May 14, 2015 EITF Educational meeting for an example calculation illustrating this point in a cash flow hedge accounting relationship. Accounting Guidance and Other Relevant Information Codification Guidance 7. Many state that the guidance in Topic 815 is not explicitly clear regarding the effect of derivative contract novations on existing hedge accounting relationships. Furthermore, the existing guidance, which is limited, can be read in different ways, each of which may be considered a reasonable interpretation. 8. The following excerpts from the guidance are often considered as part of the analysis of this Issue: a. Paragraph 815-25-40-1 for fair value hedges [paragraph 815-30-40-1 for cash flow hedges] states, in part: An entity shall discontinue prospectively the accounting specified in paragraphs 815-25-35-1 through 35-6 [815-30-35-3 and 815-30-35-38] for an existing hedge if any one of the following occurs: (b) the derivative instrument expires or is sold, terminated, or exercised. [Emphasis added.] b. Paragraph 815-20-55-56 states the following: This Subtopic permits a hedging relationship to be de-designated (that is, discontinued) at any time. If an entity wishes to change any of the critical terms of the hedging relationship (including the method designated for use in assessing hedge effectiveness), as documented at inception, the mechanism provided in this Subtopic to accomplish that change is the de-designation of the original hedging relationship and the designation of a new hedging relationship that incorporates the desired changes. [Emphasis added.] 9. The staff understands that questions exist in practice as to whether the novation of a derivative instrument to a new counterparty, in and of itself, is considered to be a termination of the original derivative instrument in the context of the hedge accounting guidance in Topic 815. Similarly, questions have arisen as to whether the counterparty to the derivative instrument represents a critical term of a hedge accounting relationship. Page 4 of 26
The answers to those questions drive the determination of whether the novation of a derivative instrument that is part of an existing hedge accounting relationship results in a requirement to dedesignate that relationship and therefore discontinue the application of hedge accounting. SEC Letter to the International Swaps and Derivatives Association (ISDA) 10. Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Act) established a new framework for regulatory and supervisory oversight of the OTC derivatives market. The Act mandates a number of reforms to the OTC derivatives market, including the mandatory clearing of certain derivatives transactions. Under the Act, certain derivatives that are currently executed in the OTC market may be required to be cleared through derivatives clearing organizations or clearing agencies (each a central counterparty ). That requirement would result in the novation of the contracts underlying such transactions, which would effect a change in the counterparties to the contracts. Specifically, clearing results in the novation of an OTC derivative contract such that the central counterparty becomes the new counterparty via two new contracts, one with each of the original parties to the original derivative contract, rather than the original parties remaining counterparties to each other via the one original contract. 11. In addition, while the final rule implementing the mandatory clearing requirements of the Act does not require the clearing of derivatives contracts entered into prior to the application of the clearing requirement, provided that such transactions are reported to registered data repositories, ISDA indicated that certain counterparties to such derivatives contracts may choose to voluntarily clear such transactions through a central counterparty. 12. In 2012, ISDA requested that the SEC Office of the Chief Accountant (OCA) provide its view on the accounting effect under GAAP, if any, of the novation of a bilateral OTC derivative contract to a central counterparty on the same financial terms. Specifically, ISDA asked whether the novation of a derivative contract (that has been designated as an accounting hedge) to a central counterparty would result in the termination of the original derivative contract and associated hedging relationship, such that the use of hedge Page 5 of 26
accounting subsequent to novation would require the designation of a new hedging relationship. 13. In its letter to ISDA, the OCA communicated that it did not object to a conclusion that the original derivative contract has not been terminated and replaced with a new derivative contract, and therefore did not object to the continuation of hedge accounting for existing relationships, in any of the following circumstances: a. For an OTC derivative transaction entered into prior to the application of the mandatory clearing requirements, an entity voluntarily clears the underlying OTC derivative contract through a central counterparty, even though the counterparties had not agreed in advance that the contract would be novated to effect central clearing. b. For an OTC derivative transaction entered into subsequent to the application of the mandatory clearing requirements, the counterparties to the underlying contract agree in advance that the contract will be cleared through a central counterparty in accordance with standard market terms and conventions, and the hedging documentation describes the counterparties expectations that the contract will be novated to the central counterparty. c. A counterparty to an OTC derivative transaction who is prohibited by Section 716 of the Act (or expected to be so prohibited) from engaging in certain types of derivative transactions novates the underlying contract to a consolidated affiliate that is not insured by the FDIC and does not have access to Federal Reserve credit facilities. Speech by SEC Staff at the 2014 AICPA Conference on PCAOB and SEC Developments 14. At the 2014 AICPA Conference, the SEC staff delivered a speech communicating that it continues to receive questions from registrants about the effects of derivative contract novations on existing hedge accounting relationships. In addition to reiterating the views expressed in its letter to ISDA (referenced above), the SEC staff also outlined the Page 6 of 26
