derivatives and hedge accounting refresher/ibor transition

Derivatives and hedge accounting refresher/IBOR transition

Glen Hecht, EY PartnerPower and UtilitiesFinancial Accounting Advisory Services

Derivatives and hedge accounting: overview and update

Disclaimer

The views expressed by the presenters are not necessarily those of Ernst & Young LLP or other members of the global EY organization. These slides are for educational purposes only and are not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice.


Agenda

• Definition of a derivative • Normal purchases normal sales exception• Hedge Accounting• IBOR Transition


Contract assessment framework

US GAAP accounting model

Is it a derivative?

Primary beneficiary of variable interest entity (VIE)?

Is it a lease?

Normal treatment?

Hedge accounting?

Five possible accounting results

Consolidation of VIE

Lease accounting

Accrual accounting

Mark-to-market (MTM) accounting

Hedge accounting

Yes

No

Yes

Yes

Yes

Yes

No

No

No

No

ASC 810

(FAS 167)

ASC 842

(SFAS 13 and

EITF 01-08)

ASC 815

(SFAS 133)

DIG issues related EITFs

Applicable accounting standards


Definition of a derivative


Derivatives and hedge accounting refresher/IBOR transition

Glen Hecht, EY PartnerPower and UtilitiesFinancial Accounting Advisory Services


Definition of a DerivativeCharacteristics (ASC 815-10-15-83)

• Underlying and notional amount or a payment provision.• No initial net investment or smaller initial net investment than would be required

for other types of contracts with similar responses to changes in market factors.• Net settlement by any of the following means:

• Its terms implicitly or explicitly require or permit net settlement.• It can readily be settled net by a means outside the contract.• It provides for delivery of an asset that puts the recipient in a position not

substantially different from net settlement (i.e., readily convertible to cash).


What is an underlying? (ASC 815-10-15-88 through 89)

• A variable whose movements cause the fair market value or cash flows of a derivative to fluctuate.

• Examples:• Price or index of a commodity or security• Interest rate index• Credit rating• Foreign exchange rate• Occurrence or nonoccurrence of a specific event


What is a notional amount? (ASC 815-10-15-92)

• The notional amount is the quantity that determines the size of the change caused by the movement.

• Examples:• MWhs, MMBtus, tons, bushels, barrels, units

• The determination of a notional must be performed over the life of the contract.• International Financial Reporting Standards (IFRS) — no concept of notional.


What is a payment provision? (ASC 815-10-15-93)

• Payment provision specifies a fixed or determinable settlement to be made if the underlying behaves in a specified way.

• Example:• Power Company A and Coal Mine B enter into a contract whereby B will supply

A with one million tons of coal at a fixed price of US$90 per ton over a defined period, unless the spot price of coal rises above US$100 per ton at any time during that period, at which point Company A will pay to Coal Mine B $200,000.

• Payment provision may be fixed or determinable.


What is initial net investment? (ASC 815-10-15-94 through 98)

• Derivatives are unique in that the parties to the contract generally do not have to initially invest in, own or exchange an asset or liability; therefore, a derivative requires either:• No initial net investment, or• A smaller initial net investment

• “Smaller” could be over 85% of contract value (815-10-55-168) • Compensation for time value (for example, option contracts)• Premium on a forward purchase contract with a price less than the current

forward price• Initial margin or collateral posted is excluded from this assessment.


What is net settlement? (ASC 815-10-15-99 through 122)

• One or more of the following must be met:• Net settlement under contract terms• Net settlement by a market mechanism outside the contract (e.g., futures

exchange):• Delivery of an asset that is readily convertible to cash

*IFRS — settlement of a future date only


Net settlement under contract terms (contract focus)

• In a contractual net settlement, the terms of the contract itself explicitly permit or require net settlement:• Neither party is required to deliver an asset associated with the notional• Accomplished through exchange of cash or other assets

• Net settlement may be satisfied through the event of default:• Asymmetrical vs. symmetrical default provisions• Fixed penalty vs. variable penalty


Net settlement by market mechanism

• Market mechanism refers to the environment that the contract is being executed (rather than the commodity).

