The Financial Accounting Standards Board issued an accounting standards update Monday aimed at better aligning hedge accounting with an organization’s risk management strategies.
The update builds on the hedging standard that FASB released in 2017 that also tried to better align the economic results of risk management activities with hedge accounting. That standard upped the transparency around how the results of hedging activities are presented on the face of the financial statements as well as in the footnotes, for investors and analysts when hedge accounting is applied.
One of the major provisions of the hedging standard was the addition of the last-of-layer hedging method. For a closed portfolio of fixed-rate prepayable financial assets or one or more beneficial interests secured by a portfolio of prepayable financial instruments, including mortgages or mortgage-backed securities, the last-of-layer method enables an entity to hedge its exposure to fair value changes due to changes in interest rates for a portion of the portfolio that is not expected to be affected by prepayments, defaults and other events affecting the timing and amount of cash flows.
However, since issuing that standard five years ago, various stakeholders have told FASB that the ability to elect hedge accounting for a single layer is useful, but hedge accounting could better reflect risk management activities if it were expanded to allow multiple layers of a single closed portfolio to be hedged under the method. Hence, the new update expands the current single-layer method to permit multiple hedged layers of a single closed portfolio under the method. To reflect that expansion, the last-of-layer method has now been renamed the portfolio layer method.
“The expanded hedge accounting method better reflects the effects of risk management activities in the financial statements and ultimately provides investors and other allocators of capital with more transparent, decision-useful information around an entity’s use of derivatives,” said FASB chair Richard Jones in a statement.
In addition, the update expands the scope of the portfolio layer method to include nonprepayable assets, and specifies eligible hedging instruments in a single-layer hedge. It also provides extra guidance on the accounting for and disclosure of hedge basis adjustments under the portfolio layer method, as well as specifying how hedge basis adjustments should be considered when determining credit losses for the assets included in the closed portfolio.
The accounting standards update will apply to all entities that elect to apply the portfolio layer method of hedge accounting. For public business entities, the ASU is effective for fiscal years beginning after Dec. 15, 2022, and interim periods within those fiscal years. For all other entities, the ASU takes effect for fiscal years starting after Dec. 15, 2023, and interim periods within those fiscal years. In addition, early adoption is permitted.