Abstract: On March 31, 2021, the FASB decided to change the name “last-of-layer” hedging method and to propose expanding the accounting model that was introduced about four years ago. This article explains the proposal and how it may better align financial reporting for hedging transactions with the entity’s risk management approach.
On March 31, 2021, the Financial Accounting Standards Board (FASB) decided to change the name “last-of-layer” to the “portfolio layer” hedging method. The FASB also approved a proposal to expand the accounting model that was introduced about four years ago. Specifically, the current single-layer hedge accounting model will be expanded to a multiple-layer model.
Transitioning to a new philosophy
The last-of-layer model was introduced in 2017 under Accounting Standards Update (ASU) No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. The updated standard took effect in 2019 for calendar-year public companies. Calendar-year private companies got a deferral from 2020 to 2021.
This method provides a strategy to more easily hedge portfolios of prepayable financial assets and beneficial interests secured by portfolios of prepayable financial instruments. For example, residential mortgages or mortgage backed securities.
The FASB has been working on a project to address whether it’s permissible for an entity to employ a multiple-layer hedging strategy to a closed portfolio. It held discussions on the project in January 2020, and those decisions were sent to be externally reviewed.
On March 31, based on feedback from the external review, the FASB also decided on attributes of assets in a closed portfolio and interaction with beneficial interests (asset-backed securities). It decided to allow a “sub-pool” approach for determining the maturity profile of assets eligible to be hedged in a multiple-layer hedge. It also agreed to propose “that assets in a closed portfolio with time-based contingencies may become prepayable at any time during a multiple-layer strategy.” Additionally, the FASB would require that all entities “sequence the order of hedging relationship discontinuance based on layer duration” if more than one hedge could be discontinued.
FASB member Christine Botosan observed that the board’s work would change the philosophy of hedging over time. “I think this is an interesting journey that we’re on with hedge accounting, and I’ll be very interested to watch how it evolves from this point in time forward,” she said.
Mirroring the entity’s risk management approach
A multiple-layer model helps align hedge accounting with an entity’s risk management activities, which, in turn, provides better information to financial statement users. “All we’re doing is keeping in line with what Sarbanes-Oxley requires us to do. As the business environment changes, we must think about the implications of those changes in accounting,” said FASB member Harold Schroeder.
The forthcoming proposal, in addition to introducing a multiple-layer model, would add guidance on basis adjustments. This change aims to provide more clarity and consistency in financial reporting outcomes.
To simplify transition, the FASB will propose modified retrospective application “for fair value hedge basis adjustments whereby the effect of applying the proposed amendments would be recorded as a cumulative-effect adjustment to the opening balance of retained earnings in the year of adoption.” The proposal would allow banks and financial institutions to reclassify debt securities from held to maturity to available for sale in transition if the reclassified securities qualify for the portfolio layer method.
The proposed guidance will be subject to a 60-day public comment period. Then the FASB will evaluate the feedback and decide how to proceed. Contact your CPA for the latest developments.