Chapter 2 — Hedge Accounting Requirements

2.2 Qualifying Hedged Items

For an item to be designated as a hedged item in a qualifying hedging relationship, it must have the potential to affect earnings. ASC 815-20 breaks down its discussion of hedgeable transactions and risks into the two major types of hedges: fair value and cash flow. There is not much detailed guidance on what sorts of items can qualify as the hedged item in a net investment hedge because there is really only one item that qualifies — a net investment in a foreign operation — and one type of risk to be hedged — foreign currency risk. However, before we cover the criteria that items must satisfy to qualify for designation as hedged items in fair value and cash flow hedges, we will discuss items that are specifically prohibited from being designated as the hedged item in a qualifying hedging relationship, regardless of the type of hedge an entity is seeking.

2.2.1 Items Prohibited From Being Designated as the Hedged Item

ASC 815-20

25-15 A forecasted transaction is eligible for designation as a hedged transaction in a cash flow hedge if all of the following additional criteria are met: . . .

d. The forecasted transaction is not the acquisition of an asset or incurrence of a liability that will subsequently be remeasured with changes in fair value attributable to the hedged risk reported currently in earnings.

e. If the forecasted transaction relates to a recognized asset or liability, the asset or liability is not remeasured with changes in fair value attributable to the hedged risk reported currently in earnings. . . .

g. The forecasted transaction does not involve a business combination subject to the provisions of Topic 805 or a combination accounted for by an NFP that is subject to the provisions of Subtopic 958-805.

h. The forecasted transaction is not a transaction (such as a forecasted purchase, sale, or dividend) involving either of the following:

1. A parent entity’s interests in consolidated subsidiaries

2. An entity’s own equity instruments. . . .

25-43 Besides those hedged items and transactions that fail to meet the specified eligibility criteria, none of the following shall be designated as a hedged item or transaction in the respective hedges:

Subparagraph not used
With respect to both fair value hedges and cash flow hedges:
1. An investment accounted for by the equity method in accordance with the requirements of Subtopic 323-10 or in accordance with the requirements of Topic 321
2. A noncontrolling interest in one or more consolidated subsidiaries
3. Transactions with stockholders as stockholders, such as either of the following:
  1. Projected purchases of treasury stock
  2. Payments of dividends.
4. Intra-entity transactions (except for foreign-currency-denominated forecasted intra-entity transactions) between entities included in consolidated financial statements
5. The price of stock expected to be issued pursuant to a stock option plan for which recognized compensation expense is not based on changes in stock prices after the date of grant.
With respect to fair value hedges only:
1. If the entire asset or liability is an instrument with variable cash flows, an implicit fixed-to-variable swap (or similar instrument) perceived to be embedded in a host contract with fixed cash flows
2. For a held-to-maturity debt security, the risk of changes in its fair value attributable to interest rate risk
3. An asset or liability that is remeasured with the changes in fair value attributable to the hedged risk reported currently in earnings
4. An equity investment in a consolidated subsidiary
5. A firm commitment either to enter into a business combination or to acquire or dispose of a subsidiary, a noncontrolling interest, or an equity method investee
6. An equity instrument issued by the entity and classified in stockholders’ equity in the statement of financial position
7. A component of an embedded derivative in a hybrid instrument — for example, embedded options in a hybrid instrument that are required to be considered a single forward contract under paragraph 815-10-25-10 cannot be designated as items hedged individually in a fair value hedge in which the hedging instrument is a separate, unrelated freestanding option. . . .