following fact patterns whereby the OCA staff has not objected to an entity continuing to apply hedge accounting upon a derivative novation: a. The reporting entity s derivative counterparty merges with and into a surviving entity that assumes the same rights and obligations that existed under a preexisting derivative instrument of the merged entities b. The reporting entity s derivative counterparty novates a derivative instrument to an entity under common control with the derivative counterparty c. At the inception of the hedging relationship, the reporting entity knows and contemporaneously documents that all or part of the derivative will be novated to a new counterparty during the hedging relationship. 15. In addition, the SEC staff indicated that the views expressed in its speech at the 2014 AICPA Conference should not be applied by analogy. 16. Therefore, questions regarding the treatment of derivative contract novations in fact patterns other than those specifically addressed by the SEC in its letter to ISDA and in the SEC staff speech at the 2014 AICPA Conference remain (for example, novations related to a financial institution voluntarily exiting a particular derivative business or customer relationship). In addition, there are questions in practice about how to interpret the limited authoritative accounting literature that exists in GAAP with respect to this Issue. 17. The staff recognizes that the Board s current project on hedge accounting could potentially address this issue. However, the staff believes that this issue will arise more frequently as derivative counterparties continue to evaluate potential changes in the regulatory environment. The staff also believes that this is a discrete issue that can be addressed without affecting the other topics being deliberated in the broader hedge accounting project. Therefore, the staff believes that there is a benefit to the Task Force addressing this discrete issue on a more timely basis. The staff also believes that addressing this issue separately would avoid the risk that its resolution could be slowed down by the other decisions being made in the context of the broader hedge accounting project. Page 7 of 26
Question 1 for the Task Force 1. Which alternative does the Task Force prefer with respect to determining the effect, if any, on an existing hedge accounting relationship of a change in one of the parties to the derivative contract? Staff Analysis and Alternatives 18. The staff has identified the following alternatives for the Task Force s consideration: Alternative A: A change in one of the parties to a derivative contract that is part of an existing hedge accounting relationship, in and of itself, requires dedesignation of that hedge relationship. Alternative B: A change in one of the parties to a derivative contract that is part of an existing hedge accounting relationship requires dedesignation of that hedge relationship unless the change in one of the parties is done to effect central clearing with a central counterparty as a consequence of laws or regulations. Alternative C: A change in one of the parties to a derivative contract that is part of an existing hedge accounting relationship requires dedesignation of that hedge relationship unless the change in one of the parties relates to one of the fact patterns outlined by the SEC in its letter to ISDA (paragraph 13 above) or in the SEC speech at the 2014 AICPA Conference (paragraph 14 above). Alternative D: A change in one of the parties to a derivative contract that is part of an existing hedge accounting relationship does not, in and of itself, require dedesignation of that hedge relationship. Alternative E: A change in one of the parties to a derivative contract that is part of an existing hedge accounting relationship does not require dedesignation of that hedge relationship provided the creditworthiness of the new counterparty is similar to or better than the creditworthiness of the old counterparty. Page 8 of 26
Alternative A 19. Under Alternative A, a change in one of the parties to a derivative contract that is part of an existing hedge accounting relationship, in and of itself, requires dedesignation of that hedge relationship. 20. Proponents of Alternative A argue that because a novation represents the legal termination of the original derivative, it also should be viewed as a termination for accounting purposes; therefore, the criteria in paragraph 815-25-40-1(b) for fair value hedges and in paragraph 815-30-40-1(b) for cash flow hedges have been met. That is, because the original derivative instrument has been terminated in the context of the hedge accounting guidance in Topic 815, the existing hedging relationship must be dedesignated. 