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MANAGEMENT ACCOUNTING

of economic results from hedging activity. For a Also, the nature of debt (as a financial asset)
closed portfolio of prepayable debt securities, ASU is that it has prepayment risk, which results in
2017-12 introduced the “last-of-layer” method different estimated maturities in a closed portfolio,
permitting fair-value hedging for the proportion of creating more than one fair-value risk. Borrowers
the debt securities expected to be outstanding for commonly settle debt before maturity as business
the designated hedge period. It also simplified this needs and economic conditions change. In addition,
hedging by clarifying that prepayment risk would debt instruments may contain put and call options.
not impact hedged-item value measurement. Prior to ASU 2022-01, accounting guidance
ASU 2017-12 expanded and refined accounting permitted only a single hedge (called the last-of-
for hedging activities, but the improvements were layer method) on a closed portfolio. This created
limited. Firstly, allowing hedging for only a single risk management challenges because a single hedge
layer of a closed portfolio did not align well with could not match all portfolio value risks, resulting
company risk management activities. Secondly, in many risks being unhedged.
because cash flow and interest rate risks exist in ASU 2022-01 creates new flexibility for com-
both prepayable and nonprepayable debt securities, bining and hedging financial assets with different
nonprepayable debt securities in a closed portfolio maturity profiles in a single closed portfolio. It
should also be eligible for hedging. Thirdly, the permits hedging multiple stated amounts in differ-
update did not provide accounting guidance for ent periods by designating multiple hedged layers,
fair-value hedge basis adjustments associated with a process referred to as “layering.” This reduces the
last-of-layer hedges. need to construct several separate closed portfolios.
Layering allows the total closed-portfolio
HOW ASU 2022-01 HELPS WITH HEDGING hedged amount to change with anticipated
ASU 2022-01 addresses some of the questions changes in the amount of the closed portfolio still
resulting from ASU 2017-12. It improves hedg- outstanding. Larger stated amounts are hedged
ing risk management in two ways: by increasing in earlier periods, and smaller stated amounts are
the number of portfolio hedges permitted and by hedged in later periods. Amounts in later periods
expanding the types of financial assets that qualify are typically smaller due to prepayments and
for hedging. defaults. The benefit is that a greater portion of the
closed portfolio’s interest rate risk now qualifies for
Using the portfolio-layer method hedge accounting.
The first step in implementing fair-value hedges for Financial assets with a longer maturity may sup-
debt securities is establishing a closed portfolio of port a shorter hedged-layer maturity, but not vice
the financial assets. The portfolio is termed “closed” versa. For example, financial assets with five years
because new assets may not be added, although remaining until maturity can support a hedged
assets may be removed because of prepayments, layer designated for years one to three but not a
defaults, or other factors. The company forms hedged layer designated for years one to 10. The
the closed portfolio with financial assets that are reason is that a five-year asset hedged for changes
anticipated to remain outstanding for the desig- in the designated benchmark interest rate does
nated hedge period and identifies this portfolio as not exhibit the same interest rate risk profile as a
the hedged item. 10-year asset hedged for changes in the same rate.

IN BRIEF adjustments. Its effective date for adjustments or for dedesignating a
public business entities is in 2023. portfolio layer. The update prohibits
■ FASB’s updated hedge accounting ■ At a time when many companies including closed-portfolio asset
guidance allows for multiple hedge are hedging to reduce interest rate basis adjustments when measuring
layers in a closed portfolio, expands risk exposure, the standard update expected credit losses or when
the scope to nonprepayable financial improves hedging risk management. determining available-for-sale
assets, and provides additional ■ The update also provides accounting security impairment.
guidance for fair-value hedge basis guidance for closed-portfolio basis
To comment on this article or to suggest an idea for another article, contact Courtney Vien at Courtney.Vien@aicpa-cima.com.

22 | Journal of Accountancy March 2023