FASB Issues New Standards to Simplify Private Company Accounting for Certain Interest Rate Swaps
Interest rate swap arrangements are now ubiquitous as most bank creditors have shifted interest rate risks to borrowers. Compliance with current accounting standards for interest rate swaps can be quite complex and costly. In January 2014, the FASB issued a new standard allowing private companies a simplified alternative to existing accounting principles for certain receive-variable, pay-fixed interest rate swaps.
According to the FASB, Private companies may elect to adopt the new standard or are also permitted to continue following existing GAAP guidelines. Public companies and not-for-profit entities are not permitted to apply the new standard. In making this decision, we recommend companies consider the needs and expectations of their financial statement users and potential acquirers. The new standard is effective for fiscal years beginning after December 15, 2014, but early adoption is permitted and private companies may want to consider adopting the standards for fiscal year 2013.
Simplified Hedge Accounting Approach
Existing accounting standards require that derivative instruments be recorded as an asset or liability at fair value on a company’s balance sheet with changes in the fair value of an entity’s derivatives included in net income. If a derivative qualifies for hedge accounting, changes in fair value can be reported in other comprehensive income, rather than net income. Unfortunately, the existing requirements to qualify for hedge accounting are difficult to meet.
The FASB has made a simplified hedge accounting approach available to private companies as an alternative to the existing rule. Companies that elect to adopt the simplified hedge accounting approach can assume no hedge ineffectiveness for receive-variable, pay-fixed interest rate swaps that hedge the cash-flows of a variable rate borrowing if certain conditions are met. Under the simplified hedge accounting approach, the swap is recorded as an asset or liability at either its settlement amount or its fair value. Changes in the carrying amount of the swap are reported in other comprehensive income until settlement occurs.
Receive-variable, pay-fixed interest rate swaps held by private companies qualify for the simplified hedge accounting approach when all of the following criteria are met:
- The variable rate on the swap and the related debt are based on the same index or interest rate benchmark.
- The terms of the swap do not include a floor or cap on the variable interest rate unless the borrowing has a comparable floor or cap.
- The repricing and settlement dates for the swap and the borrowing match or differ by only a few days.
- The swap’s fair value at inception is at or near zero.
- The notional amount of the swap is equal to or less than the principal amount of the borrowing.
- The term of the swap is equal to or less than the term of the borrowing.
Under the simplified hedge accounting approach, the reporting entity is still required to document the hedging relationship and the risk management objective and strategy for undertaking the hedge. However, the documentation can be prepared at any time prior to the issuance of the company’s financial statements and need not be prepared at the inception of the hedge.
A company can elect to adopt the alternative on a swap-by-swap basis. A company could choose to implement the new standard on either a retrospective basis or a modified retrospective basis. If you have or are considering an interest rate swap arrangement and would like to better understand this new accounting option, please contact Candace Vaughn.