21. Furthermore, proponents of Alternative A believe that the counterparty to the derivative instrument is a critical term of the hedge accounting relationship, and paragraph 815-20- 55-56 states that changes to critical terms require dedesignation of an existing hedge accounting relationship. They argue that the derivative is the instrument in the hedge accounting relationship that provides the offsetting changes in fair value (or cash flows) against the hedged item (that is, the derivative is the hedge), and, therefore, the counterparty that is providing that derivative instrument is inherently a critical term in the hedge accounting relationship. They argue that this is particularly true in a contract (such as a derivative instrument) in which there is counterparty performance risk. Alternative B 22. Under Alternative B, a change in one of the parties to a derivative contract that is part of an existing hedge accounting relationship requires dedesignation of that hedge relationship unless the change in one of the parties is done to effect central clearing with a central counterparty as a consequence of laws or regulations. 23. The arguments and rationale for Alternative B are similar to those in Alternative A. However, this alternative would provide an exception for certain novations done to effect central clearing. Page 9 of 26
24. As noted earlier, the Act mandates a number of reforms to the OTC derivatives market, including the mandatory clearing of certain derivatives transactions. This means that certain derivatives that are currently executed in the OTC market may be required to be cleared through derivatives clearing organizations or clearing agencies in the future. This will result in the novation of the contracts underlying such transactions, which would effect a change in the counterparties to the contract. 25. This alternative is similar to the decision reached by the IASB in June 2013 when the IASB published Novation of Derivatives and Continuation of Hedge Accounting (Amendments to IAS 39), which allows hedge accounting to continue when the novation of a derivative is done to effect central clearing with a central counterparty as a consequence of laws or regulations. Similar relief was carried forward into IFRS 9 (paragraph 6.5.6). That guidance was provided in response to a request received by the IASB to clarify whether an entity is required to discontinue hedge accounting for hedging relationships in which a derivative contract is novated to a central counterparty due to the introduction of a new law or regulation. 26. In the basis for conclusions of IFRS 9 (paragraphs BC6.332 through BC6.352), the IASB noted its belief that, as a technical matter, the novation of a derivative to a central clearing counterparty results in the derecognition of the original derivative instrument and the recognition of a new derivative instrument, which would require an existing hedge accounting relationship to be discontinued. However, the IASB noted that the widespread legislative changes across jurisdictions to improve transparency and regulation of OTC derivatives would result in many of today s standardized OTC derivatives contracts being cleared through a central clearing party in the future. 27. Therefore, the IASB was concerned about the financial reporting effects that would arise from novations that result from new laws or regulations. Specifically, the IASB noted that the requirement to discontinue hedge accounting means that although an entity could attempt to redesignate the derivative as the hedging instrument in a new hedging relationship, it could result in more hedge ineffectiveness, especially for cash flow hedges, compared to continuing the existing hedging relationship. That is because the Page 10 of 26
seasoned derivative that would be newly designated as the hedging instrument would likely be off-market (that is, have a non-zero fair value) at the time of the redesignation. 28. The IASB, taking note of this financial reporting effect, was convinced that accounting for the hedging relationship that existed before the novation as a continuing hedging relationship, in this specific situation, would provide more useful information to users of financial statements. 29. An important point to note regarding the IASB s decision relates to voluntary versus required clearing of derivatives. The IASB noted that voluntary novation to a central clearing party could be prevalent in some circumstances such as novation in anticipation of regulatory changes, novation due to operational ease, and novation induced but not actually mandated by laws or regulations as a result of the imposition of charges or penalties. The IASB observed, however, that for hedge accounting to continue, voluntary novation to a central clearing party should be associated with laws or regulations that are relevant to central clearing of derivatives. The IASB noted that while a novation need not be required by laws or regulations for hedge accounting to be allowed to continue, allowing all novations to central clearing parties to be accommodated was broader than the IASB had intended. Therefore, the IASB agreed that hedge accounting should continue when novations are performed as a consequence of laws or regulations or the introduction of laws of regulations, but noted that the mere possibility of laws or regulations being introduced was not a sufficient basis for the continuation of hedge accounting. Alternative C 30. Under Alternative C, a change in one of the parties to a derivative contract that is part of an existing hedge accounting relationship requires dedesignation of that hedge relationship unless the change in one of the parties relates to one of the fact patterns outlined by the SEC in its letter to ISDA or in the SEC staff speech at the 2014 AICPA Conference. 31. Like Alternatives A and B, the concept underlying Alternative C is that a change in one of the parties to a derivative contract that is part of an existing hedge accounting relationship Page 11 of 26
