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Hedge accounting: How new guidance will impact your risk strategy · PwC's accounting podcast

• 0:00
  SPEAKER_02: Thought leadership from PWC's National Office.
• 0:06
  SPEAKER_00: Hello, and welcome to PWC's Accounting Podcast.
• 0:10
  SPEAKER_00: I'm Heather Horn.
• 0:12
  SPEAKER_00: Thanks for joining us today as we jump into current topics in accounting and reporting.
• 0:17
  SPEAKER_00: For today's discussion, I'm pleased to welcome guest host, Diana Stoltzfitz, a partner in PWC's national office and a podcast regular.
• 0:27
  SPEAKER_00: I'll hand it over to Diana for more details on today's episode.
• 0:35
  SPEAKER_01: Today we're talking about hedge accounting, what's changed, what's ahead, and what it all means for companies managing interest rate, foreign currency, and commodity risk.
• 0:44
  SPEAKER_01: The FASBI recently issued new guidance that makes targeted but meaningful changes in several complex areas of derivatives and hedging.
• 0:52
  SPEAKER_01: And we'll talk through some of these updates today.
• 0:54
  SPEAKER_01: In addition, the board has outlined additional hedge accounting projects that could further reshape parts of the model.
• 1:00
  SPEAKER_01: So a lot's happening in this space.
• 1:02
  SPEAKER_01: To help break it all down, I'm joined by Nick Malone, a partner in PWC's financial markets and real estate practice, and Chip Curry, a partner in our national office.
• 1:11
  SPEAKER_01: Both bring deep technical knowledge and experience working with clients and engagement teams on these issues.
• 1:18
  SPEAKER_01: Thanks so much for joining me.
• 1:19
  SPEAKER_01: I'm looking forward to the discussion.
• 1:21
  SPEAKER_01: So I thought we'd start off today by talking about what you guys are seeing in the hedging space, what's coming up in client conversations, and what you're seeing from a hedging activity.
• 1:30
  SPEAKER_01: So, Nick, maybe I'll start with you.
• 1:31
  SPEAKER_05: Yeah, thanks, Diana.
• 1:32
  SPEAKER_05: So, yeah, we're definitely having a lot of conversations with clients about derivatives and hedging and sort of risk management in general.
• 1:37
  SPEAKER_05: Uh, it's a topic that always seems to be top of mind for a lot of our clients.
• 1:41
  SPEAKER_05: And, you know, certainly today, given the volatility and interest rates, foreign exchange, and commodity markets, clients are actively managing some of these risk exposures and they're evaluating different hedging strategies.
• 1:51
  SPEAKER_05: You know, tenors, risk uh risk profiles, um, risk tolerances, uh, are their programs fit for purpose given the volatility we're seeing in today's markets?
• 2:00
  SPEAKER_05: You know, not all hedging strategies involve the use of derivatives, though.
• 2:03
  SPEAKER_05: There are a number of tools at the disposal of our of our clients that to manage risks.
• 2:07
  SPEAKER_05: Uh, you can manage risk by uh changing your interest rate risk profile of how you fund yourself.
• 2:12
  SPEAKER_05: So fixed versus floating, uh, the tenor in which you're you're issuing debt.
• 2:16
  SPEAKER_05: Um, but derivatives are often used in these risk management strategies because they're uh really sort of effective and efficient ways to manage the risks and they and they can be you know cost effective.
• 2:25
  SPEAKER_03: Yeah, I agree with everything Nick just said.
• 2:27
  SPEAKER_03: Uh we're seeing the same thing from questions coming up through through our national office.
• 2:31
  SPEAKER_03: Um, and you referenced this a little bit when you kicked off that we we are definitely seeing some standard setting activity, right?
• 2:38
  SPEAKER_03: So uh they issued new guidance in November, which we'll talk a little bit about.
• 2:42
  SPEAKER_03: And they've sort of laid out a path forward for future amendments to the standard.
• 2:47
  SPEAKER_03: They've kind of broken it up into like short-term projects, a medium-term project, and you know, a longer-term project.
• 2:52
  SPEAKER_01: Okay.
• 2:52
  SPEAKER_01: Well, Chip, you mentioned that there was some new guidance that came out in November.
• 2:56
  SPEAKER_01: So let's start with that.
• 2:57
  SPEAKER_01: Can you give us an overview?
• 2:58
  SPEAKER_03: Yeah, sure.
• 2:59
  SPEAKER_03: So so for everybody who likes to write this stuff down and keep track at home, it was ASU 2025-09.
• 3:06
  SPEAKER_03: Um, and we published an in-depth summarizing uh that guidance, but but it really impacts five areas.
• 3:13
  SPEAKER_03: So the the first area is it changed and provided new guidance on how you do a similar risk assessment for cash flow hedges.
• 3:20
  SPEAKER_03: So think about this when you're trying to hedge multiple transactions together in a single hedging relationship, um, and how you demonstrate that those risks are similar so that you can and you are allowed to hedge them together in a single transaction.
• 3:33
  SPEAKER_03: The second thing it does is it effectively provides a new model for hedging choose your rate debt.
• 3:38
  SPEAKER_03: So choose your rate debt are variable rate debt instruments where the issuer can elect to change the interest rate index or the tenor from a list of specified rates within the debt agreement.