• An established market mechanism must contain four characteristics:• Enables one party to readily liquidate its net position • Results in one party to the contract becoming fully relieved of its right and

obligations• Liquidation of the net position does not require significant transaction costs• Liquidation of the net position occurs without significant negotiation and due

diligence occurs within a time frame that is customary• Evaluation of a market mechanism should be performed at inception and on an

ongoing basis.• Focuses on a single contract rather than a group of contracts.


Net settlement of an asset that is readily convertible to cash (commodity focus)

• One of the parties is required to physically deliver an asset that is readily convertible to cash or is itself a derivative instrument.

• To be readily convertible to cash, the assets must have:• Interchangeable (fungible) units• Quoted prices available in an active market that can rapidly absorb the quantity

held by the entity without significantly affecting the price• The evaluation must be performed at the inception of a contract and on an ongoing

basis.• Focus is on the commodity rather than the contract itself.


Met the definition of a derivative?

• Mark to market Accounting• Scope Exception


Normal Purchases Normal Sales (NPNS)


Scope exception; Normal Purchase Normal Sale

• ASC 815 provides an elective exception to the application of fair value accounting for physically settled derivative contracts that meet the definition of normal purchases and normal sales.

• Normal purchases and normal sales are contracts that provide for the purchase or sale of something other than a financial instrument or derivative instrument that will be delivered in quantities expected to be used or sold by the reporting entity over a reasonable period in the normal course of business.


Normal Terms

To designate one or more contracts as NPNS, the entity should evaluate the contracts within the context of its business and operational requirements and be consistent with the entities normal practice.

Considerations for NPNS (ASC 815-10-15-27 through 29)• The quantities provided under the contract and the entity’s need for the related

assets.• The locations to which delivery of the items will be made.• The period of time between entering into the contract and delivery.• The entity’s prior practices with regard to such contracts.


Documenting NPNS Contracts

• A physical contract can be designated at inception or during the term of the agreement (i.e. mark-to-market can be elected “normal” after inception)

• Once elected “normal,” a contract cannot be mark-to-market• Justification for stating a contract will be settled in a physical commodity must be

documented in order to use the normal purchase and sale exception • To qualify for the NPNS scope exception, it must be probable at inception and

throughout the terms of the contract that it will result in gross physical delivery (ASC 815-10-15-35 through 36).

• Net settlement could result in the contract losing its application of the NPNS scope exception (i.e., tainting).


Types of contracts not eligible to receive the NPNS scope exception

• Physical contracts with volumetric optionality based on a fixed price• Not applicable to power purchase agreements for capacity• Contracts that do not allow for physical settlement or which pay out on a periodic

basis (for example, unrealized gains and losses are paid daily for futures contracts)• Price features that are not considered clearly and closely related to the underlying

transaction• Freestanding options


Hedge Accounting


Changes to hedge accounting – ASU 2017-12

• ASU 2017-12 was issued by the FASB to amend the hedge accounting model in ASC 815 with the goal of

• Enabling entities to better portray the economics of their risk management activities in the financial statements

• Enhancing the transparency and understandability of hedge results

• The amendments address constituent feedback on the existing model, including:

• Complexity surrounding the application of hedge accounting

• Restrictions on risks that are eligible to be hedged

• Users’ difficulty in understanding hedge results, including hedge ineffectiveness

• The guidance is effective for public business entities for fiscal years beginning after 15 December 2018, including interim periods within those years.


Guidance in ASC 815 not related to hedge accounting (e.g., definition of a derivative, bifurcation of embedded derivatives)

Types of hedge accounting relationships (i.e., cash flow hedges, fair value hedges, net investment hedges)

Requirement to assess hedge effectiveness prospectively and retrospectively

Existing methods to qualitatively assess hedge effectiveness (i.e., shortcut, critical terms match, simplified hedge accounting approach)

“Highly effective” threshold

Requirement to contemporaneously document hedging relationships

Ability for entities to voluntarily discontinue hedge accounting

ASU 2017-12What stayed the same


IBOR Transition Update


Rate Reform

• LIBOR and other IBORs are used extensively in the US and global markets as reference interest rates in a broad range of financial instruments and commercial agreements, the reliability of these benchmark interest rates has been called into question.

• The Financial Stability Board published a report in 2014 setting out recommendations to reform some of the major interest rate benchmarks, including LIBOR.