requires dedesignation of that hedge relationship. However, relative to Alternative B, Alternative C broadens the population of acceptable novations (that is, those that do not cause a hedge dedesignation) by codifying in GAAP the guidance in the SEC letter to ISDA and the SEC staff speech at the 2014 AICPA Conference. 32. Proponents note that Alternative C would effectively result in codifying and affirming current practice. They argue that codifying the guidance in GAAP is an improvement because current practice has effectively developed based on ad hoc guidance by the SEC staff in letters and speeches. In addition, proponents of Alternative C argue that Alternatives A and B are more restrictive than current practice and could therefore be viewed as a step backwards. 33. Opponents of Alternative C argue that maintaining a list of exceptions to the general principle that derivative contract novations require existing hedge accounting relationships to be dedesignated is not ideal. Opponents argue that questions related to other fact patterns will continue to come up and diversity may increase over time, particularly if those questions continue to be answered on an ad-hoc basis and if the list of acceptable novations continues to grow. 34. Additionally, opponents argue that Alternative C does not provide a coherent model that can consistently be applied across different fact patterns. Alternative D 35. Under Alternative D, a change in one of the parties to a derivative contract that is part of an existing hedge accounting relationship does not, in and of itself, require dedesignation of that hedge accounting relationship. 36. Proponents of Alternative D argue that the analysis of whether a derivative has been terminated in the context of the guidance in Topic 815 was intended to go beyond a legal determination and instead focus on whether the hedging relationship itself would continue to exist. If the only change to the derivative is the counterparty (and no concerns exist with respect to collectability of cash flows on the derivative), the risk profile of the Page 12 of 26
derivative is largely unchanged. Therefore, termination of the derivative has not occurred. 37. These proponents also argue that the reference to critical terms in paragraph 815-20-55-56 should be interpreted to refer only to those terms of the hedged item and hedging instrument that affect the contractual cash flows of the hedge relationship. They note that the hedge accounting guidance refers to critical terms in other contexts (for example, the critical terms match method of hedge accounting) and does not cite the counterparty as a critical term. In those contexts, critical terms refer to factors that affect the amount and timing of contractual cash flows. All other terms of a hedge relationship that do not affect the contractual cash flows may affect the probability of performance of the contractual terms. They argue that those terms that inform the probability of performance of the contractual requirements of each instrument are addressed by paragraphs 815-20-35-14 through 35-16 (the counterparty default guidance), which is outlined below: For an entity to conclude on an ongoing basis that the hedging relationship is expected to be highly effective in achieving offsetting changes in cash flows, the entity shall not ignore whether it will collect the payments it would be owed under the contractual provisions of the derivative instrument. In complying with the requirements of paragraph 815-20-25-75(b), the entity shall assess the possibility of whether the counterparty to the derivative instrument will default by failing to make any contractually required payments to the entity as scheduled in the derivative instrument. In making that assessment, the entity shall also consider the effect of any related collateralization or financial guarantees. The entity shall be aware of the counterparty s creditworthiness (and changes therein) in determining the fair value of the derivative instrument. Although a change in the counterparty s creditworthiness would not necessarily indicate that the counterparty would default on its obligations, such a change shall warrant further evaluation. If the likelihood that the counterparty will not default ceases to be probable, an entity would be unable to conclude that the hedging relationship in a cash flow hedge is expected to be highly effective in achieving offsetting cash flows. In contrast, a change in the creditworthiness of the derivative instrument's counterparty in a fair value hedge would have an immediate impact because that change in creditworthiness would affect Page 13 of 26
the change in the derivative instrument's fair value, which would immediately affect both of the following: a. The assessment of whether the relationship qualifies for hedge accounting b. The amount of ineffectiveness recognized in earnings under fair value hedge accounting. 38. As a result of the guidance above, proponents of Alternative D argue that a reporting entity is always required to assess the creditworthiness of the derivative counterparty in a hedge accounting relationship (both in the normal course of the hedge accounting relationship and upon a novation). Therefore, if a derivative novation involves a new counterparty with significantly lower creditworthiness than the old counterparty, that change in creditworthiness must be considered by the reporting entity in determining both of the following: a. Whether the hedging relationship continues to qualify for hedge accounting at all b. The amount of hedge ineffectiveness to be recorded to the extent that it does qualify for hedge accounting. 