Financial Markets Insights Novations? No-problem. April 2016

Financial Markets Insights
April 2016
Novations? No-problem.
In March, 2016, the FASB issued Accounting
Standards Update 2016-05, Effect of Derivative
Contract Novations on Existing Hedge
Accounting Relationships (the “ASU”). The ASU
addresses a lack of guidance in existing US
GAAP related to the impact of derivative
contract novations on existing hedge accounting
relationships under Accounting Standards
Codification Topic 815, Derivatives and Hedging
(“ASC 815”). The ASU clarifies that a change in
one of the parties (a novation) to a derivative
contract that is part of an existing hedge
accounting relationship under ASC 815 does not,
in and of itself, require a de-designation of that
hedge accounting relationship.
Why do novations happen?
Derivative contract novations occur for a variety
of business and regulatory reasons:

Mergers – A financial institution merges and
the surviving entity assumes the rights and
obligations of derivative instruments that
existed before the merger. The change in name
or legal entity that is party to the derivative
contract occurs through a novation.

Exiting a business – A financial
institution or an end user may decide to exit
a particular derivatives business or a
banking/customer relationship. For
example, a company may decide to close a
business unit and exit all derivative
contracts in the business (i.e., commodities
exposures). The derivative contracts are
novated to another party to allow the exit.

Internal credit limits – A financial
institution or end user may seek to limit or
reduce exposure to a particular
counterparty to manage internal credit
limits. For example, a decline in a
counterparty’s creditworthiness may cause
the other party to seek to reduce their
exposure to that counterparty. The
derivative contract could be novated to
another party to reduce its exposure to the
original counterparty.

Regulatory requirements – Due to
regulatory requirements, such as Title VII of
Dodd-Frank, certain over-the-counter
derivative transactions must be cleared
through central clearing houses. This is
achieved by a novation that replaces the
counterparty with a clearing house for the
financial institution and the end user.
What is a novation?
A novation refers to replacing one party to a
derivative contract. The new counterparty ‘steps
into the shoes’ of the original counterparty and
assumes all rights and obligations under the
derivative. In many novations, the key terms of
the derivative do not change:

Notional amount

Maturity date

Rates/spreads

Payment date

Other key terms
Typically, consent is required by the remaining
party to the derivative.
Financial Markets Insights April 2016
What is changing and how does it help?
Historically, if a derivative instrument was
“terminated” (ASC 815-25-40-1 and ASC 815-3040-1) or if there were changes to any of the
“critical terms of the hedging relationship” (ASC
815-20-55-56), then the existing hedge accounting
relationship was generally de-designated.
A de-designation event, requires an entity to cease
the application of hedge accounting, and creates
operational complexities and future P&L volatility.
For example, if a de-designation event occurred,
the reporting entity could attempt to re-designate
a new hedge accounting relationship, assuming
that all of the criteria for hedge accounting are
met. However, that newly re-designated hedge
accounting relationship may result in incremental
hedge ineffectiveness, or the hedge may fail to
meet the highly effective threshold to qualify for
hedge accounting, as a result of the hedging
instrument being off-market (that is, having a
non-zero fair value) upon re-designation.
The operational complexities are particularly
acute for those entities that have been applying an
abbreviated assessment of hedge effectiveness
prior to the hedge de-designation (for example,
the shortcut method). After re-designation, the
entity would be required to perform complex
quantitative hedge effectiveness calculations
under the long-haul method.
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There was diversity in practice around whether a
novation triggered a hedge de-designation under
US GAAP. The increasing use of clearing houses
and the potential financial statement impact of
de-designation events exacerbated the impact of
that diversity in practice.
The guidance makes clear that a change in one of
the parties to a derivative contract that is part of
an existing hedge accounting relationship does
not, in and of itself, trigger de-designation of that
hedge relationship. The creditworthiness of the
new counterparty would need to be evaluated to
qualify as highly effective.
A novation of a derivative to a counterparty with
significantly different credit risk could potentially
result in the de-designation of a hedging
relationship if it fails to meet the “high
effectiveness” criterion.
What’s next?
The new guidance will be effective for public
business entities in fiscal years beginning after
December 15, 2016, including interim periods
within those years.
For non-public business entities, the amendments
will be effective for fiscal years beginning after
December 15, 2017, and interim periods within
fiscal years beginning after December 15, 2018.
Early adoption is permitted for all entities.
Entities have the option to adopt the new ASU on
a prospective basis to derivative contract
novations that occur subsequent to the adoption
of the ASU, or on a modified retrospective basis.
PwC
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Financial Markets Insights April 2016
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Who can be involved in a continued dialogue?
Dave Lukach
Partner
646 471 3150
[email protected]
Ross Drucker
Manager
646 471 5947
[email protected]
Nick Milone
Partner
646 471 4813
[email protected]
Matt Keller
Manager
646 471 6742
[email protected]
Jonathan Bergeson
Director
415 498 6776
[email protected]
Contributor: Jeanna Yu
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