• 3:49
  SPEAKER_03: Um, it provides new guidance and a new model for hedging uh cash flow hedges of forecasted purchases and sales of nonfinancial assets.
• 3:57
  SPEAKER_03: It eliminates the current model or the previous model that existed, where you could hedge contractually specified components with a new model that allows you to hedge components and subcomponents of transactions.
• 4:10
  SPEAKER_03: And this new model works for purchases that are either executed under contractual agreements, like forwards to acquire non-financial assets, but it also works for transactions executed in the spot market.
• 4:21
  SPEAKER_03: Um, the last two things are a little bit more specific.
• 4:24
  SPEAKER_03: Uh, it provides a new scope exception from having to do the written option test for certain interest rate hedges when you're using interest rate swaps, would that have embedded written options?
• 4:34
  SPEAKER_03: And it changes the guidance for what um people call dual hedges.
• 4:38
  SPEAKER_03: It's not, it's not a super common transaction, but it involves where you have foreign-denominated debt, so with debt liability, that has been designated as the hedging instrument of a net investment hedge, but it is also the hedged item where people are hedging fair value risk.
• 4:55
  SPEAKER_03: So a little more complicated, a little less frequent, but those are sort of the five areas.
• 4:59
  SPEAKER_01: Wow.
• 5:00
  SPEAKER_01: That those are some pretty specific areas that were addressed by this new guidance.
• 5:04
  SPEAKER_01: So maybe just thinking about what of these amendments will impact the broadest amount of companies.
• 5:10
  SPEAKER_01: Nick, what's your thoughts on that?
• 5:12
  SPEAKER_05: Yeah, thanks, Lana.
• 5:13
  SPEAKER_05: You're right.
• 5:13
  SPEAKER_05: I think they are very specific, sort of very targeted changes, um, but they are all in response to feedback that FASB's received.
• 5:20
  SPEAKER_05: I think the guidance on the that you mentioned on the similar risk assessment and the net written option relief are probably likely to have the greatest impact on some of our financial service companies.
• 5:29
  SPEAKER_05: Um, and for the non-financial service companies, I think the guidance on choose your rate debt uh is is likely to have a big impact as well.
• 5:36
  SPEAKER_05: Um, as Chip mentioned, for choose your rate debt, it allows the borrower at each sort of interest reset date to choose from a specified list of rates that they're going to pay interest based off of.
• 5:45
  SPEAKER_05: Um, we see this a lot in in borrowing facilities where the borrower will have the right to borrow either overnight sofa, one, three, six-month term sofa, and they have that choice every every interest period, uh, which rate to choose.
• 5:57
  SPEAKER_05: And so, under today's guidance, if you wanted to get hedge accounting and and get get sort of favorable hedge accounting treatment, you need to be sort of very specific in terms of asserting what you're what rate you're hedging.
• 6:07
  SPEAKER_05: So, even despite the flexibility that the contract gives you, you're you're you're really picking up, you know, I assert that I'm going to only pick overnight sofa, despite the fact that the contract gives me other options.
• 6:17
  SPEAKER_05: And that's the way to sort of get favorable hedge accounting today.
• 6:20
  SPEAKER_05: Um and so that obviously removes a lot of the flexibility that that's that's inherent in the in the contract.
• 6:25
  SPEAKER_01: Yeah.
• 6:25
  SPEAKER_01: So it seems like it basically takes away the benefits of entering into that contract if you essentially have to make all those choices up front.
• 6:31
  SPEAKER_05: Yeah, exactly, exactly right.
• 6:32
  SPEAKER_05: And I think so.
• 6:33
  SPEAKER_05: What the new guidance is is designed to do is it's allow, it's supposed to allow companies some flexibility um in terms of choosing those, you know, picking those different rates at different times during the life of the borrowing without having to worry about missed forecast transactions and without having to D and re-designate the hedge, provided that the hedge remains highly effective.
• 6:53
  SPEAKER_05: And so, you know, you kind of think about this model as having a number of exceptions to the normal cash flow hedging rules.
• 6:59
  SPEAKER_05: So it's not something that can be analogized to.
• 7:02
  SPEAKER_05: It has to be, it only applies to choose your rate debt.
• 7:04
  SPEAKER_05: Um, probably not a surprise to people, but there are a list of rules that you need to comply with to follow this model.
• 7:11
  SPEAKER_05: And even deeper than that, the rules are a little bit different for existing floating, existing choose your rate debt.
• 7:17
  SPEAKER_05: Um, so debt that's outstanding currently, as uh versus you know, choose your rate debt that you might issue in the future, like forecasts of debt issuance.
• 7:25
  SPEAKER_05: So again, the rules are probably a little bit too complex or nuanced to get to get through in a podcast like this.
• 7:31
  SPEAKER_05: So maybe just to hit on a couple of the key aspects of the model as it relates to existing um choose your rate debt.
• 7:36
  SPEAKER_05: That's probably that's probably sort of the most, I think, impactful immediately for companies out there.
• 7:42
  SPEAKER_05: Um, so again, the one of the things I already mentioned about the new model is it allows the issuer to exercise sort of the optionality in the debt without worrying about missed forecast transactions and D and redesignation.