39. Specifically, for a fair value hedge, a change in the creditworthiness of the derivative instrument s counterparty would have an immediate effect because that change in creditworthiness would affect the change in the derivative instrument s fair value, which would immediately affect both the assessment of hedge effectiveness and measurement of hedge ineffectiveness. For a cash flow hedge, a change in the creditworthiness of the derivative instrument s counterparty would affect both (a) the change in the actual derivative instrument s fair value, and (b) the change in the hypothetical derivative instrument s fair value, in a similar manner (that is, the same discount rate would be used to value both the actual and hypothetical derivatives). However, if the likelihood that the counterparty will not default ceases to be probable, an entity would be unable to conclude that the hedging relationship is expected to be highly effective in achieving offsetting cash flows; therefore, the hedge accounting relationship would require dedesignation at that point. Page 14 of 26
40. Proponents of Alternative D also argue that the financial reporting result of dedesignating a hedge accounting relationship upon a derivative novation (that is, creation of an offmarket derivative that may or may not qualify to be redesignated as part of a new hedge accounting relationship) does not provide decision-useful information to users of financial statements when the reporting entity plans to continue the hedge accounting relationship. They note that as part of the feedback received by the FASB on its previous hedge accounting exposure drafts in June 2008 and May 2010, users expressed frustration with understanding the financial reporting implications of reporting entities going in and out of hedge accounting. Proponents believe that Alternative D results in accounting that best captures the economic substance of the novation transactions discussed in this Issue Summary. 41. In addition, proponents of Alternative D note that assessments of hedge effectiveness and measurements of hedge ineffectiveness when off-market derivatives are involved are complex and nuanced calculations. Therefore, they believe that requiring a hedge dedesignation upon a derivative novation may increase the cost and complexity of complying with an accounting standard that is already extremely complex. That would be particularly true for those entities that may have been applying an abbreviated qualitative assessment of hedge effectiveness prior to the hedge dedesignation (for example, the shortcut method), but who would be required to perform complex quantitative hedge effectiveness calculations under the long-haul method subsequent to redesignation. 1 42. Proponents also point to the fact that elsewhere in the accounting literature it is clear that transactions in the market between investors (counterparties) do not affect the accounting for the issuer (reporting entity). For example, paragraph 470-50-40-7 states: Transactions among debt holders do not result in a modification of the original debt's terms or an exchange of debt instruments between the debtor and the debt holders and do not impact the accounting by the debtor. 1 One of the requirements to apply the shortcut method or a number of the other qualitative methods of assessing hedge effectiveness in Topic 815 is that the derivative has a zero fair value upon designation of the hedge accounting relationship (that is, the derivative is on-market at hedge inception). That condition is unlikely to be met for a seasoned derivative that has been dedesignated from its original hedging relationship and redesignated in a new hedging relationship. Page 15 of 26
43. As an example, if Reporting Entity X had hedged its floating rate loan from Bank Y with an interest rate swap, and that loan was sold (novated) from Bank Y to Bank Z, Reporting Entity X would not account for the change in the counterparty as an extinguishment of its loan liability or dedesignate the hedging relationship. Therefore, it appears inconsistent to proponents of Alternative D that changing the counterparty to the hedging instrument would cause a dedesignation of the hedging relationship under Topic 815, while changing the counterparty to the hedged item would not. Alternative E 44. Under Alternative E, a change in one of the parties to a derivative contract that is part of an existing hedge accounting relationship does not require dedesignation of that hedge relationship provided the creditworthiness of the new counterparty is similar to or better than the creditworthiness of the old counterparty. 45. Proponents of Alternative E agree with many of the arguments made by proponents of Alternative D. However, proponents of Alternative E argue that the safeguards built into the accounting guidance regarding the creditworthiness of the derivative counterparty (paragraphs 815-20-35-14 through 35-16 discussed above) are not sufficient. They argue that a significant change in creditworthiness would need to occur before that guidance would significantly affect either (a) a reporting entity s ability to qualify for hedge accounting or (b) the amount of hedge ineffectiveness to the extent that it does qualify. 46. Therefore, they argue that an incremental safeguard with a higher hurdle must be put in place for an existing hedge accounting relationship to continue subsequent to a derivative contract novation. Specifically, they believe that the creditworthiness of the new counterparty must be similar to or better than that of the old counterparty. They believe that this safeguard ensures that the risk profile of the derivative pre- and post-novation is largely unchanged (or that the risk profile has actually been improved), which they also believe puts the reporting entity in the best position to argue that the existing hedge accounting relationship should continue uninterrupted. 47. Opponents argue that it is not an exact science to determine whether the creditworthiness of the new counterparty is similar to or better than the old counterparty, and that diversity Page 16 of 26
