In mid-January 2014, the FASB released Accounting Standard Update 2014-03 Derivatives and Hedging (Topic 815): Accounting for Certain Receive – Variable, Pay – Fixed Interest Rate Swaps (ASU 2014-03). ASU 2014-03 is the second standard issued by the FASB upon endorsement of a consensus of the Private Company Council that is specifically designed to meet the needs of private companies by providing an alternative within US GAAP. Companies that are unable to borrow at fixed rates often rely on variable-rate debt combined with an interest rate swap. In effect, they receive variable rates and pay fixed rates. The net effect is similar to borrowing at fixed rates. But the accounting and disclosure requirements are considerably more complex when an interest rate swap is involved.
In mid-January 2014, the FASB released Accounting Standard Update 2014-03 Derivatives and Hedging (Topic 815): Accounting for Certain Receive – Variable, Pay – Fixed Interest Rate Swaps (ASU 2014-03). ASU 2014-03 is the second standard issued by the FASB upon endorsement of a consensus of the Private Company Council that is specifically designed to meet the needs of private companies by providing an alternative within US GAAP.
The Issue
Companies that are unable to borrow at fixed rates often rely on variable-rate debt combined with an interest rate swap. In effect, they receive variable rates and pay fixed rates. The net effect is similar to borrowing at fixed rates. But the accounting and disclosure requirements are considerably more complex when an interest rate swap is involved.
Current accounting standards require companies to recognize all their derivative instruments (including interest swaps) on their balance sheets as assets or liabilities and to measure them at fair value. The standards allow companies to mitigate the income statement effect of any swings in fair value attributable to interest rate risks by applying an accounting method known as “cash flow hedge” accounting. This technique has the effect of presenting interest
January 2014
FASB Releases Simplification for the Accounting for Certain Interest Rate Swaps for Private Companies
expense in the income statement as if the company had a fixed rate debt. But some entities, especially private companies, have expressed concerns about the practical difficulties involved in applying the current standards.
• Companies often say they lack the accounting resources and/or expertise to comply with all the requirements that must be met to use the cash flow hedge method. These requirements include formal and timely documentation at the inception of the hedge, (known as contemporaneous documentation).
• Additionally, to qualify for hedge accounting, the hedging relationship must be expected to be highly effective, both at the inception of the hedge and on an ongoing basis. As a result, an assessment of hedge effectiveness is required whenever financial statements are reported and at least every three months. If certain other conditions are met, current accounting standards permit the reporting entity to use a qualitative method (known as the shortcut method) to assess hedge effectiveness. In practice, however, many private companies find their interest rate swaps do not qualify for the shortcut method, with the result that they need to use a technique known as the long haul method and they often lack the resources or expertise to use the long haul method.
• The requirement to report interest rate swaps at fair value can trigger burdensome disclosure requirements about the fair values of other financial instruments under current accounting standards.
Because of the practical difficulties, many private companies do not use hedge accounting, with the result that the change in the fair value of an interest rate swap used by a private company typically flows through the company’s income statement. Users of their financial statements have indicated that they do not find this result useful and some have said they typically reverse the effects of changes in the fair value of the swaps in the financial statements.
The Alternative
The simplified hedge accounting approach provides a practical expedient that enables certain entities to obtain cash flow hedge accounting for interest rate swaps that are entered into for the purpose of economically converting variable rate interest payments to fixed-rate payments. This practical expedient is available to private companies other than financial institutions (e.g., banks, savings and loan associations, savings banks, credit unions, finance companies, and insurance entities).
Highlights of the simplified hedge accounting approach are as follows:
• The simplified hedge accounting approach assumes no ineffectiveness and it results in an income statement charge for interest that is similar to the amount that would result if the private company had entered into fixed-rate borrowing instead of variable rate borrowing.
• To qualify for the alternative treatment, interest rate swaps need to meet certain criteria. For example, the terms of the swap must be typical (i.e., a “plain vanilla” swap). In addition, the repricing and settlement dates for the swap and borrowing must match or differ by only a few days, the notional amount of the swap must be equal to or less than the principal amount of the borrowing, the variable rates on the swap and borrowing must be based on the same index and reset period, and the swap’s
fair value at inception must be at or near zero.
• A private company has the option to measure the designated swap at settlement value instead of fair value, and it has additional time to prepare the hedge documentation. This documentation does not need to be contemporaneous, but it must be completed by the date on which the annual financial statements are available to be issued.
• Companies can elect the alternative treatment on a swap-by-swap basis, provided the swap meets the appropriate criteria. The policy election does not need to apply to all swaps. The disclosure requirements are simplified because use of the simplified hedge accounting approach will not trigger fair value disclosure requirements for other financial instruments.
The effective date is for annual periods beginning after December 15, 2014 and interim periods within annual periods beginning after December 15, 2014. Early adoption is permitted for any period for which the company’s annual or interim financial statements have not yet been made available for issuance. Private companies are permitted to apply either the modified retrospective approach or the full retrospective approach upon adoption of the simplified hedge accounting approach. Existing swaps as of the date of adoption may qualify for the simplified hedge accounting approach.
What should companies do now?
While each company’s situation is unique, here are some general steps that companies may find helpful now:
• Private companies should consider whether they qualify for the alternative approach and, if so, whether and when they wish to adopt the approach in their financial statements. If you are considering applying the alternative in your 2013
The information in this MHM Messenger is a brief summary and may not include all the details relevant to your situation. Please contact your MHM auditor to further discuss the impact on your audit or audit report.
financial statements, you may wish to consult with your accounting firm sooner rather than later.
• All companies that use private company financial statements should understand the key provisions for any new alternative accounting treatments, so they can analyze the financial statements effectively. This includes lenders, suppliers to private companies, and public companies that may need to include private company financial information in their SEC filings — either now (if they have already invested in a private company) or in the near future (if they are considering acquiring a private company).
The simplified hedge accounting approach was finalized as ASU 2014-03 and issued early in 2014. The effective date is for annual periods beginning after December 15, 2014, and interim periods within annual periods beginning after December 15, 2014, with early adoption permitted. Existing swaps as of the date of adoption may qualify for the simplified hedge accounting approach.
What to watch for in 2014
The FASB intends to consider whether to permit public business entities and not-for-profit entities to use this simplified approach as part of its larger project on hedge accounting. In addition the PCC is considering an additional alternative for the accounting for certain interest rate swaps called the combined instruments approach that would eliminate the need to apply hedge accounting in some instances.
For more information
MHM’s Professional Standards Group will continue to monitor progress on private company standard-setting, and we are prepared to help our private company clients with any implementation issues that may arise.
If you have any specific questions, comments or concerns, please share them with Ernie Baugh or James Comito of MHM’s Professional Standards Group or your MHM service professional. You can reach Ernie at [email protected] or 423.870.0511 and James at [email protected] or 858.795.2029.
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