As indicated in the guidance above, entities are prohibited from designating the following items as the hedged item in a hedging relationship:

Items that are already remeasured at fair value, with changes in fair value recognized in earnings (see Section 2.2.1.1).
Investments in equity securities (see Section 2.2.1.2):
- Equity securities within the scope of ASC 321.
- Equity method investments.
- Equity investments in consolidated subsidiaries.
Forecasted transactions and firm commitments that are related to business combinations, the acquisition or disposition of a subsidiary, a noncontrolling interest, or an equity method investee (see Section 2.2.1.3).
Own-equity transactions (see Section 2.2.1.4):
- Noncontrolling interests.
- Treasury stock transactions.
- Dividends to shareholders.
- The fair value of issued shares classified in equity.
- The forecasted issuances of shares classified in equity.
Other items that do not affect earnings (see Section 2.2.1.5):
- Most intra-entity1 transactions.2
- The price of stock that is expected to be issued under a stock option plan if compensation expense will not vary on the basis of changes in stock price.
Implicit embedded derivatives or components of embedded derivatives (see Section 2.2.1.6).

2.2.1.1 Items That Are Already Remeasured at Fair Value, With Changes in Fair Value Recognized in Earnings

As discussed in Section 1.1, for hedges of an asset or a liability that is already remeasured at fair value, with changes in fair value recognized in earnings, an entity does not generally need to use specialized hedge accounting to achieve the same accounting result as it would in a qualifying fair value hedging relationship. If an entity chooses to economically hedge such an asset or a liability with a derivative, the gains and losses on the derivative will already be recognized in the same period as the gains and losses on the hedged item. Accordingly, ASC 815-20-25-43(c)(3) prohibits an entity from designating as hedged items assets or liabilities that are remeasured at fair value, with changes in fair value recognized in earnings, in fair value hedges.

Similarly, ASC 815-20-25-15 lists acceptable cash flow hedging strategies and prohibits entities from designating as the hedged item the forecasted acquisition of an asset or incurrence of a liability that will subsequently be remeasured at fair value, with changes in fair value attributable to the hedged risk recognized in current earnings. The reason for this prohibition is that those items must be recognized at fair value upon recognition. Accordingly, there is no earnings exposure before their initial recognition. Also, ASC 815-20-25-15(e) prohibits entities from designating as a hedged item a forecasted transaction involving a recognized asset or liability that is remeasured, with changes in fair value attributable to the hedged risk reported currently in earnings.

Items that do not qualify for designation as hedged items under the above criteria include derivatives (such as bifurcated embedded derivatives), financial assets and financial liabilities for which the entity has elected a fair value option, debt securities accounted for as trading securities, and investments in equity securities within the scope of ASC 321 (see further discussion in the next section).

2.2.1.2 Investments in Equity Securities

Investments in equity securities do not qualify as hedged items; however, the reasons for this depend on the type of equity investment. Before the issuance of ASU 2016-01, which added ASC 321, investments in equity securities that did not result in consolidation or the application of the equity method would be accounted for either at cost (if the security did not have a readily determinable fair value) or fair value, with changes in fair value recognized in either OCI (available-for-sale [AFS] securities) or earnings (trading securities), depending on the classification of the security. However, ASU 2016-01 eliminated both the cost method and the AFS designation for investments in equity securities.

Under ASC 321, all equity securities with a readily determinable fair value are accounted for at fair value, with changes in fair value recognized in earnings. Accordingly, as discussed in Section 2.2.1.1, those equity securities do not qualify for designation as the hedged item in a hedging relationship. Investments in equity securities that do not have a readily determinable fair value qualify for a measurement alternative under which the entity would initially recognize the investment at cost (fair value less transaction costs) and then subsequently remeasure the investment if (1) there is an orderly transaction in the identical or a similar investment of the same issuer or (2) there is an impairment. However, if remeasurement is required, the investment is remeasured at fair value, with changes in fair value since the last measurement recognized in current-period earnings. Thus, investments in equity securities in which the measurement alternative is applied do not qualify for designation as hedged items even though remeasurement is not necessarily required in every period. ASC 815-20-25-43(b) does not make any distinction between the two measurement methods in ASC 321; it simply says that the hedged item may not be an investment that is accounted for “in accordance with the requirements of Topic 321.”

In addition, since the issuance of FASB Statement 133, entities have been prohibited from designating as hedged items investments accounted for under the equity method (ASC 323-10). The rationale for this prohibition is stated in the Background Information and Basis for Conclusions of FASB Statement 133.

