aga accounting principles committee meeting

FASB’s new hedging standard

AGA Accounting Principles Committee Meeting

Glen Hecht, PartnerAugust 14, 2017

1 Overview………………………………………………………………………..2 Impact of change and business opportunities…………….3 Key implementation considerations…………………….4 Other

Contents

31725

Presenter

Presentation Notes

To be updated once slides finalized

Overview

What’s staying the same?

► All aspects of Accounting Standards Codification topic (ASC) 815 not related to hedge accounting

► Types of accounting hedges (i.e., cash flow hedges, fair value hedges, net investment hedges)

► Need to assess hedge effectiveness prospectively and retrospectively► “Highly effective” threshold► Requirement to contemporaneously document hedging relationships

What’s changing?

► The Financial Accounting Standards Board (FASB) has proposed targeted amendments to its hedge accounting model to better portray the economics of an entity’s risk management activities in its financial reporting

► Proposed changes address constituent feedback on the existing model, including: ► Complexity surrounding the application of hedge accounting► Restrictions on risks that are eligible to be hedged ► Users’ difficulty in understanding hedge results, including hedge ineffectiveness

► The proposed guidance is expected to be issued in Q3 2017 and available for early adoption immediately

Snapshot of key proposed changes

The standard would impact companies in the following ways:

Allow contractually specified risk components to be hedged

Simplify certain hedge documentation and assessment

requirements

Complexity surrounding the application of hedge accounting

New hedge strategy opportunities

Restrictions on risks that are eligible to be hedged

Improve existing hedge strategies

Aligning the financial reporting for derivatives with an entity’s risk

management objectives by permitting certain hedge strategies

that were previously disallowed

Reducing operational cost and complexity when applying hedge

accounting

Introduce additional disclosures and align presentation and timing of

earnings recognition

New presentation and disclosure requirements

Users difficulty in understanding hedging results

Eliminating the need to separately measure and present hedge

ineffectiveness

Provide more useful disclosures

Current criticism with

ASC 815

FASB’s proposed

improvements

Impact & expected benefits

A B C

Shortcut method► FASB’s proposal would retain the shortcut method but attempt to reduce the

potential impact associated with its misapplication

Critical terms match method► When hedging a group of forecasted transactions (e.g., foreign denominated sales

occurring over a specified month), the proposal would allow entities to use the critical terms match method, without initial quantitative analysis, if:► The hedging instrument’s maturity and the forecasted transactions occur within the same

31-day period► All other critical terms match

Improve existing hedge strategiesA

Effectiveness testing► Would continue to be required at inception (unless qualified for the critical terms

match, shortcut or simplified hedge accounting method) ► Would allow companies until the end of the quarter to complete the quantitative

testing portion of hedge documentation requirements► All other documentation requirements will continue to be required, including a description

of how the hedge relationship will be assessed

► Option to perform subsequent tests qualitatively unless “facts and circumstances change” to an extent cannot qualitatively assert hedge was, and continues to be, highly effective► Under the existing model, quantitative effectiveness testing is required at inception and at

least quarterly thereafter (unless qualified for the critical terms match, shortcut or simplified hedge accounting method)

Improve existing hedge strategiesA

Current US GAAP requires the designation of the total price risk

Hedged item

NYMEXNat gas

Transportation

NYMEX Nat gas

Derivative

New hedging strategy opportunitiesNonfinancial hedging relationshipsB

Grade differential

► Under the existing model, companies are generally required to hedge the total price risk of nonfinancial items such as commodities.► Total price risk typically includes a base price or market index and a basis differential

related to the location or grade of the commodity

► This requirement can result in the recognition of ineffectiveness or, in some cases, the failure to qualify for hedge accounting

Company ABC enters into a contract to sell natural gas at Transco Zone 6 for a variable price specified in the contract as NYMEX price + variable spread. The company can identify the NYMEX price as the hedged risk and hedge just that component.

