Calendar Changing

In this week’s installment, Part III and our final installment of our series, we look at the impact hedge accounting rules and changes can have on your hedging program in 2014. In Part II, we looked derivatives regulation on your hedging program, and in Part I,  Fed Policy and its impact on hedging programs.

Part III: Hedge Accounting. Several key developments in the world of hedge accounting last year could impact your derivatives and hedging programs this year. First, the FASB approved in July 2013 the use of the Fed Funds Effective Rate (or OIS) as a benchmark interest rate, which along with LIBOR and Treasury rates can now receive favorable hedge accounting treatment under many routine hedging strategies. This is great news for entities with floating-rate assets or liabilities indexed to the Fed Funds Effective Rate, as it simplifies their ability to hedge their interest rate risk accordingly. More significantly, however, the expansion of the benchmark interest rate is good news for any company that is considering (1) swapping fixed-rate debt (or assets) to floating or (2) forward hedging an anticipated debt issuance. OIS-based swaps may reduce earnings volatility when swapping fixed-rate assets or liabilities to floating, and forward-starting OIS-based swaps may offer certain advantages over either T-locks or forward-starting LIBOR-based swaps when forward hedging. Although this guidance was issued last year, more companies are expected to avail themselves of OIS/Fed Funds hedging opportunities as the word continues to “get out” throughout 2014.

Another key pronouncement involves hedge accounting rules for use by private companies. In September 2013, The Private Company Council asked the FASB to approve certain exemptions to GAAP for private companies, including one to simplify the hedge accounting requirements for hedges of floating-rate debt swapped to fixed. The so-called “simplified hedge accounting approach” would provide private companies with a practical expedient to qualify for hedge accounting for certain interest rate swaps when the following criteria are met:

– Both the variable rate on the swap and borrowing are based on the same index and interest rate;

– The swap is “plain vanilla” and there is no floor or cap on the variable interest rate of the swap unless the borrowing has a comparable floor or cap;

– The repricing and settlement dates for the swap and the borrowing match or differ by no more than a few days;

– The swap’s fair value at the time the simplified hedge accounting approach is applied is at or near zero;

– The notional amount of the swap is equal to or less than the principal amount of the borrowing; and

– The term of the swap is equal to or less than the term of the borrowing.

One-time transition relief would be allowed, so that companies could apply the simplified hedge accounting approach to existing swaps that meet the criteria. The exception would take effect for fiscal years beginning after December 15, 2014, and early adoption would be permitted. Note, however, that financial institutions are not permitted to use the simplified hedging approach.

Next, let’s look at how companies that apply IFRS are impacted. During 2013, the IASB finalized its guidance on hedge accounting, which is included in IFRS 9. The standard provides a new hedge accounting framework that focuses on aligning hedge accounting with a company’s risk management objectives. A few of the key changes in IFRS 9 include expanding the risks that can be designated as being hedged, establishing different effectiveness assessment criteria, and permitting time value from options to be recorded to other comprehensive income rather than requiring immediate expensing in earnings. The Standard does not currently have a mandatory effective date, but it can be adopted early. Companies exposed to commodities price risk or that use options are more likely to consider early adoption because of the favorable treatment under IFRS 9 compared to the current treatment under IAS 39. Despite this, companies in Europe must wait for endorsement by the EU before they can apply the standard.

The IASB is also working on a project to create a new standard on “macro hedging,” which is a form of hedge accounting that is permitted under IAS 39 and is used by some financial institutions to hedge portfolios of financial assets and liabilities. In April 2013, the IASB decided to work on issuing a new macro hedging standard separate from IFRS 9. Simultaneously, the IASB included a scope exemption in IFRS 9 allowing companies to continue to apply the hedge accounting provisions of IAS 39, rather than requiring adoption of IFRS 9, until the new macro hedging standard is issued. The IASB is in the early stages of development of a macro hedging standard, so it could be a long time until a final standard is issued. As a result, companies could elect to continue applying IAS 39 for a number of years into the future, leaving companies with the task of determining which approach is most appropriate – continue applying IAS 39 or early adopting IFRS 9.

In addition, IFRS 13, the fair value measurement standard under IFRS, became effective in 2013. This standard introduces a framework for measuring the fair value of financial assets and liabilities, including derivatives, equivalent to the framework that has existed under US GAAP since 2008 (ASC 820). The definition of fair value has been changed in IFRS 13 and will require companies to calculate credit and debit valuation adjustments, or CVA/DVA, as part of their fair value measurements for derivatives. The proper calculation of a CVA/DVA is quite complicated and is challenging for most companies. In addition, as companies have implemented the standard, some have discovered that the incorporation of CVA/DVA under IFRS creates issues with respect to qualifying for hedge accounting, causing certain hedging relationships that previously qualified for hedge accounting to fail once the CVA/DVA has been incorporated into the periodic hedge effectiveness assessments.

Hopefully your 2014 is off to a great start. Over the past three weeks we looked at the impact on your hedging program from Fed Policy, derivatives regulation, and changes in hedge accounting. Whether you are still easing into 2014, or taking the year by storm, don’t hesitate to lean on Chatham to help you assess the impact on your business and hedging programs from these key areas!

Join us on Thursday, February 27th at 2pm ET for a webinar on FX Hedge Accounting.

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