FASB Statement 133 (Pre-Codification Guidance)

Investment Accounted for by the Equity Method

455. The Board decided to retain the prohibition in the Exposure Draft from designating an investment accounted for by the equity method as a hedged item to avoid conflicts with the existing accounting requirements for that item. Providing fair value hedge accounting for an equity method investment conflicts with the notion underlying APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. Opinion 18 requires an investor in common stock and corporate joint ventures to apply the equity method of accounting when the investor has the ability to exercise significant influence over the operating and financial policies of the investee. Under the equity method of accounting, the investor generally records its share of the investee’s earnings or losses from its investment. It does not account for changes in the price of the common stock, which would become part of the basis of an equity method investment under fair value hedge accounting. Changes in the earnings of an equity method investee presumably would affect the fair value of its common stock. Applying fair value hedge accounting to an equity method investment thus could result in some amount of double counting of the investor’s share of the investee’s earnings. The Board believes that result would be inappropriate. In addition to those conceptual issues, the Board was concerned that it would be difficult to develop a method of implementing fair value hedge accounting, including measuring hedge ineffectiveness, for equity method investments and that the results of any method would be difficult to understand. For similar reasons, this Statement also prohibits fair value hedge accounting for an unrecognized firm commitment to acquire or dispose of an investment accounted for by the equity method.

The FASB cited similar reasons for the prohibition against designating an investment in the equity of a consolidated subsidiary as a hedged item. However, an entity that has an equity investment in a consolidated subsidiary does not actually account for the equity investment individually since all of the assets and liabilities of the subsidiary are recognized on the consolidated balance sheet of the investor entity.

2.2.1.3 Business Combinations and Disposals of Subsidiaries

For reasons that are similar to those for prohibiting hedges of equity method investments, entities are also prohibited from designating as hedged items transactions that involve the acquisition or disposition of subsidiaries. The Board was concerned that on a conceptual basis, some aspects of acquiring an entity through a business combination would not affect earnings, especially if the effects of hedge accounting were recognized in goodwill. The operational difficulties involved with hedging the acquisition or disposition of a subsidiary probably weighed heavily on the Board’s decision as well. For example, if an entity were allowed to hedge the acquisition price of all of an acquired entity’s equity shares, the effects of that hedge accounting might have to be allocated to all of the acquired entity’s individual assets and liabilities once the business combination was completed. As a result, the entity might be required to perform a theoretical purchase price allocation both at the inception and the completion of the hedge. Paragraph 473 of the Background Information and Basis for Conclusions of FASB Statement 133 discusses these concerns by stating:

The Board noted that the current accounting for a business combination is based on considering the combination as a discrete event at the consummation date. Applying cash flow hedge accounting to a forecasted business combination would be inconsistent with that current accounting. It would also be, at best, difficult to determine when to reclassify the gain or loss on the hedging derivative to earnings.

ASC 815-20-25-15(g) prohibits the hedge of a forecasted transaction involving a business combination. In addition, ASC 815-20-25-43(c)(5) prohibits a fair value hedge of “a firm commitment either to enter into a business combination or to acquire or dispose of a subsidiary, a noncontrolling interest, or an equity method investee.”

2.2.1.4 Own-Equity Transactions

One of the requirements for hedge accounting is that the hedged transaction must be exposed to a risk that could affect earnings. Transactions in an entity’s own equity are recorded in equity and do not have an earnings impact. Accordingly, even though there are economic risks that could affect cash flows, transactions in an entity’s own equity do not qualify for designation as hedged items. The following are examples of prohibited hedged items related to equity transactions:

Prohibited Hedged Item	ASC Reference
Noncontrolling interest in a consolidated subsidiary	ASC 815-20-25-43(b)(2)
Forecasted purchases of treasury stock	ASC 815-20-25-43(b)(3)
Forecasted issuance of equity3	ASC 815-20-25-15(h)
Forecasted dividends on equity4	ASC 815-20-25-15(h) and ASC 815-20-25-43(b)(3)
Fair value of issued equity5	ASC 815-20-25-43(c)(6)