may continue to exist in practice. Under this alternative, reporting entities may need to consider the following: a. Whether the analysis would be qualitative or quantitative? b. If qualitative, what factors should be considered? c. If quantitative, would the analysis be based on credit ratings, credit default swap (CDS) spreads 2, or both? What if the credit ratings and CDS spreads provide different answers? What if credit ratings differ by credit rating agency? Or what if credit ratings differ based on short-term or long-term assessments? d. How should collateral arrangements be considered? For example, what would the outcome of the analysis be if the original counterparty was AA rated and there was no collateral arrangement in place, while the new counterparty was BBB rated but there is a collateral arrangement in place? These opponents argue that the judgments around these determinations may lead to continued diversity in practice. 48. Opponents note that Alternative E may actually be more restrictive than Alternative C (current practice) in certain circumstances, because the guidance provided by the SEC in its letter to ISDA and in its speech at the 2014 AICPA Conference does not contain a requirement that the creditworthiness of the new counterparty be similar to or better than that of the old counterparty. In those circumstances, opponents argue that Alternative E could actually be viewed as a step backwards. 49. Opponents also argue that, functionally, Alternative D and Alternative E are likely to result in similar outcomes in practice in many circumstances. That is, the incremental safeguard in Alternative E is not necessary because novations generally require the consent of the remaining party to the derivative contract, and the remaining party is unlikely to agree to a novation in which the creditworthiness of the new counterparty is significantly worse than the creditworthiness of the old counterparty. As a result, in 2 The staff notes that there are many legal entities for which CDS spreads are not available. They are generally available only when the entity has liquid public bonds outstanding. Page 17 of 26
practice under Alternative D, novations are only likely to occur if the creditworthiness of the new counterparty is similar to or better than that of the old counterparty. Under this line of thinking, opponents argue that Alternative E would be adding an additional requirement to be assessed, which adds cost, complexity, and (potentially) diversity, while not serving a functional purpose in many circumstances. However, the staff notes that it may not always be the case that the remaining party to the derivative contract has the ability to consent to the novation. For example, if a reporting entity s derivative counterparty merges with and into a surviving entity [paragraph 14(a)], then it is possible that the reporting entity could be left with a lower creditworthy counterparty without consenting to the novation. Staff Recommendation 50. For the reasons noted in paragraphs 36-43, the staff recommends Alternative D. In addition, for the reasons noted in paragraph 49, the staff does not believe that an incremental safeguard ensuring that the creditworthiness of the new counterparty is similar to or better than that of the old counterparty (as in Alternative E) is necessary. Issue 2: Transition Questions 2 and 3 for the Task Force 2. Which transition alternative does the Task Force prefer? 3. In addition, does the Task Force wish to permit, but not require, a full retrospective transition methodology? 51. Before discussing transition methodologies specifically, the staff believes that it is important to note that each of the alternatives discussed earlier in this memo will have potentially different effects on hedge accounting relationships that (a) exist as of the effective date of the guidance and (b) had a derivative contract novation that occurred prior to the effective date of this guidance. The staff believes that understanding these potential outcomes will help focus the transition discussion by highlighting the scope of Page 18 of 26
the hedge accounting relationships that will be affected depending on which alternative is chosen by the Task Force. Specifically: a. If the Task Force chooses Alternatives B or C [assuming the novation was related to one of the acceptable fact patterns], Alternative D, or Alternative E [assuming the creditworthiness criterion is met], the potential outcomes are: (i) (ii) A reporting entity that had not dedesignated a hedge accounting relationship upon a past novation having that accounting affirmed A reporting entity that had dedesignated a hedge accounting relationship upon a past novation being told that it actually did not have to dedesignate the hedge accounting relationship as a result of the novation. b. If the Task Force chooses Alternative A, Alternatives B or C [assuming the novation was not related to one of the acceptable fact patterns], or Alternative E [assuming the creditworthiness criterion is not met], the potential outcomes are: (i) (ii) A reporting entity that had not dedesignated a hedge accounting relationship upon a past novation being told that it should have dedesignated the hedge accounting relationship as a result of the novation A reporting entity that had dedesignated a hedge accounting relationship upon a past novation having that accounting affirmed. 52. The staff observes that the reporting entities in paragraph 51(a) above would not be directly affected by the proposed guidance. Specifically, the reporting entities in paragraph 51(a)(i) would have their accounting affirmed by the proposed guidance. In addition, because the guidance in Topic 815 allows reporting entities to voluntarily dedesignate and redesignate a hedge accounting relationship at any time, those reporting entities in paragraph 51(a)(ii) who had dedesignated a hedge relationship as a result of a past novation (even though they would not have been technically required to do so) would not be in conflict with the proposed guidance. Page 19 of 26