• 7:52
  SPEAKER_05: Uh, the way to do this is in terms of their the company's hedge documentation, what they would write down in their documentation is sort of list out all the different indices that the that the contract would allow them to borrow off of.
• 8:03
  SPEAKER_05: So again, like overnight sofa, one, three, six month-term sofa.
• 8:06
  SPEAKER_05: And because all of those choices or tenors are written down in your hedge documentation, if the company does elect to change the rate from say overnight to one month term sofa, it's not considered a missed forecasted transaction because it was outlined and written up front in the hedge documentation.
• 8:23
  SPEAKER_05: Um, so in terms of assessing effectiveness under this choose you rate that model, you know, similar to existing hedge accounting, it's at least quarterly.
• 8:30
  SPEAKER_05: Uh, but there's also an incremental requirement that to assess effectiveness if and when you actually choose to change the index you're you're you're borrowing off of.
• 8:39
  SPEAKER_05: So, you know, you're sort of you get to sort of ignore the optionality while you're, you know, while you've you've chosen a rate.
• 8:45
  SPEAKER_05: So if you choose overnight sofa, you're assessing effectiveness based off of overnight sofa until you choose a different rate.
• 8:51
  SPEAKER_05: And so when you choose that different rate, you would sort of update your hedge document, your your hedge effectiveness assessment to be based off of now your one-month term sofer option.
• 8:59
  SPEAKER_05: And and and you know, just making sure that that that uh that assessment of effectiveness shows that the hedge is still highly effective, given your new, the the new rate you've chosen.
• 9:07
  SPEAKER_01: Okay, so I get it.
• 9:08
  SPEAKER_01: So basically you're looking at the contract and you'll look at the effectiveness, like the rate that you had chosen previously.
• 9:14
  SPEAKER_01: You do that when you're doing your retrospective test.
• 9:17
  SPEAKER_01: And then you think about as long as you're choosing one of those options that was written down in your initial, you know, hedge documentation, then you would use that for your effectiveness test going forward.
• 9:26
  SPEAKER_05: Correct.
• 9:26
  SPEAKER_05: Yeah.
• 9:27
  SPEAKER_05: Um, and and sort of sort of very similar to today, you know, if you fail your retrospective test, you know, the backward-looking test, you know, you know, you don't get hedge accounting for the for the past period.
• 9:36
  SPEAKER_05: If you fail your prospective test based off of a new index, you don't get hedge accounting in the in the in the subsequent period.
• 9:42
  SPEAKER_05: Um so that's that that's very similar to to you know hedge accounting today.
• 9:46
  SPEAKER_05: You know, I mentioned the model is pretty complex.
• 9:48
  SPEAKER_05: Uh, so there's a lot more to it than than than what we talked about.
• 9:51
  SPEAKER_05: And there are, you know, some maybe what you call downsides to it.
• 9:55
  SPEAKER_05: Um, you know, for example, it's because of the way the model works, it's it's less likely that you're gonna have a missed forecast.
• 10:01
  SPEAKER_05: But the consequences of having a missed forecast are probably a little even more severe than they are under current gap.
• 10:06
  SPEAKER_05: There's also some sort of nuances around you know, incorporating the ability if you wanted to replace existing choose your rate debt with new debt in the future via some sort of refinancing.
• 10:15
  SPEAKER_05: There's some very nuanced rules around that.
• 10:17
  SPEAKER_05: Um, and and so because of all that, the the the this new choose your rate debt model um is elective.
• 10:23
  SPEAKER_05: It's optional.
• 10:24
  SPEAKER_05: You don't you don't have to use it.
• 10:25
  SPEAKER_05: You could still apply the sort of the current gap around, you know, I I promise or assert I'm I'm only gonna borrow based off of this rate, despite the the flexibility.
• 10:34
  SPEAKER_05: So even you could still use the current guidance, even even with all its limitations, um, if if you don't want to, if if for whatever reason you don't want to comply with uh, you know, the the laundry list of rules in the new choose your rate debt model.
• 10:45
  SPEAKER_01: So it sounds like entities that are thinking about using this model should evaluate or or that are entering these types of transactions and want to get hedge accounting, you can evaluate what might make the most sense.
• 10:54
  SPEAKER_01: But it seems like there are a lot of rules and details that it's important to understand and how that interacts with your own facts and circumstances.
• 11:01
  SPEAKER_01: So maybe chip, we you mentioned that another one of the changes related to hedging purchases and sales of non-financial assets.
• 11:09
  SPEAKER_01: So maybe we can pivot to that.
• 11:10
  SPEAKER_03: Yeah.
• 11:11
  SPEAKER_03: So maybe we start out prior to the adoption of the ASU.
• 11:14
  SPEAKER_03: What did what does the landscape look like if you're looking to hedge like a forecasted purchase or sale of a non-financial asset?
• 11:21
  SPEAKER_03: So, what are we talking about here?
• 11:22
  SPEAKER_03: We're talking about situations where you're a company that needs to acquire like a raw material to use that in your production.
• 11:29
  SPEAKER_03: And what you're trying to do is hedge the variability in price of what that raw material is gonna cost you in the future.
• 11:36
  SPEAKER_03: So um, so what could you do before the adoption of the ASU?
• 11:39
  SPEAKER_03: Well, you you could really do three things.
• 11:42
  SPEAKER_03: One is you could hedge FX risk.
