Companies hedging nonfinancial items (such as energy commodities) face many challenges when trying to achieve hedge accounting. This process has become so painful that many companies have abandoned hedge accounting all together. However, there is hope as the FASB has proposed significant changes to the hedge accounting rules.
Under current US GAAP, companies are generally required to designate the total price risk of forecasted purchases or sales of nonfinancial items as the hedged item (e.g., the total price reflecting the location of the item). This often results in the failure to qualify for hedge accounting or the recognition of ineffectiveness. This is because many entities hedge with derivatives that are based on the commodity price quoted at a liquid hub location (e.g., a New York Mercantile Exchange (NYMEX) crude oil futures contract with settlement in Cushing, OK), rather than the price at the location where the commodity will be bought or sold.
In September, the FASB proposed a number of targeted amendments to its hedge accounting guidance aimed at more clearly portraying the economics of an entity’s risk management activities in its financial statements. This is largely due to one of the amendments allowing an entity to hedge the variability in cash flows due to changes in a contractually specified component in the forecasted purchase or sale of a nonfinancial asset. This proposal allowing component hedging could increase the number of nonfinancial hedging strategies that would qualify for hedge accounting. Going back to our example of crude oil, this means that under the proposal, an entity would be able to hedge the variability in the price of crude oil that is due solely to changes in the NYMEX price, if NYMEX is specified in the purchase contract.
The other targeted amendments that will alleviate the burden of applying hedge accounting include:
- Ineffectiveness measurement will be eliminated.
- Once hedge effectiveness is established at inception, ongoing retrospective and prospective effectiveness testing can be replaced with qualitative assurances that the critical terms of the hedged item have not changed.
- Initial quantitative effectiveness testing is no longer required “contemporaneously” with hedge execution. Rather, it will be required to be completed by quarter end.
Comments on the proposal are due back to the FASB by November 22, 2016.