53. The staff observes that the reporting entities in paragraph 51(b)(ii) above would not be affected, as those reporting entities would have their accounting affirmed by the proposed guidance. However, the reporting entities in paragraph 51(b)(i) would be affected by the proposed guidance, and therefore should be the focus of the transition discussion. 3 54. The staff has developed the following two transition alternatives for the Task Force s consideration: a. Transition Alternative A: Prospective transition to (i) all existing hedge accounting relationships in which a change in derivative counterparty occurred prior to the effective date of the proposed guidance, and (ii) all existing hedge accounting relationships in which a change in derivative counterparty occurs subsequent to the effective date of the proposed guidance. b. Transition Alternative B: Prospective transition to all existing hedge accounting relationships in which a change in the derivative counterparty occurs subsequent to the effective date of the proposed guidance. Transition Alternative A 55. Transition Alternative A would require entities to review all existing hedge accounting relationships as of the effective date of the proposed guidance to determine whether a change in counterparty had occurred prior to the effective date of the proposed guidance. If so, and the change in counterparty did not relate to one of the acceptable fact patterns, this alternative would result in a dedesignation of the hedge accounting relationship as of the effective date of the guidance. 56. If the hedge accounting relationship had been a fair value hedge, the recognition in earnings of the adjustment of the carrying amount of the hedged asset or liability under paragraphs 815-25-35-1(b) and 815-25-35-6 for the period prior to the effective date should not be reversed. Rather, the adjustment of the carrying amount of the hedged item 3 The staff acknowledges that the reporting entities described in paragraph 51(a)(ii) would not have been required to dedesignate those hedge accounting relationships under the proposed guidance. Therefore, the Task Force may also consider providing relief to those entities by allowing a full retrospective transition alternative (discussed later in this section of the Issue Summary). Page 20 of 26
should be accounted for under paragraphs 815-25-35-8 and 815-25-35-9. Those paragraphs indicate that the adjustment of the carrying amount of a hedged asset or liability shall be accounted for in the same manner as other components of the carrying amount of that asset or liability. For example, an adjustment of the carrying amount of a hedged asset held for sale (such as inventory) would remain part of the carrying amount of that asset until the asset is sold, at which point the entire carrying amount of the hedged asset would be recognized as the cost of the item sold in determining earnings. An adjustment of the carrying amount of a hedged interest-bearing financial instrument shall be amortized to earnings. 57. If the hedge accounting relationship had been a cash flow hedge or a net investment hedge, the effective portion of the derivative s gain or loss for the period prior to the effective date of the proposed guidance shall remain in accumulated other comprehensive income (OCI) and be reclassified into earnings consistent with the provisions of paragraphs 815-30-35-38 and 815-30-40-5, which generally require amounts in accumulated OCI to be reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings (for example, when a forecasted sale actually occurs), or when it is probable that the hedged forecasted transaction will not occur. Transition Alternative B 58. Transition Alternative B would require a prospective application of the proposed guidance to all changes in the derivative counterparty that occur subsequent to the effective date. Full Retrospective Transition Alternative 59. As noted in footnote 3 above, the staff acknowledges that the reporting entities described in paragraph 51(a)(ii) would not have been required to dedesignate those hedge accounting relationships under the proposed guidance (although the fact that they did dedesignate would not be inconsistent with existing guidance in Topic 815 or the Page 21 of 26