• 11:44
  SPEAKER_03: So if you're a US dollar functional uh currency company and you're selling non-financial assets and and those sales are gonna be in euro, then you can hedge the FX risk.
• 11:55
  SPEAKER_03: And nothing's really changed on this ASU with your ability to do that.
• 11:59
  SPEAKER_03: The second thing you could do is you could hedge the overall variability in purchase or sale price.
• 12:04
  SPEAKER_03: And again, nothing's really changing from the ASU.
• 12:07
  SPEAKER_03: The third thing you can do under current gap is if you have a contract to purchase or sell a non-financial asset, um, and that contract wasn't being accounted for as a derivative in of itself, like if it, for example, if you were elected the normal purchase normal sales scope exception, if that contract has like a variable price component to it, you could hedge the variability of that contractually specified component.
• 12:33
  SPEAKER_03: So sometimes when people enter into forecasted purchases of raw materials, what the contract would say is you're gonna pay like a rate, you know, the formula for the price you pay is gonna equal to like a spot price or a price of uh at a liquid location plus a fixed delivery cost.
• 12:52
  SPEAKER_03: So if you had a contract that said that, you could hedge that specific contractually specified variable component.
• 12:59
  SPEAKER_03: That model, that third model we talked about, the contractually specified component, had had a number of issues with it.
• 13:06
  SPEAKER_03: Um the the the biggest issue that people identified is it didn't really work when you were buying something in the spot market.
• 13:13
  SPEAKER_03: Because when you buy things in the spot market, there isn't a contract that spells out the terms for the price of purchase.
• 13:20
  SPEAKER_03: You just get a receipt saying how much you purchased and what price.
• 13:23
  SPEAKER_03: So, for example, when you pull your car into the gas station and you fill it with gas, you don't get sign a contract that says I'm paying oil plus this minus what you just get a receipt that says you paid, you know, what's it now?
• 13:40
  SPEAKER_03: Over like$3 a gallon, right?
• 13:42
  SPEAKER_03: But whatnot.
• 13:43
  SPEAKER_03: Um, so what's changing?
• 13:45
  SPEAKER_03: So what the new guidance does is focuses on hedging components and subcomponents more broadly.
• 13:51
  SPEAKER_03: So what you to L to identify like what's an eligible component or subcomponent, the new guidance leverages the clearly and closely related model from the normal purchase normal sale guidance.
• 14:04
  SPEAKER_03: All right.
• 14:04
  SPEAKER_03: So what does that mean?
• 14:06
  SPEAKER_03: So if you have a contract to purchase or sell a non-financial asset, and that contract has a variable price component, you can hedge that variable price component as long as you can demonstrate that that variable component is clearly and closely related under the normal purchase normal sale model to the non-financial asset.
• 14:27
  SPEAKER_03: So that's step one of the model.
• 14:29
  SPEAKER_01: Okay.
• 14:29
  SPEAKER_03: Um now that doesn't sound like a radical change.
• 14:32
  SPEAKER_01: It sounds kind of like the model we have today.
• 14:35
  SPEAKER_03: Exactly.
• 14:36
  SPEAKER_03: With the addition of the clearly and closer related, yeah.
• 14:39
  SPEAKER_03: Okay, but so now what the new guidance would allow you to do is hedge a subcomponent of that contractually specified variable component.
• 14:48
  SPEAKER_03: Um, so I'll steal an example from the standard.
• 14:52
  SPEAKER_03: So um let's say you have a contract to purchase copper wire that you're gonna need, and that contract is not being accounted for as a derivative.
• 15:01
  SPEAKER_03: And when you look at the terms of that contract, the price that you're gonna pay per pound of copper wire fluctuates based upon like a copper wire index.
• 15:11
  SPEAKER_03: We call it the ABC copper wire index.
• 15:13
  SPEAKER_03: Okay, plus some sort of like fixed spread.
• 15:17
  SPEAKER_03: Well, you might find there's no liquid derivative on the ABC copper wire index.
• 15:23
  SPEAKER_03: But you can demonstrate that the ABC copper wire index price is based upon like a price of raw copper plus processing costs.
• 15:32
  SPEAKER_03: So if you can demonstrate that copper costs are clearly and closer related to that copper wire index in the contract, then and you can prove that the index in the contract is clearly and closer related to the final product.
• 15:47
  SPEAKER_03: So it's like a two-step test, okay, then you can hedge a subcomponent.
• 15:51
  SPEAKER_03: So that's a bit complex.
• 15:52
  SPEAKER_03: There's a couple of things you need to demonstrate, but the concept is you can hedge a subcomponent of a contractually specified component if you can prove you that there are the subcomponents clearly and closer related to the component, and the components clearly and closer related to the overall asset you're purchasing.
• 16:10
  SPEAKER_03: So that's new, that's different.
• 16:12
  SPEAKER_03: It allows you to drill down at a more granular level.
• 16:15
  SPEAKER_03: Um, so that's sort of the change when you focus on like contractually specified components and contracts to purchase or sell things that have a variable component.
• 16:26
  SPEAKER_03: That's the big change.
• 16:27
  SPEAKER_01: Okay.
• 16:28
  SPEAKER_01: So I see your point related to now the ability to hedge these subcomponents.
