New hedging standard - Benchmark Interest Rates

Under the current guidance [ASC 815], companies are limited to hedging the following benchmark interest rates only:

·         Interest rates on direct Treasury obligations of the U.S. government (the U.S. Treasury Rate)

·         London Interbank Offered Rate (LIBOR) Swap Rate

·         Fed Funds Effective Swap Rate (also referred to as the Overnight Index Swap Rate or OIS)

The new hedging standard will newly allow i) any contractually specified interest rates and ii) Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate to be designated as the hedged interest rate risk.

i) Cash flow hedges of variable-rate financial instruments

·         The concept of benchmark interest rate will be eliminated.

·         An entity may designate any contractually specified interest rate as the hedged risk in cash flow hedges of interest rate risk. For example, a bank could hedge the variability in cash flows of a variable-rate loan based on its own prime rate as long as the rate is contractually specified in the loan.

·         An entity may designate as the hedged risk only the change in cash flows of the contractually specified interest rate index, not an implied rate embedded in the interest rate index. For example, if an entity issues variable-rate debt based on its own prime rate, it cannot designate the change in cash flows of the Fed Funds Target rate or the Wall Street Journal prime rate as the hedged risk.

ii) Fair value hedges of fixed-rate financial instruments

·         The concept and definition of the term benchmark interest rate and list of the current eligible benchmark interest rates (see above) is retained.

·         The SIFMA Municipal Swap Rate is added to the list of permissible benchmark rates, which would allow an entity that issues or invests in fixed-rate tax-exempt financial instruments to designate as the hedged risk changes in fair value attributable to interest rate risk related to the SIFMA Municipal Swap Rate rather than overall changes in fair value.

·         SIFMA is the average rate at which high-credit-quality U.S. municipalities may obtain short-term financing and currently is the predominant rate referenced in issuances of variable-rate municipal bonds. For that reason, the FASB believes that it should be considered a benchmark rate.

·         If an entity modifies a tax-exempt financial instrument’s hedged risk from total price risk to interest rate risk related to the SIFMA Municipal Swap Rate, the modification would be considered a dedesignation and immediate redesignation of the hedging relationship. In this situation, the cumulative basis adjustment of the hedged item from the dedesignated hedging relationship would be amortized to earnings over the remaining life of the hedged item on a level-yield basis.

Heads-up: New hedging standard coming your way

During the third quarter of 2017, the Financial Accounting Standards Board (FASB) is expected to issue a new standard that will improve and simplify hedge accounting. The new standard will take effect for public companies in 2019 and private companies in 2020. Early adoption will be permitted upon issuance. Companies may want to evaluate whether the early adoption is feasible and the benefit of applying the new guidance (even those that do not currently apply hedge accounting).

The new guidance will:

·         Expand hedge accounting for nonfinancial and financial risk components to allow entities to qualify for hedge accounting for more of their risk management activities;

·         Decrease the complexity of preparing and understanding hedge results by eliminating the separate measurement and reporting of hedge ineffectiveness;

·         Enhance transparency, comparability, and understandability of hedge results through enhanced disclosures and changing the presentation of hedge results to align the effects of the hedging instrument and the hedged item; and

·         Reduce the cost and complexity of applying hedge accounting by simplifying the way assessments of hedge effectiveness may be performed.

The new standard will include a number of changes that will impact all areas of hedge accounting, including (but not limited to) financial and nonfinancial hedges, the timing of documentation, effectiveness testing, and presentation and disclosure. Summarized below are some of the key changes:

·         Benchmark Interest Rates

·         Nonfinancial Hedges

·         Recognition and Presentation of Changes in the Fair Value of Hedging Instruments

·         Fair Value Hedges of Interest Rate Risk

·         Shortcut Method and Critical Terms Match (CTM) Method

·         Documentation and Effectiveness Testing

·         Disclosures

·         Transition