Airline XYZ enters into a contract to purchase jet fuel for a variable price specified in the contract of Gulf Coast Platts Jet fuel + variable spread. The airline wants to use a crude oil derivative to hedge its jet fuel purchase. The airline cannot identify the crude oil component in the jet fuel price as it is not contractually specified

Platts Jet — not crude oil

component

Contractually specified

component

Hedged item

NYMEXNat gas

Variablespread

Derivative Hedged item

WTI Crude Oil Platts Jet

Variablespread

To qualify for hedge accounting, XYZ will need to demonstrate that a hedge of Platts Jet (not the crude oil component within it) will be highly effective.

NYMEX Nat gas

Derivative


► Under the proposed guidance companies would be allowed to hedge contractually specified components linked to an index or price stated in the contract (applicable to cash flow hedges only). For example:


Additional conditions to hedge nonfinancial components ► The variable exposure attributable to the contractually specified component must

exist throughout the life of the hedging relationship.► All stated components of the price must:

► Relate to the cost of purchasing or selling the asset in the normal course of business and reflect market conditions at contract inception

► Caps or floors in the contract that limit variability in the specified component need to be considered in assessing hedge effectiveness.

► A contract is not required throughout the entire hedging period► However, the component being hedged must be specified in the contract

when executed► If the contract specifies a different component, the hedge would not need to be de-

designated if the different component that is specified would still be highly effective


Additional considerations► Understanding what constitutes an “agreement.”

► For example: Could an entity designate the contractually specified component of a spot commodity purchase if it receives an invoice or receipt at the time of purchase that specifies how the spot price was determined? Final wording will be important.

► Entities that purchase commodities using fixed price contracts but hedge the variability of that purchase in advance of signing the contract and fixing the price.► The proposed amendments would suggest that an entity could not designate a

nonfinancial component in this relationship but would instead be required to designate the total price risk.

New hedging strategy opportunitiesFinancial hedging relationshipsB

Hedging components of financial items ► Variable-rate hedged items – Would allow any contractually specified index rate to

be designated as the hedged risk (not just benchmark interest rates)► Fixed-rate hedged items – Component hedging would still be limited to benchmark

interest rates, but SIFMA municipal swap rate would be added to the list of eligible benchmark interest rates

► Under the existing model, for both variable- and fixed-rate items, only benchmark interest rates specified in ASC 815 may be identified as the hedged risk

New hedging strategy opportunitiesFinancial hedging relationshipsB

Long-haul method for fair value hedges of interest rate risk► Proposal would provide entities with flexibility in measuring the change in the fair

value of hedged item by allowing:► Entities to determine the change in fair value of the hedged item using only the portion of

the contractual cash flows related to the benchmark interest rate, not the entire coupon► Entities that hedge prepayable instruments to consider only how changes in the

benchmark interest rate affect the decision to prepay the instrument, rather than all factors that would affect this decision

► Entities to calculate the change in fair value of a hedged item in a partial-term hedge of a fixed-rate financial instrument by assuming that its maturity date matches the designated cash flows being hedged

The proposal will further align the timing of earnings recognition and income statement presentation of the hedging instrument with the hedged item.

► The proposal eliminates the need to separately measure and report hedge ineffectiveness.

► Timing of when change in FV of hedging instrument is reported in earnings► Cash flow and net investment hedges

► The entire change in fair value of the hedging derivative included in the assessment of hedge effectiveness would be recorded in accumulated other comprehensive income (AOCI) and reclassified into earnings when the hedged item affects earnings.

► Fair value hedges – no change► Excluded components base recognition model is amortization approach

► Presentation ► Generally require entities to report the entire effect of the hedging instrument and the

hedged item in the same income statement line item.

New presentation and disclosure requirementsC

Excluded components► Certain components of a hedging instrument (i.e., forward points) are allowed to be

excluded from the hedging relationship and effectiveness assessment. ► The FASB decided that the base recognition model for excluded components would

be amortization to earnings over the expected life of the hedged item.► Entities also would be allowed, as an accounting policy election, to apply a mark-to-

market through earnings approach for excluded components.► Cross currency basis spread was added to the list of excluded components.