• 16:32
  SPEAKER_01: But you also mentioned there was some criticism in the current model that was focused on spot markets.
• 16:36
  SPEAKER_01: So maybe back to your example related to the gas prices.
• 16:39
  SPEAKER_03: Yeah.
• 16:39
  SPEAKER_03: So, so, so now the model will also work in the spot markets because we're not necessarily focused on whether you have a contractually specified component.
• 16:48
  SPEAKER_03: We're trying to identify whether there's a component that's clearly and closely related to the overall purchase or sale price.
• 16:55
  SPEAKER_03: So when you're purchasing in the spot market, like we talked about, like in the gas example, there's no contract to look at and see variable components.
• 17:03
  SPEAKER_03: Um, the purchaser and seller negotiate a price that you're gonna pay, or perhaps the seller, like in the gas station, posts a price and you agree to pay it by pulling in and filling up your car.
• 17:12
  SPEAKER_03: So, what you can do in this case is you can hedge a component of spot price.
• 17:16
  SPEAKER_03: Subcomponents not really relevant, a relevant concept in spot markets.
• 17:22
  SPEAKER_03: That's when you're hedging a portion of a contractually specified component, but it's the same concept.
• 17:27
  SPEAKER_03: You can hedge a component of overall spot price.
• 17:30
  SPEAKER_03: So, again, like stealing from the example in the standard, let's say that you're a company and you're going to be purchasing soybeans and you're going to be doing that in the spot market.
• 17:40
  SPEAKER_03: And based upon where you're buying the soybeans, you know, the location and the delivery location of those soybeans, you know that the soybean index price, like an index price, like the example they use is another ABC index price.
• 17:56
  SPEAKER_03: You know that that's how the market prices.
• 18:00
  SPEAKER_03: What you could say is you could say, well, that's an eligible component because I can demonstrate it that index price is clearly and closer related to the purchase price of the asset at that location.
• 18:10
  SPEAKER_03: And instead of hedging the overall purchase price, I can just hedge that component.
• 18:15
  SPEAKER_03: Okay.
• 18:16
  SPEAKER_03: So same concept, right?
• 18:18
  SPEAKER_03: Hedging components and subcomponents, same rules.
• 18:21
  SPEAKER_03: You have to prove each step along the way that it's clearly and closer related, but it allows you to hedge things at a more granular level where you're not always forced into hedging overall purchase price or sale price.
• 18:34
  SPEAKER_01: Okay, that's helpful.
• 18:35
  SPEAKER_05: Yeah, I think some of the changes that Chip just talked about, you know, like the ability to hedge a component or subcomponent uh of a purchase or sale of a non-financial asset or hedging components in the spot markets, um, could could really could really open up a lot of opportunity for companies to apply hedge accounting.
• 18:50
  SPEAKER_05: I think today in this space, in the non financial hedging space, we often see derivatives utilized uh as economic hedges of exposures.
• 18:59
  SPEAKER_05: Um, but sometimes, you know, hedge account because of the current rules or the current guidance, the hedge accounting isn't applied.
• 19:04
  SPEAKER_05: Um or maybe we we we see companies applying hedge accounting, but um, you know, the company seeing noise in the hedge effectiveness results as a result of some of the current rules.
• 19:14
  SPEAKER_05: And so I do think the ability to hedge components or subcomponents, um, you know, as opposed to overall purchase price will are in many cases gonna make uh you know hedge relationship more effective.
• 19:24
  SPEAKER_05: And so I think like Chip said, I think the magic in this new model is sort of defining and identifying the component or subcomponent that you're gonna hedge.
• 19:31
  SPEAKER_05: Um and then typically I think the the the expected result is that you're gonna have a much more uh effective uh hedge result.
• 19:38
  SPEAKER_03: Yeah, now I mentioned a couple of times this clearly and closer related requirement and that it's based upon the clearly and closer related guidance in the normal purchase normal sale guidance.
• 19:47
  SPEAKER_03: So just as a quick um refresh circle back, yeah, refresher on that.
• 19:52
  SPEAKER_03: So so normal purchase normal sale is a scope exception in the standard for contracts that would otherwise be derivatives, that if you're if it's probable you're gonna take physical delivery and you're gonna use that in your normal production and to run your business, then you can elect to apply a scope exception.
• 20:08
  SPEAKER_03: To apply that scope exception, when you have variable price components in that contract, you have to demonstrate that they're clearly and closely related.
• 20:16
  SPEAKER_03: And the clearly and closer related guidance, right, Nick, it's it's a little bit different in normal purchase, normal sale than like the normal, clearly and closer related guidance that you would apply if you're assessing for embedded derivatives in like dead instruments or things like that.
• 20:30
  SPEAKER_05: Yeah, I think the I guess the in general, I guess the way I sort of think about it is the scope exception in normal purchase, normal sales is a little bit more structured than the sort of the general uh clearly and closely related guidance around embedded derivatives.
• 20:44
  SPEAKER_05: Um for embedded derivatives, you're typically looking at just like the overall economic risks and characteristics of the embedded derivative versus the host contract.
• 20:52
  SPEAKER_05: Um, under the normal purchase normal sales scope exception, clearly and closely related is getting more at or asking you to do more around the actual sort of pricing, um the pricing impact of the component.