proposed guidance in this Issue). Therefore, the Task Force may also consider allowing a full retrospective transition option. That would provide those reporting entities with an option to go back and re-do hedge accounting in prior periods under the assumption that a dedesignation had not taken place. 60. The staff notes that a full retrospective application of the proposed guidance would provide for consistent use of the same accounting methodology from one historical accounting period to another, which enhances the comparability of financial statements between periods. Staff Analysis and Recommendation 61. The staff recommends Transition Alternative B. In addition, the staff recommends that the Task Force permit, but not require, a full retrospective transition methodology. 62. The staff acknowledges that Transition Alternative A would: a. Be consistent with the transition provisions in Derivative Implementation Group (DIG) Issue K5, Miscellaneous: Transition Provisions for Applying the Guidance in Statement 133 Implementation Issues, which states, in part, An entity that had designated a qualifying hedging relationship that no longer qualifies for hedge accounting based on newly issued cleared implementation guidance must dedesignate that hedging relationship prospectively (that is, the hedging relationship must be dedesignated at the effective date). b. Result in greater comparability within an entity s financial statements than Alternative B (because all hedges that have experienced a change in derivative counterparty would be evaluated under the same guidance, regardless of whether the novation occurred prior to or subsequent to the effective date of the proposed guidance). 63. However, the staff believes that Transition Alternative B is more cost-beneficial than Transition Alternative A. Specifically, under Transition Alternative A, if a reporting entity had previously applied an abbreviated method of hedge accounting (such as the shortcut method), and is now required to dedesignate the hedge accounting relationship as Page 22 of 26
a result of the Task Force s decision on Issue 1, that entity must either (a) set up an infrastructure to perform the long-haul assessments of hedge effectiveness and measurements of hedge ineffectiveness or (b) terminate the existing derivative entirely and enter into a brand new on-market derivative. As noted earlier in this Issue Summary, as part of the feedback received by the FASB on its previous hedge accounting exposure drafts in June 2008 and May 2010, users expressed frustration with understanding hedge ineffectiveness and the financial reporting implications of reporting entities going in and out of hedge accounting (both of which may occur under Transition Alternative A). As a result, the staff believes that Transition Alternative A would be more costly for preparers than Transition Alternative B, while not providing incremental decision-useful information to users. 64. In addition, the staff believes that the fact pattern related to this Issue is different from many of the fact patterns that led to the transition provisions established by the DIG in DIG Issue K5. With respect to this Issue, reporting entities may have been relying on SEC guidance (either the SEC s letter to ISDA or the SEC staff speech at the 2014 AICPA Conference) when determining whether to dedesignate a hedge accounting relationship upon a novation. For example, a reporting entity may have been applying the shortcut method of hedge accounting and continued using the shortcut method without dedesignation subsequent to a novation after relying on the SEC s guidance. That is, the decision made by the reporting entity was not simply an interpretation of the accounting guidance that they made on their own (which makes this Issue different from many of the issues dealt with by the DIG). Depending on the alternative chosen by the Task Force in Issue 1 of this Issue Summary, the SEC guidance that those reporting entities had relied upon may be reversed. Had those reporting entities known that the guidance they relied upon could be reversed, they might have made a different business decision entirely with respect to past novations. Page 23 of 26
Issue 3: Transition Disclosures 65. Subtopic 250-10, Accounting Changes and Error Corrections Overall, requires the following disclosures in the period in which a change in accounting principle is made: 250-10-50-1 An entity shall disclose all of the following in the fiscal period in which a change in accounting principle is made: a. The nature of and reason for the change in accounting principle, including an explanation of why the newly adopted accounting principle is preferable. b. The method of applying the change, including all of the following: 1. A description of the prior-period information that has been retrospectively adjusted, if any. 2. The effect of the change on income from continuing operations, net income (or other appropriate captions of changes in the applicable net assets or performance indicator), any other affected financial statement line item, and any affected per-share amounts for the current period and any prior periods retrospectively adjusted. Presentation of the effect on financial statement subtotals and totals other than income from continuing operations and net income (or other appropriate captions of changes in the applicable net assets or performance indicator) is not required. 3. The cumulative effect of the change on retained earnings or other components of equity or net assets in the statement of financial position as of the beginning of the earliest period presented. 4. If retrospective application to all prior periods is impracticable, disclosure of the reasons therefore, and a description of the alternative method used to report the change (see paragraphs 250-10-45-5 through 45-7). c. If indirect effects of a change in accounting principle are recognized both of the following shall be disclosed: 1. A description of the indirect effects of a change in accounting principle, including the amounts that have been recognized in the current period, and the related per-share amounts, if applicable 2. Unless impracticable, the amount of the total recognized indirect effects of the accounting change and the related per-share amounts, if applicable, that are attributable to each prior period presented. Compliance with this Page 24 of 26