Hedging is an approach where a corporation utilizes a derivative to balance future modifications in their fair market value or cash flow of either their liability or asset. The most common situations in which corporations can employ hedging include money market activities, forward exchange for currencies, and interest rate fluctuations. Hedging accounting links an item with a derivative and subsequently recognizes both assets’ corresponding profits and losses (Bragg, 2018). The Securities and Exchange Commission has acknowledged the Financial Accounting Standards Board (FASB) as the primary accounting quality-setting organization for publicly held corporations in the United States (Bragg, 2018). Several organizations, including the American Institute of CPAs and State Boards of Accountancy, consider FASB standards to be authoritative (AICPA). In the world of business and corporate finance, GAAP is a set of rules and regulations that govern the accounting practices of companies and corporations. The FASB utilizes GAAP as the basis for its complete collection of recognized accounting practices and methodologies. This paper delves into the exposure draft published by the FASB by looking at its brief history, status, implication of the draft adoption and suggests the need for new provisions.
History of Hedge Accounting
The development of hedge accounting began in the early 90s in response to an escalated need for openness in the derivatives market (Bloomberg Professional Services, 2020). However, even though systems such as FAS existed (FASB 52 and FASB 80), which defined the mode of derivative classification, they did not have the consistency required to enhance the transparent character needed in the financial sector to be successful. FAS 133 has been revised to provide the openness necessary as well as to improve the codification that has already been established. FAS 133 became the most effective system for all institutions, including non-for-profit organizations, in 2000, even though the report did not convey specific items concerning hedges that were mainly for not-for-profit organizations and their company’s investment format (FASB, 2016).
The decisions of this project were met as of February 3, 2021, when the Board of Directors discussed the project’s direction to assist guide the research and outreach activities of the organization’s personnel. Board members deemed it necessary to include the following instruments and features in the project’s scope:
- all of the properties of a derivative instrument are present in these freestanding financial products.
- Even if the instrument isn’t a derivative, it might be resolved in a company’s stock.
- Derivative features are built into the product’s core functionality.
Generally, the main aim of the exposure draft was to make codification adjustments and address stakeholder concerns during the February 14 and March 28, 2018, board meetings (FASB, 2020). It mainly focuses on the proposed changes to the accounting standards and is highlighted in subtopic 815-20, which consists of four main issues, and subtopic 815-30, which consists of two main agendas. Under subtopic 815-20, an individual concentrates on the change in cash flow (hedge risk). Therefore, the primary descriptions of the adjustments include:
- Revised the requirements to show that a company should indicate its best estimation of the risk that is likely to trigger the variation in cashflows in predicted transactions,
- Incorporated suggestions for determining the existence of any previously unreported hedged risks that may have been part of a given transaction,
- Revised guidance on how to achieve practical assessments of cash flows,
- Excluded foreign currency and credit risk hedges from the revised guidelines on hedged risk scope (FASB, 2019).
Subtopic number two focuses on contractually defined components in cash flow hedges if non-financial projected transactions are included. This issue’s modifications are outlined as follows:
- To qualify as a cash flow hedge, an anticipated transaction to buy or sell a non-financial asset under an agreement that is a derivative must meet specific conditions.
- Revised and modified advice on the designation of a protected rights component as the hedged risk in an anticipated acquisition or sale of an intangible asset has been reordered and amended (FASB, 2019).
Problem Areas and Suggested Changes
The FASB and the IASB have been collaborating for a very long time to develop the universal framework for financial statements, now referred to as the conceptual framework. Unfortunately, both parties were unable to reach a comprehensive agreement on the conceptual framework, and as a result, each committee developed its conceptual framework. The FASB has suggested the Hedging Accounting Exposure Draft, which served as the inspiration for the study presented in this article. Therefore, it is possible to directly examine the FASB Conceptual Framework to determine how the new hedge accounting rules improve the qualitative qualities that provide meaningful information (Di Clemente, 2015). Even though the FASB has emphasized the exposure draft, the IASB framework should also be considered since the FASB’s new solutions could result in changes related to how IFRS will proceed with variations in hedge accounting and its necessities in the future.
FASB Conceptual Framework and Hedge Accounting Provisions
The FASB Conceptual Model distinguishes between two qualitative features of helpful details that are accurate representations and relevant today (FASB, 2016). Following FASB (2016), financial information is deemed appropriate if it has the potential to influence the end choice users. When the words and figures in financial information accurately describe the economic phenomena, it purports to represent; this information is deemed faithfully represented (FASB, 2016). The current exposure draft specifies both meaningful and faithful depictions, as with the previous version. The part titled “Benefits and Costs” mentions it plainly—the trustees also feel that the transparency offered by the presented modifications would sequel a more accurate portrayal of hedging actions for preparers economically.
Hedge accounting is already complicated, and it may be tough to grasp. It can be even more difficult for end-users to appreciate its importance and whether or not it is accurately represented in the financial statements. As a result of this complexity, hedge reporting requirements are elective under IFRS No. 9. Therefore, a business may choose to adopt the hedge financial statements of IAS No. 39 instead of those of IFRS No. 9 as its accounting policy (Schroeder et al., 2017). The IFRS restrictions on financial reporting are not unique; issues have arisen throughout the FASB’s assessment of hedge accounting policies. A significant portion of these issues is attributed to the intensive corporate financial engineering that has resulted in the creation of unexpected products.
IASB Conceptual Framework and Hedge Accounting Provisions
In addition, the IASB says that quality features of valuable information include truthful portrayal and relevance. Four more subjective elements are identified by the ISAB, and the data’s comparable, verifiable, and timely nature (IAS Plus, 2018). The first provision clarifies the parameters for hedging risk and cash flow to guarantee that all firms in an industry adhere to the same rules when employing hedge accounting. Doing this will enable the financial statements of different organizations to be examined by using the same standards. End users can comprehend financial information better if the language used in specific accounting treatments is clarified and ambiguous terms removed, as stipulated in clause number four.
Actual Hedge Case
Despite its billions in profits, political power, and enormous size, Fannie Mae could not appropriately execute FAS 133, the accounting regulation for hedging and derivative instruments. Fannie Mae’s regulator allegedly broke accounting regulations to level out profit volatility. In order to meet executive incentive goals, the timing of loss recognition under another accounting regulation was allegedly altered by Fannie Mae to move a $200 million loss recognition to a later period. Fannie Mae faced various operational issues and the possibility of severe profit fluctuation due to FAS 133, which went into force in 2001. It was claimed that Fannie Mae did not adequately examine and measure the efficiency of its hedges under FAS 133 criteria.
Implications of the Project Adoption
The FASB guarantees that the capital providers are given a transparent and accountable service for their money to avoid losses. Local governments develop the financial statements presented to capital suppliers to involve residents. The company has been able to expand to new heights throughout the years. The accounting rules are unique to the company, which is in the best interest of all the stakeholders involved because it is an autonomous entity. As a result of the organization’s commitment to openness, stakeholders have complete faith in its operations. FASB’s outstanding leadership has made it essential for years, ensuring that all stakeholders are included in the decision-making process (FASB, 2020).
Investors rely on FASB initiatives because the accounting rules they develop let them decide whether or not to put their money into a firm. Investors will decide whether or not to put in their resources based on the company’s financial status (FASB, 2020). Nearly everyone who works for the organization has a stakeholder role in the FASB, from the company’s investors and lenders to its auditors and other financial statement preparers. Everyone in the organization was involved in making choices and evaluating them since the company had a code of inclusivity that encouraged everyone to be involved.
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