• 21:02
  SPEAKER_05: So both, you know, talk the literature talks about both qualitative and quantitative analysis uh of the pricing features within the contract.
• 21:09
  SPEAKER_05: It says, you know, the pricing feature can't be extraneous or have a sort of disproportionate impact on the price.
• 21:15
  SPEAKER_05: You know, it's a it's effectively sort of looking at and saying, you know, is the component or subcomponent, you know, expected to, you know, have a have an impact on the price in a manner that would be comparable to, you know, if the parties were to sort of reprice the contract under then current market conditions, you know, at each delivery date.
• 21:31
  SPEAKER_05: Um, and so it's a little, it's similar concepts, but a little bit more structured, a little bit more focused on the pricing impact of the component in the normal purchase normal sales scope exception, you know, again, versus the sort of general, clearly and closely related guidance for embedded derivatives.
• 21:45
  SPEAKER_01: Okay.
• 21:46
  SPEAKER_01: Well, so we've covered two of the aspects of the new derivative guidance the hedging choose your rate debt and hedging of purchases and sales of non financial assets.
• 21:56
  SPEAKER_01: But you mentioned at the beginning, Chip, that there's also more.
• 22:00
  SPEAKER_01: Items on the FASBE's agenda, the both the short term and long term.
• 22:03
  SPEAKER_01: So what do we see coming?
• 22:05
  SPEAKER_03: Yeah, I mean it's it's a it's a timely topic to be talking about here.
• 22:09
  SPEAKER_03: Um so we went through two aspects, and and one of your observations rightfully so is there's still a lot of rules.
• 22:16
  SPEAKER_03: Um and one, I think the of the issues that they had in making these changes is without changing some of the fundamental framework of the derivative guidance, you're sort of one, limited to what you can do if you want to operate within that framework.
• 22:32
  SPEAKER_03: And two, when you want to do something outside of that framework, you have to make exceptions.
• 22:37
  SPEAKER_03: So that's why, like Nick said, the new choose your rate debt model has to be thought about like as an exception to the normal rules.
• 22:44
  SPEAKER_03: Right.
• 22:44
  SPEAKER_03: Because to get it to work, to get that flexibility, they had to create exceptions.
• 22:49
  SPEAKER_03: So at the end of February, the the board met to sort of chart out this path forward.
• 22:54
  SPEAKER_03: I think we mentioned that a bit before.
• 22:56
  SPEAKER_03: And um, when doing that, they thought about some of the things that were brought up to them.
• 23:02
  SPEAKER_03: If, and I think we've had uh discussions about this or webcasts about this too, like Fazbee did their invitation to comment where they were seeking input.
• 23:10
  SPEAKER_03: So they took a lot of the feedback on hedging that they got as part of that invitation to comment um and come up with their kind of short-term, medium-term, and long-term goals.
• 23:19
  SPEAKER_01: And what does that look like?
• 23:21
  SPEAKER_05: Yeah, so I think it's um, you know, just piggybacking off what Chip said, I think it's important just to remember what we talked about earlier.
• 23:26
  SPEAKER_05: So the choose your rate debt and uh the hedging the components of work asset purchases, the sales of non-financial assets, those are in the the standard of the ASU that was already issued.
• 23:36
  SPEAKER_05: Um, and those can be early adopted.
• 23:37
  SPEAKER_05: So those are those are out and and and and and sort of final rules.
• 23:42
  SPEAKER_05: Um the the project Chip's talking about, you know, the the short, medium, and longer term projects, these are sort of different or incremental to to the ASU that was already issued.
• 23:51
  SPEAKER_03: Yeah, absolutely.
• 23:51
  SPEAKER_03: I mean, very fair point.
• 23:53
  SPEAKER_03: Those things we talked about earlier, you can early adopt that new standard.
• 23:57
  SPEAKER_03: This is all still what we're gonna talk about next is still coming.
• 23:59
  SPEAKER_03: So, I mean, I guess we'll start logically maybe and start with the short-term project.
• 24:04
  SPEAKER_03: Um, so the short-term project um as currently contemplated has three elements of it.
• 24:10
  SPEAKER_03: One is adding the ability to hedge interest rate risk of health to maturity securities.
• 24:16
  SPEAKER_03: The second is removing the overnight index swap language from the guidance defining what is a benchmark interest rate.
• 24:24
  SPEAKER_03: Um, and the third is allowing float-to-flow cross-currency swaps that have different reset dates qualify for hedges of net investments.
• 24:32
  SPEAKER_01: That sounds like some narrow improvements to the standard.
• 24:36
  SPEAKER_05: Uh yeah, I mean, I I'd agree.
• 24:38
  SPEAKER_05: I think that I mean they're narrow in scope, but I think they are potentially pretty impactful.
• 24:41
  SPEAKER_05: Um I think I think the first thing Chip mentioned about you know the ability to hedge um interest rate risk on held and maturity securities, um, it's probably a big deal for a lot of our bank clients.
• 24:50
  SPEAKER_05: I think that's something they've wanted to do for a long time.
• 24:52
  SPEAKER_05: Um, and the rules will allow for that.
• 24:55
  SPEAKER_05: Um, I think the second point Chip brought up about sort of an expansion of the definition of a benchmark where interest rate from you know just overnight sofa to now incorporating um some of the some of the term sofa indices that are out there that are, that are, that are heavily used.