• Regulators and public authorities from various jurisdictions have been working to replace LIBOR and other IBORs with reference interest rates that are supported by transactions in liquid and observable markets and are, therefore, less susceptible to manipulation

• Markets are preparing for the transition to alternative reference rates• The guidance in ASC 848 applies to contracts and other transactions that refer to LIBOR or other

reference rates that are expected to be discontinued due to reference rate reform

IBOR transition update

U.S. LIBOR transitionAlternative Reference Rate Committee and the ‘paced transition plan’

The ARRC’s Paced Transition Plan is ahead of schedule with the following steps completed to date:

ARRC members trading futures and OIS

CME launched SOFR Futures on May 7, 2018; ICE launched on October 22, 2018

LCH began clearing SOFR swaps on July 18, 2018

CME began clearing SOFR swaps on October 1, 2018

CME began clearing SOFR swaps using SOFR PAI/discounting on October 1, 2018

1

2

3

4

5

The LIBOR transition pace is accelerating

▪ Regulators have emphasized that the efforts to transition from LIBOR to SOFR (FRB recommended) or other alternate reference rates (ARRs) must accelerate and the financial services industry should prepare for discontinuation of LIBOR.

▪ Volumes of listed derivatives referencing SOFR in the U.S. are increasing and swaps are trading.

▪ A small set of institutions have issued SOFR-linked debt instruments, including SOFR linked FRNs, CDs and ABCP.

▪ Industry groups (ISDA, ARRC) are making progress on introducing proposed new fallback language for derivative and cash products including derivatives, floating rate notes, syndicated loans, bilateral business loans and securitizations.

Trading infrastructure

established - H2

Trading BeginsSOFR Futures and/or Bilateral, Uncleared

OIS (reference SOFR) - end of ‘18

CCPs No Longer Accept new swap contracts for

clearing with EFFR PAI and discounting – Q2

Creation of a term reference rate based on SOFR-derivatives markets – end of ‘21

Trading begins in cleared OIS that

reference SOFR in the EFFR price aligned interest

(PAI) and discounting

environment - Q1

The Paced Transition Plan

2018

2019

2020

2021

CCPs to begin allowing a

choice between clearing new or modified swap

contracts in current PAI/discounting

environment or SOFR for PAI/discounting

Banks no longer obligated to make LIBOR submissions

No new LIBOR loans or derivatives that

increase LIBOR risk

IBOR transition update

Accounting for reference rate reform ASC 848

The FASB issued an Exposure Draft which provides optional expedients and exceptions to contracts, hedging relationships and other transactions impacted by the IBOR reform if certain criteria are met. The proposed guidance would be effective immediately through December 31, 2022. A summary of the main provisions is included below:

If affected by IBOR reform:

• Loans and debt instruments would be accounted for prospectively

• Leases would not be reassessed or remeasured

• No reassessment for embedded derivatives

If relief criteria are met:

• Will not result in de-designation

• Will not result in a change to notional or effectiveness method

That meet certain criteria:

• An entity may take P&L immediately or amortize it over life of the hedged item

• The shortcut method can continue to be applied

If affected by IBOR reform:

• An entity may disregard the potential change when assessing probably cash flows

• Existing cash flow hedges an entity may continue to assume perfect effectiveness

• For a new cash flow hedge an entity may disregard the mismatch in the variable interest rate indices

• For both existing and new cash flow hedges, an entity may disregard the mismatch in variable interest rate indices or elect to continue cash flow hedge accounting

Contract modifications

Critical terms of a derivative in a hedging relationship

Fair value hedges

Cash flow hedges


Thank you

A special thank you to AGA and EEI for organizing the 2021 Spring Accounting Conference

Derivatives and hedge accounting: Updates and hot topicsPage 29

EY | Assurance | Tax | Strategy and Transactions | Consulting

About EYEY is a global leader in assurance, tax, strategy, transaction and consulting services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities.

EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. Information about how EY collects and uses personal data and a description of the rights individuals have under data protection legislation are available via ey.com/privacy. For more information about our organization, please visit ey.com.

Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US.

© 2020 Ernst & Young LLP.All Rights Reserved.

US SCORE no. 09678-201US2008-3563767ED None

This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice.

ey.com

derivatives and hedge accounting refresher/ibor transition

Documents