Fair Value Hedging – Portfolio Layer Method
Fair Value Hedging – Portfolio Layer Method
Background
A fair value hedge protects an entity from changes in the value of recognized assets, liabilities, and unrecognized firm commitments that are attributable to a particular risk. For example, an entity with a fixed-rate loan may hedge against changes in fair value of the loan due to changes in the benchmark interest rate over the term of that loan.
Under existing guidance in ASC 815, the “last-of-layer” method permits an entity to designate the portion of a closed portfolio of prepayable financial assets that is expected to be outstanding for the designated hedge period as the hedged item in a fair value hedge.[4] Also, the last-of-layer method permits only a single hedged layer (that is, one hedging relationship associated with a closed portfolio). Although applicable to other prepayable assets, the last-of-layer model was designed with a focus on mortgage loans or mortgage-backed securities.
Main Provisions
The Update expands the scope of the last-of-layer method (which has been renamed the “portfolio layer” method) to allow all financial assets to be included in a hedged closed portfolio. This means an entity can apply the portfolio layer method to closed portfolios of prepayable and/or non-prepayable financial assets.
The Update also allows entities to designate hedges of multiple layers in a closed portfolio of financial assets or one or more beneficial interests if certain criteria are met. The entity will be required to perform and document an analysis supporting its expectation that the hedged items will be outstanding for the hedge periods at hedge inception and each subsequent assessment date. This will involve an assessment of whether sufficient assets remain in the closed portfolio to support all outstanding hedged layers in aggregate.
The Update also provides additional guidance on accounting for fair value hedge basis adjustments associated with portfolio layer method hedges. Generally, the change in fair value of the hedged item attributable to the hedge risk in existing portfolio layer hedges does not adjust the carrying value of the individual assets or beneficial interest(s) in or removed from the closed portfolio. Rather, these amounts will be required to be maintained on a closed portfolio basis.
See Appendix A for a summary of the significant amendments included in the Update.
Effective Dates and Transition
The Update is effective for public companies in fiscal years beginning after December 15, 2022, and interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2023, and interim periods within those fiscal years. Early adoption is permitted on any date on or after the issuance of this Update for any entity that has adopted the amendments in ASU 2017-12 for the corresponding period.
The Update will be applied using the following transition methods:
Furthermore, an entity may reclassify debt securities from held to maturity to available for sale if it includes them in a closed portfolio that is hedged under the portfolio layer method. The entity has 30 days after the date of adoption to reclassify debt securities and include them in a hedged closed portfolio.
For questions related to matters discussed above, please contact Tim Kviz (333-8685 internal or 703-245-8685 external), Adam Brown (327-0673 internal or 214-665-0673 external), or another member of the Professional Practice Group.
Appendix A
[1] Derivatives and Hedging (Topic 815), Fair Value Hedging—Portfolio Layer Method
[2] While assets may be removed from the portfolio because of prepayments, defaults, sales, and reclassifications, new assets may not be added to a closed portfolio.
[3] In 2017, the FASB issued ASU 2017-12 to introduce the last-of-layer approach for hedging closed portfolios of prepayable financial assets.
[4] Paragraph 815-20-25-12A
[5] If an entity had allocated the fair value basis adjustment in a last-of-layer hedge to the individual assets in the closed portfolio before adopting the guidance, it would reverse the effect of this allocation through a cumulative-effect adjustment to the opening balance of retained earnings as of the date of adoption.
SHARE