• 25:09
  SPEAKER_05: Um, I think that'll be helpful in terms of making it easier to to get hedge accounting when you're using swaps that are indexed to to term sofa.
• 25:16
  SPEAKER_03: Yeah, so um, so that's the short-term agenda.
• 25:19
  SPEAKER_03: And again, they are very focused, but in a world where you can't, you're not gonna make significant changes to the standard to a certain degree, you are a bit limited to what you can do.
• 25:31
  SPEAKER_03: Um, so now we'll talk about the medium term project.
• 25:34
  SPEAKER_03: So the only thing that's currently on the docket for the medium term project is to extend um what's referred to in the guidance as the portfolio layer method, um, head strategies, which is you could currently only apply to assets.
• 25:48
  SPEAKER_03: This project would be to extend it so you could apply it to liabilities.
• 25:52
  SPEAKER_01: That seems like it's pretty straightforward.
• 25:54
  SPEAKER_01: Why is that on the medium term versus the short term?
• 25:57
  SPEAKER_05: So I'd say just to maybe level set for folks, what what what is the portfolio layer method?
• 26:02
  SPEAKER_05: Um, it's a fair value hedge of interest rate risk.
• 26:05
  SPEAKER_05: You know, think of it as it's a closed pool of fixed rate assets that the company's hedging interest rate risk on.
• 26:12
  SPEAKER_05: It it it's it's effectively where you're saying, for example, I have$100 of fixed rate loans in this in this closed pool.
• 26:20
  SPEAKER_05: And over the next three, I want to hedge those over the next three years.
• 26:23
  SPEAKER_05: And I don't know, I can't tell you which loans are gonna prepay or be sold or go away, but I can tell you that I'm gonna have at least 80 of loans outstanding over the out of the hundred, 80 will be outstanding at the end of year three.
• 26:35
  SPEAKER_05: Um, and so it allows you to basically say I'm hedging that$80 portion of the pool without identifying sort of the specific loans uh that that are being hedged because you don't know which ones are gonna be the 80 that remain.
• 26:46
  SPEAKER_05: Um so it's effectively an exception to the to the general you know hedge accounting rules.
• 26:50
  SPEAKER_05: But but as Chip mentioned, you know, the the issue here would be to extend that to liabilities uh where people would want to apply sort of a similar concept of I don't know which liabilities are gonna go away, but I know I'm gonna have at least X amount over some timeframe.
• 27:03
  SPEAKER_05: Um so this is, you know, you think about different sort of use cases that we see out there.
• 27:08
  SPEAKER_05: Um for banks, I think you know, we we we talk a lot about hedging sort of pools of brokered CDs.
• 27:14
  SPEAKER_05: Um insurance companies always want to hedge portfolios of their uh uh of their liabilities.
• 27:19
  SPEAKER_05: Um and you know, corporates can think about you know hedging pools of um you know prepayable or callable debt that they have outstanding on the liability side.
• 27:28
  SPEAKER_05: Um and so I think it's a it's a bit of a meatier change than some of the other short-term items we discussed.
• 27:34
  SPEAKER_05: And so I think that's maybe why it's on the on the the you know the medium-term agenda.
• 27:38
  SPEAKER_01: Okay.
• 27:38
  SPEAKER_01: So what are they thinking about from a long-term perspective, Chip?
• 27:42
  SPEAKER_03: Yeah, so I mean, like you would expect, the the longer-term project would involve some more fundamental changes to the hedging model.
• 27:49
  SPEAKER_03: Um and it'll likely consider a number of different paths that they could take.
• 27:53
  SPEAKER_03: So one path, um, maybe the path of of least resistance, not not no resistance, but the path of least resistance would be to amend some of the quote fundamental rules that underlying the standard, but not all of them.
• 28:09
  SPEAKER_03: So, for example, in order to get hedge accounting um under today's rules, the item that you're hedging has to have the potential to impact earnings.
• 28:18
  SPEAKER_03: So you could eliminate that as a requirement to get hedge accounting, which would have ripple effects to different types of things that people are trying to do.
• 28:28
  SPEAKER_03: But that would be a more, I don't know about minor, but it would be a smaller change because you're just pulling one of the smaller columns, if you will, that hold 815 up.
• 28:38
  SPEAKER_03: Right.
• 28:39
  SPEAKER_05: Yeah, right.
• 28:40
  SPEAKER_05: I think you know, another path would be sort of a complete rewrite and start from scratch.
• 28:44
  SPEAKER_05: You know, I remember years ago when I was at the FASB, there was a board member who always used to say, like, what if you got a clean sheet of paper?
• 28:49
  SPEAKER_05: Like, what would you do?
• 28:50
  SPEAKER_05: Um, and so that that might involve, you know, bigger ticket, more fundamental changes, like, you know, migrating away from the current model, which really is really focused on sort of hedging, you know, on a transaction by transaction basis, or even, you know, sometimes you know you're allowed to hedge limited, you know, do limited pool edging.
• 29:06
  SPEAKER_05: Um, but moving away from that sort of model to more of a, you know, hedging net positions, more of a macro view of the world.
• 29:13
  SPEAKER_05: You know, I think banks and insurance companies often manage certain risks like interest rate risk by looking at their net exposures.
