September 2013

New Shortcut Method Proposed for Private Companies If you have or are contemplating entering into a pay-fixed interest rate swap and are a private company there may be some relief on the horizon from some of the current hedge accounting requirements. The FASB on 7/1/13 issued an Exposure Draft as a Proposed Accounting Standard Update (PASU); a proposal of the Private Company Council (PCC) PCC Issue 13-03 that would allow two versions of a shortcut method of reporting pay-fixed interest rate swaps that hedge variable rate borrowings. While the PASU is attractive to preparers and accountants responsible for private company financial statements, the PASU is surprising in light of the fundamental principles of the hedging rules of FAS 133 (now ASC 815, Derivatives and Hedging), recent hedge accounting proposals by the FASB and the new Dodd-Frank regulations of interest rate swaps. We will highlight the new provisions of PCC Issue 13-03 and qualifying criteria, compare how these proposed changes line up with current guidance and offer some of our comments. PCC Issue No. 13-03, “Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps” The proposal currently applies to private companies but the FASB is considering and comment letters have suggested that it be expanded to not-for-profit entities and potentially to public companies. Financial institutions including banks, insurance companies, savings and loan associations and finance companies are specifically excluded. The qualifying criteria for the new shortcut method of reporting under the PASU are much more flexible than current ASC 815 shortcut method requirements for cash flow hedges. The current shortcut method requirements prevent most pay-fixed swaps from qualifying, however, in practice many companies have found alternatives that essentially provide the same benefit as the shortcut method which are no hedge ineffectiveness and accompanying income statement volatility.

The PASU provides two similar shortcut method proposals: 1) The Combined Instruments Approach 2) The Simplified Hedge Accounting Approach Under both methods the income statement would reflect interest expense at an amount that would result had the entity entered into a fixed rate borrowing, a result that is no different than current situations where cash flow hedge accounting reflects 100% hedge effectiveness. The qualifying requirements are: a) The variable rate on the swap and the borrowing are based on the same index and interest rate, i.e., 3 Month LIBOR b) The terms of the swap are “typical” and do not include a cap or floor unless the underlying borrowing has a comparable cap or floor (the intent is that the swap be a “plain vanilla swap” and if there is a floor included in the loan, a comparable floor must be included in the swap) c) The repricing and settlement dates match or differ by no more than a few days d) The swap has a fair value at inception of at or near zero e) The swap is not forward starting f) The notional amount of the swap is less than or equal to the principal amount of the borrowing These additional requirements apply only to the Combined Instruments Approach: g) The term of the swap approximates the term of the borrowing h) The swap is effective at the same time or within a few days of the borrowing. While the PCC did not use the terminology, the Combined Instrument Approach can be viewed as a Synthetic Instrument application as the swap and the variable rate borrowing are combined and are accounted for as a single instrument fixed rate borrowing. Except for current period swap accruals, there is no reflection of the swap on the balance sheet. Unlike current shortcut method requirements, contemporaneous hedge documentation is not required. The documentation is to be completed within a few weeks of swap execution. Disclosure rules are also relaxed and the swap can be disclosed at “settlement value” rather than fair value. The Combined Instrument Approach is an entity-wide accounting policy election and applies to all current and new swaps. In contrast, under the Simplified Accounting Approach, an election to apply can be made on a swap-by-swap basis to both

existing and new swaps. And while the Simplified Accounting Approach requires disclosures in line with ASC 815, the swap can still be disclosed at settlement value. Settlement value (which is not exit value as defined in ASC 820) is defined as the fair value of the swap excluding an adjustment for counterparty non-performance risk. This fair value measurement adjustment is known as Counterparty Valuation Adjustments or CVA. And while there is required disclosure of the nature or existence of credit-related contingent features in the swap and the circumstances in which those features could be triggered for a swap in a loss position at the end of a reporting period, the current requirement under ASC 815 that disallow continuing use of hedge accounting when circumstances indicate the counterparty may default on its contractually required payment obligations is not contained in the PASU. Current Standards 1) Synthetic Instrument Accounting; The Combined Instrument Approach allows synthetic instrument accounting while ASC 815 (ASC 815-10-25-4) specifically prohibits it. Synthetic instrument accounting views two or more distinct financial instruments (generally a derivative and a cash instrument) as having synthetically created another single cash instrument. The objective is to present those multiple instruments in the financial statements as if they were the single instrument that the entity sought to create. When FAS 133 was issued, the FASB decided not to allow synthetic instrument accounting because to do so would be inconsistent with one of the four fundamental provisions of hedge accounting. That is that derivative instruments should be measured and reported at fair value. The FASB reasoned that to allow synthetic instrument accounting would be inconsistent with (a) the fundamental decision to report all derivatives in the financial statements, (b) the fundamental decision to measure all derivatives at fair value (c) the Board’s objective to increase transparency of derivatives and derivative activities, and (d) the Board’s objective of providing consistent accounting for all derivative instruments and hedging strategies. Synthetic instrument accounting is also deficient as it results in netting assets against liabilities (or visa versa) for no reason other than an asserted connection between the netted items. The PASU contemplated a requirement that the swap and the borrowing be done with the same counterparty but dropped it. As to the reflection of the swap on the financial statement at fair value, the PCC reasoned that most users of the private company financials are lenders and they now back out the swap’s fair value changes from earnings as their primary focus is on cash flows. But, clearly there will be a loss of transparency as the swap’s value would be

