FASB simplifies hedge accounting for private companies
Stakeholders and accountants for private companies have complained for years about the complexity and cost of compliance with U.S. GAAP, and many users simply ignore the parts of financial statements they deem irrelevant. Because they lack the personnel and resources that public companies have, many private companies struggle to comply with some of the more complex parts of GAAP.
Fortunately, in 2014, in response to suggestions from FASB’s Private Company Council (PCC), FASB released four updates that simplify accounting for private companies in goodwill, accounting for interest rate swaps, leasing arrangements with variable interest entities and intangibles resulting from business combinations. The original pronouncements included effective dates for implementing these alternatives, but, in 2016, FASB eliminated those effective dates, which means that private companies can adopt these at any time.
Let’s take a look at the Accounting Standard Update (ASU) 2014-03, Derivatives and Hedging (Topic 815): Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps – Simplified Hedge Accounting Approach. Any company, except for public business entities, not-for-profit organizations, employee benefit plans and financial institutions, can adopt these simplifications.
Small private companies often have a hard time securing fixed-rate financing. However, they can often convert their variable-rate financing into an effective fixed-rate when they enter into receive-variable, pay-fixed interest swaps.
These kinds of arrangements are classified as derivatives, and Topic 815 allows these to be accounted for using hedge accounting. Under hedge accounting, gains and losses on the original debt, and the hedging instrument, can be netted, reducing volatility in the income statement. However, the rules for hedge accounting are complex, and private companies generally lack the resources and expertise to comply with them.
For example, one requirement is that all of the documentation for the swap arrangement must be in place at, or before, the time the transaction takes place. However, in many private companies, the accountant may not find out about the deal until it’s time to put together the financials for the year. This is the key reason private companies are excluded from hedge accounting.
What are the changes?
This update for private companies makes three simplifications for hedge accounting:
- The company can elect on a swap-by-swap basis to apply this standard, and they can assume no ineffectiveness with the swap, which greatly simplifies the annual calculations.
- The company can measure each swap at settlement value instead of fair value. Settlement value is calculated as the present value of future cash flows. Fair value is the present value of future cash flows, plus an evaluation of the likelihood of nonperformance by the relevant parties.
- Documentation for the swap doesn’t have to be in place until the date that the financial statements are issued.
Which deals qualify?
The criteria for the simplified method were designed to fit the most common circumstances for swap arrangements in private companies. The following must be met for the duration of the debt being hedged:
- The variable rates on the original debt and on the hedging instrument must be based on the same index rate and reset period. For example, both must be based on the three-month London Interbank Offered Rate.
- The swap must be a “plain vanilla swap.”
- Repricing and settlement dates of both pieces must be no more than a few days apart.
- The swap’s fair value at inception must be close to, or equal to, zero.
- The notional amount of the swap and the underlying debt must be the same, although the entire amount of the debt need not be hedged.
- All of the variable interest rate payments on the debt must be designated as hedged, either in total or in proportion to the amount of debt that’s hedged.
This simplification can be elected on a swap-by-swap basis for existing swaps and for those entered into at a later date. Companies have a one-time opportunity on election to determine which existing swaps will be accounted for under the new method.
Going public? This might not be for you
This simplification may not be appropriate for private companies considering going public or which may be acquired by a public company. In either of those situations, the company’s financials will have to be restated to be in agreement with the accounting standards used by public companies.
If your clients have trouble securing fixed-rate financing, this simplification may make it easier and more inviting for your clients to enter into swaps.