ASU 2017-12: Targeted Improvements to Hedge Accounting

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2017-12 to simplify the application of hedge accounting. The update aims to better align an organization’s risk management strategies with its financial reporting. This alignment improves the transparency and understandability of how a company manages risk for financial statement users.

Modifications to Hedge Effectiveness Assessment

Before ASU 2017-12, the rules for assessing hedge effectiveness were rigid and quantitative. Companies had to follow a strict statistical measure known as the “80-125 rule.” This rule required the change in the hedging instrument’s value to be between 80% and 125% of the inverse change in the hedged item’s value. This threshold was often difficult to meet, causing economically sound hedges to fail to qualify for hedge accounting.

The update eliminated the need to separately measure and report hedge ineffectiveness in earnings for cash flow and net investment hedges. Instead of a numerical test, the guidance focuses on a forward-looking expectation that the hedge will be “highly effective.” This assessment can be qualitative, both initially and in subsequent periods if circumstances have not changed.

For a qualifying cash flow hedge, the entire change in the fair value of the hedging instrument is now recorded in other comprehensive income (OCI). These amounts are reclassified into earnings when the hedged transaction affects earnings. This approach avoids the income statement volatility caused by recognizing the “ineffective” portion of the hedge under the old rules.

For example, if a company hedges a future purchase, the old rules required immediate income statement recognition for any ineffectiveness. If a derivative’s value changed by $100 while the purchase’s value changed by $90, the $10 difference was recognized as a loss. Under ASU 2017-12, the full $100 change is deferred in OCI and recognized later when the purchase impacts earnings.

Expansion of Eligible Hedged Items and Strategies

ASU 2017-12 broadened the scope of items and risks that can qualify for hedge accounting, providing companies with greater flexibility to manage their exposures. The changes address both nonfinancial and financial items, allowing for more precise hedging strategies to be reflected in financial reporting.

For nonfinancial items, the update allows hedging of contractually specified components. Previously, a company had to hedge the entire price of a nonfinancial item. Now, an entity can isolate a specific risk component. For instance, a bakery buying flour can hedge the wheat component of the price, rather than the entire flour price which includes other costs like processing.

The standard also expanded eligible risks for interest rate hedges. For cash flow hedges of variable-rate instruments, companies are no longer restricted to hedging only benchmark interest rates. They can now hedge the variability in cash flows from any contractually specified interest rate component, such as a prime rate, allowing for more tailored hedging.

For fair value hedges of fixed-rate financial instruments, the update permits hedging the contractually specified interest rate component as the hedged risk. This differs from the prior model, which was limited to hedging against changes in a benchmark interest rate. This change allows a company to better isolate the specific risk being managed.

Financial Statement Presentation and Disclosure Requirements

The update established new presentation and disclosure requirements for hedging activities. The goal is to make the effects of a company’s risk management more visible and comprehensible in its financial statements and footnotes.

A primary change is the requirement to present the earnings effect of the hedging instrument in the same income statement line item as the hedged item. For example, if a company hedges inventory costs, gains or losses from the hedge must be presented in the cost of sales line. This co-presentation clarifies the economic substance of the transaction.

ASU 2017-12 also introduced enhanced disclosure requirements using a new tabular format. Companies must provide detailed tables showing the location and amount of gains and losses on hedging instruments. These tables must also show their effect on the statement of financial performance.

Disclosures must also detail the carrying amounts and cumulative adjustments for fair value hedges. Additionally, they must include information about the amounts in accumulated other comprehensive income for cash flow and net investment hedges. This provides a more complete view of the entity’s hedging portfolio and its impact.