reflected only in the financial statement footnotes and at settlement rather than fair value. 2) Current Financial Instrument Project: While as part of the FASB project on Financial Instruments has yet to propose updated provisions for Derivatives and Hedging, the FASB’s last Exposure Draft on Hedge Accounting (5/26/10) contained a proposal that would to eliminate both the shortcut method and critical terms matching method from ASC 815. Perhaps the PCC proposal is an indication that the FASB is reconsidering these provisions. If so, a revision of the current requirements adding the necessary flexibility that would actually allow companies to use the provisions for hedge effectiveness testing might be a better way to go. 3) Current Shortcut Method Requirements: ASC 815-20-25-102 provides that if all of the shortcut method requirements are met an entity may assume no ineffectiveness in a hedging relationship of interest rate risk involving a recognized interest bearing asset or liability and an interest rate swap. Given the potential for not recognizing hedge ineffectiveness in earnings under the shortcut method, its application was limited to hedging relationships that meet each and every applicable condition. In practice, these conditions have been strictly enforced and many companies have seen shortcut method applications disallowed for relatively minor violations which in some cases resulted in restatements of financial statements. The PASU requires a comparable cap or floor in the borrowing if the swap has a cap or floor not a matching cap or floor. Also, repricing and settlement dates of the swap and the borrowing don’t need to match as long as they are within a few days of each other. If adding flexibility to the conditions for the shortcut method is reasonable for private companies, perhaps these conditions could be relaxed for public companies as well. New hedge accounting provisions in the Financial Instruments project are expected to be proposed soon and changes from the last 2010 Exposure Draft are expected. However, given the project on converging US GAAP with International Accounting Standards (IAS) continuation or relaxation of the current shortcut requirement are not expected as the IAS does allow a shortcut method of testing hedge effectiveness and the FASB has never indicated any intent to do so. 4) Hedge Documentation: The PASU modifies the current requirement to document a hedge accounting election at inception of the hedge relationship as it allows an election within a few weeks of hedge execution. This 815 requirement has also been strictly enforced in practice and prevents potential income statement manipulation by retroactively electing hedge accounting. While this may be

more of a concern for public companies, a timely hedge accounting election at inception of the swap may also assist companies in meeting the end-user exemption for hedging commercial risk under the new Dodd-Frank regulations. Failing to meet the end-user exemption will require that the swap contract be cleared and executed on a facility or exchange which can result in a loss of flexibility in structuring the swap and increase costs due to posting of margin to support the hedge counterparty credit risk. 5) Counterparty Credit Risk: ASC 820 Fair Value Measurements and Disclosures requires derivative instruments consider counterparty risk when measuring fair value. While current techniques vary, the recent financial crisis demonstrated why CVA measurements are important not only to fair value measurements but also in continuing to apply hedge accounting for swaps where the counterparty is at risk of payment default. The PASU suggests that the settlement value is the termination value of a swap. And since most swap counterparties provide the settlement value, the PASU reasons that the cost of and complexity of calculating fair value is reduced for private company reporting. The settlement value that swap counterparties now provide is the present value of expected future swap cash inflows and outflows on the balance sheet date. However, it is unlikely that a bank counterparty would terminate the swap based on the settlement valuation especially for longer-dated swaps. And since settlement value is not fair value allowing swaps to be recorded or disclosed as such violates a fundamental principal of the derivative hedging rules. What is the real cost of calculating CVA? Technology is developing to accurately and cost-effectively measure counterparty credit risk. For example, GFM Solution Group will provide CVA adjustments as part of our SAAS software. See our web site http//:www.GFMsolutionsgroup.com for details. Is the Shortcut Method Proposed by PCC Issue No. 13-03 Necessary? Clearly for straight forward, vanilla hedge relationships, a shortcut method for effectiveness testing reduces cost and complexity of understanding and applying the hedge accounting provisions. We would question however why special provisions for private companies are necessary and why the current shortcut method applications can’t be revised and then applied to all companies as ASC 815 is now. Why should non-profits, financial institutions and public companies be excluded from the ability to use a shortcut method and why should so many of the fundamental provisions of the current hedge accounting rules be bypassed for private companies?

The PCC provides that private companies generally cannot secure fixed rate funding directly, experience income statement volatility without hedge accounting and have limited resources to understand and comply with the complex hedge accounting requirements. They point out that the objective of financial reporting is to provide information that is useful to present and future financial statement users in making rational investment and credit decisions. The benefits should justify the related costs. Are these concerns just unique to private companies or do they concern all companies? We suggest a broader application of the PASU is reasonable and the need to disregard the fundamental principles of hedge accounting unnecessary. Note that an electronic copy of PCC Issue 13-03 is available on the FASB web site. This proposal is not yet effective. Feedback from constituents and redeliberation of the PASU by the FASB are still on the agenda.

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