New presentation and disclosure requirementsC

Impact of change and business opportunities

Benefits of streamlining end-to-end derivative and hedge accounting operations

Today

“Value” of theactivity for the

business

In the future

Decision support & analytics

HA Compliance

activities

Control

Reporting

Potential reduction in end-to-end

hedge accounting operating

costs

Reducing the time that companies spend on Hedge Accounting (HA) compliance activities will increase their ability to focus on strategic issues

Decision support & analytics

HA Compliance activities

Control

Reporting

Improve effectiveness• Shift resourcing mix toward higher-value activities (e.g.,

treasury, purchasing, planning, reporting, etc.)• Improve internal control effectiveness• Drive focus on service and quality• Enable continuous process improvementsImprove efficiency• Reduce operations cost by:

• Eliminating redundancies and non-value added activities (ineffectiveness measurement, assessment testing, etc.)

• Optimizing processes through standardization and leveraging economies of scale and skills (e.g., hedge accounting automation)

• Reduce process errorsImprove organizational flexibility • Provide ability to meet demand variance and realign

resources • Provide ability to quickly integrate acquisitions and

divestitures

Qualitative benefits of streamlining derivative operations are invaluable

Represents the level of value the activity contributes to the business

Proposed improvements

Summary of impact of proposed changes

Permit hedging for contractually specified components of non-financial contracts (i.e., the NYMEX or CME index price)Permit amortization approach for excluded components in fair value and cash flow hedges

Permit certain assumptions to make fair value hedging of financial instruments more feasible

Permit cash flow hedges of contractually specified rate in variable-rate financial instruments

Eliminate the need to separately measure, track, and report hedge ineffectiveness

Present entire change in fair value of a hedging instrument in the same line item as the hedged itemAmend existing and introduce new disclosures to provide more meaningful information

Allow more time for the preparation of initial effectiveness testing

Reduce the costs and complexity of monitoring effectiveness testing by allowing more qualitative assessments Relax requirements for critical terms match (CTM) method of assessment

Make the shortcut method more forgiving

Increase hedge effectiveness by allowing cross currency basis spread as an excluded component

1

2

3

4

5

7

8

9

10

11

12

13

Current criticism Impact

M

M

H

L

H

H

M

L

Impr

ove

exis

ting

hedg

e st

rate

gies

New

hed

ge st

rate

gy

oppo

rtun

ities

New

requ

irem

ents

Complexity surrounding the

application of hedge accounting

Restrictions on risks that are eligible to be

hedged

Users difficulty in

understanding hedging results

A

B

C

L

H

L

H

New hedging strategy opportunities

7

BPermit hedging of contractually specified component of non-financial contracts (Cash flow hedges only)

Proposed amendments

• For cash flow hedges of nonfinancial items, an entity would be able to designate the variability in cash flows attributable to changes in a contractually specified component (i.e., NYMEX, CME, LME, etc.) as the hedged risk.

Business opportunities Challenges

• Able to hedge nonfinancial risk components that are contractually specified, e.g. a significant benefit for commodity hedging.

• Elimination of significant ineffectiveness that exists today when hedging total price risk of non-financial contracts.

• May require re-negotiation of supplier contracts to “contractually” specify risk hedged.

• Grouping commodity contracts into homogenous portfolios that share the same contractually specified risk(s).

People, process & technology impact

Data & ITHedged item modelingCommodity risk management Quantitative testing

New presentation and disclosure requirements

11

CEliminate the need to separately measure, track and report hedge ineffectiveness(Fair value, cash flow, and net investment hedges)

Proposed amendments

• Eliminate the requirement to separately measure and report hedge ineffectiveness.• As long as the hedge relationships are highly effective entire change in fair value will go to OCI/CTA for cash flow and net

investment hedges, respectively.