• 29:19
  SPEAKER_05: A lot of our multinational corporate clients do similar things for for FX exposure, where they're taking advantage of natural offsets and really just hedging sort of the open risk position.
• 29:28
  SPEAKER_05: So those, those are the more, those would be more sort of fundamental sort of rewrites, you know, different way of viewing the world in terms of hedging versus the current model.
• 29:36
  SPEAKER_01: Right.
• 29:36
  SPEAKER_01: And instead of then having all these little projects where you're just attacking things one-off, maybe more fundamental changes to to reshape it overall.
• 29:43
  SPEAKER_03: Yeah, and arguably that might, if you go down the path that Nick talked about, that's probably more closely aligning the accounting with how companies are actually doing exactly thinking about these.
• 29:54
  SPEAKER_03: Exactly.
• 29:54
  SPEAKER_03: And that's what investors really want to understand.
• 29:56
  SPEAKER_03: They want to understand like what are the risks that companies are facing and how are they managing those risks.
• 30:02
  SPEAKER_03: You know, and in the context of hedging, that'd be how you hedging market risk and price risk and things like that.
• 30:07
  SPEAKER_03: And it can be difficult to understand when the accounting model is not aligned with what companies are actually trying to accomplish.
• 30:16
  SPEAKER_03: And so you could understand why that would be a difficult path because anytime you start from scratch, it's difficult, but you could see some conceptual appeal on that path.
• 30:26
  SPEAKER_01: Yeah.
• 30:26
  SPEAKER_01: And I know from my experience too, that many times companies don't even designate things in hedge accounting because it's so hard to meet all the rules and the requirements and all these tests and that kind of thing.
• 30:37
  SPEAKER_03: Absolutely.
• 30:38
  SPEAKER_03: And that was a big piece of the feedback they got as well in in the invitation to comment.
• 30:42
  SPEAKER_03: They got feedback on specific items like some of the things we talked about in the short and medium term, but they got more basic feedback like your observations is documentation's hard.
• 30:51
  SPEAKER_03: Assessing effectiveness can be challenging.
• 30:53
  SPEAKER_03: And so that would be things that would all kind of fall into this longer term bucket.
• 30:58
  SPEAKER_01: Okay.
• 30:59
  SPEAKER_01: Well, this has been a really good discussion in the new hedge accounting standard, even though we just talked about some of the limitations with some of these rules, still seems like there's opportunities that it's created for both financial institutions as well as non-financial institutions.
• 31:13
  SPEAKER_01: So maybe as, you know, maybe as we wrap up here, we can think about what should companies be thinking about now or what would some of the takeaways you would give them as they're thinking about these new changes?
• 31:24
  SPEAKER_03: Yeah, maybe I'll start, we'll flip it and we'll start all uh you know about the current standard.
• 31:29
  SPEAKER_03: So um, so as I said, that was issued.
• 31:32
  SPEAKER_03: It's you can early adopt it.
• 31:35
  SPEAKER_03: And it has some, you know, we talked through very targeted but potentially significant changes depending on what you're doing.
• 31:42
  SPEAKER_03: Um, it does provide for transition guidance.
• 31:44
  SPEAKER_03: And that transition guidance can allow companies to go in and amend hedge documentation for their existing hedges.
• 31:51
  SPEAKER_03: Um the message that I would deliver is think really carefully and strategically about the adoption of the standard and those transition provisions, because it's a one-time opportunity upon adoption to go in and amend your hedge documentation.
• 32:07
  SPEAKER_03: So, in addition to the work you would expect if a company is going to adopt a standard of building new new processes, changing existing processes, procedures, and controls to adopt and comply with the new guidance, definitely take a couple of minutes, focus on the transition rules, think carefully about what you can use with those the things to really set yourself up for success in the longer term.
• 32:31
  SPEAKER_01: Okay.
• 32:32
  SPEAKER_01: Nick, what about you?
• 32:33
  SPEAKER_05: I'd say I think my advice would be to to companies would be just to stay engaged in the standards in the standard setting process.
• 32:39
  SPEAKER_05: Um, you know, the FASB is constantly getting feedback on the hedge accounting model.
• 32:42
  SPEAKER_05: And as we, as you can see with sort of the ASU that was issued and these short, medium, and long-term projects we discussed, the board's engaged, they're focused on hedge accounting.
• 32:51
  SPEAKER_05: Um, and there could be you know some large changes to the model coming, you know, in in in in the future here.
• 32:57
  SPEAKER_05: But you know, I think for if it's going to happen, I think the FASB always wants to hear from preparers and investors.
• 33:02
  SPEAKER_05: So, you know, engage with the the FASB staff, you know, respond to proposals that they put out.
• 33:07
  SPEAKER_05: And as we said earlier, really, really to help them understand how companies manage risk as an institution, uh, so that you know the the hedge accounting model can potentially be become better aligned with with some of those risk management strategies.
• 33:19
  SPEAKER_01: Well, I think that's great advice.
• 33:20
  SPEAKER_01: Thank you both so much for joining me today.
• 33:22
  SPEAKER_01: And if people want more information as well, there was an in-depth that was released at the end of the year when the new ASUs came out, so people can find that too on Viewpoint.
• 33:31
  SPEAKER_01: Thank you.
• 33:32
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