Business opportunities Challenges

• Eliminate earnings volatility.• Increase the benefit of cash flow and net investment

hedging strategies. • Time does not need to be spent on measuring and tracking

ineffectiveness, and for preparing related financial statement disclosures.

• May require separate accounting (e.g. OCI amortization for cash flow hedges with non-zero fair value at inception).

• Change in financial statement processes: • No need to separately quantify and explain

ineffectiveness in the disclosures/FS.

People, process & technology impact

I/S presentation changes GL changes Accounting entries

Key implementation considerations

Key considerations for implementation

Key considerations for implementation

Accounting & reporting• Develop and enhance accounting and disclosure processes to reflect

requirements of the new hedge accounting model (e.g., no requirement to book ineffectiveness, OCI tracking and release, excluded component amortization and accounting, etc.)

• Revise hedge accounting policies and change processes (including SOX testing procedures and controls)

• Develop a process to calculate transition adjustments for both cash flow and fair value hedges

Risk management/treasury• Conduct a thorough review of existing economic hedging strategies that

can be extended to apply hedge accounting under the new guidance • Identifying other exposure profiles and forecasted cash flows to identify

additional hedging programs that management can apply and that can qualify for hedge accounting under the amended guidance

• Assessing the operational risk (including SOX, internal control) framework related to transitioning to the new standard

Data, systems & IT• Develop and retain historical valuation data for disclosures and (modified)

retroactive adoption (if applicable)Education/Training• Bridge the knowledge gap between current vs. future state requirements

across all teams through educational sessions, on the job training, or workshops

TransitionAccounting and reporting

Effective date► Early adoption would be permitted at the beginning of any reporting period from date the

amendments are released (expected in Q3 2017) until the effective date. ► An entity would be required to adopt all of the amendments at one date.

Accounting policies► All accounting policies and hedge documentation would need to be updated to comply with the

amendments upon adoption.► One-time election available upon adoption to amend hedge documentation for existing hedging

relationships

Disclosures► New tabular disclosures would be required upon adoption► An entity would apply a modified retrospective approach as of the adoption date to hedging

relationships existing at that date► For cash flow and net investment hedges, the entity would record the cumulative effect of the

application of the recognition requirements in AOCI with a corresponding adjustment to the opening balance of “retained earnings” as of the adoption date

► Upon adoption, required to provide transition disclosures within ASC 250 on accounting changes and error corrections.

Key aspects of IFRS 9 vs. FASB’s Proposed Amendments

Issue IFRS 9 Exposure draft

Risk components (nonfinancial items)

Can either be contractually specified or non-contractually specified components (if separately identifiable and measurable)

Only contractually specified components can be identified

Risk components (financial items)

Separately identifiable and measurable For cash flow hedges – contractually specified; for fair value hedges –benchmark interest rates only

Assessment of hedge effectiveness and threshold

Prospective only; no bright-line threshold Both prospective and retrospective; “highly” effective threshold

Recognition of ineffectiveness for cash flow and net investment hedges

Recognize through earnings eachreporting period

Record in AOCI (or CTA) and release to earnings when hedged item affects earnings

Rebalancing Adjustment to hedge ratio to reflect expected changes between hedged item and hedging instrument

Existing hedge relationship discontinued when hedge ratio is changed

Voluntary de-designation Not permitted Permitted

Glen Hecht, Partner Financial Accounting Advisory ServiceDerivatives and financial instruments

+1 212 773 [email protected]

Contact Information

EY | Assurance | Tax | Transactions | Advisory

About EYEY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities.

EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com.

Ernst & Young LLP is a client-serving member firm ofErnst & Young Global Limited operating in the US.

© 2017 Ernst & Young LLP.All Rights Reserved.

This material has been prepared for general informational purposesonly and is not intended to be relied upon as accounting, tax or otherprofessional advice. Please refer to your advisors for specific advice.

ey.com

aga accounting principles committee meeting

Documents