2.2.1.5 Other Items That Do Not Affect Earnings

2.2.1.5.1 Stock Price Related to Stock Option Plans

As noted above, to be eligible for hedge accounting, a hedged transaction must be exposed to a risk that could affect earnings. Accordingly, ASC 815-20-25-43(b)(5) prohibits entities from designating as the hedged item the price of stock that will be issued under a stock option plan if compensation expense will not vary on the basis of changes in the underlying stock price. This prohibition is consistent with the principle that if a designated risk does not give rise to a potential earnings exposure, it is not a hedgeable risk under hedge accounting.

2.2.1.5.2 Intra-Entity Transactions

Similarly, intra-entity transactions cannot be designated as hedged transactions in the consolidated financial statements, as stated in ASC 815-20-25-43(b)(4). There is an exception for forecasted foreign-currency-denominated intra-entity transactions that potentially affect earnings. See Section 5.3.3.1.2 for further discussion of this exception.

As noted in ASC 815-20-25-44, hedge accounting may be applied to the freestanding financial statements of an entity involved in intra-entity transactions within consolidated financial statements, but any impact of such accounting must be removed from the consolidated financial statements.

Example 2-1

FarmHouse Inc. has two wholly owned subsidiaries, A and B. Subsidiary A owns and operates corn fields; B owns and operates livestock farms. Most of the corn produced by A is sold to third parties. However, B acquires corn on a monthly basis from A at the current market price and uses the corn to feed its animals. Subsidiary A expects to sell 1,000 bushels of corn to B in each of the next 12 months (A sells a total of about 100,000 bushels per month) and wants to hedge its corn price exposure related to corn sales, including its sales of corn to B, over the next year. Accordingly, A enters into financially settled futures contracts on 100,000 bushels per month for the next 12 months.

Subsidiary A’s forecasted sales of corn are as follows:

The sales from A to B are not hedgeable transactions in the consolidated financial statements of FarmHouse because those sales are eliminated in consolidation and do not present an earnings exposure. Subsidiary A could apply hedge accounting to those sales in its own freestanding financial statements, provided that the conditions for hedge accounting are met, but any effects of hedge accounting for those sales must be removed when FarmHouse prepares its consolidated financial statements.

Another potential hedging strategy that FarmHouse could employ would be to hedge its corn inventory against changes in fair value due to changes in corn prices; however, this strategy would only mitigate risks related to FarmHouse’s existing corn inventory.

Connecting the Dots

If all of the criteria for cash flow hedging are met, an entity can hedge a forecasted transaction with an equity method investee under the cash flow hedging model. To be eligible for designation as a hedged transaction under ASC 815-20-25-15(c), a forecasted transaction must meet both of the following conditions:

It is a transaction with a party external to the reporting entity (except as permitted by paragraphs 815-20-25-30 and 815-20-25-38 through 25-40).
It presents an exposure to variations in cash flows for the hedged risk that could affect reported earnings.

Although ASC 815-20-25-43(b)(4) prohibits an entity from designating as hedged items “[i]ntra-entity transactions . . . between entities included in consolidated financial statements,” this prohibition applies only to transactions (or portions thereof) that are entirely eliminated in consolidation and that therefore create no earnings exposure in the consolidated financial statements. If a forecasted transaction is only partially eliminated in consolidation, the entity may hedge the portion of the transaction that is not eliminated since it still exposes the entity to potential variations in cash flows that could affect reported earnings.

For example, ASC 323-10-35-7 through 35-9 require intra-entity transactions that involve an equity method investee to be eliminated in consolidation as though the equity method investee was consolidated. However, ASC 323-10-35-11 indicates that only a portion of the transaction would be eliminated; therefore, the portion that is not eliminated may be designated as the hedged item in a cash flow hedge (if all of the other hedge accounting criteria are satisfied).

This matter was addressed in informal discussions with the FASB staff, which agreed that the portion of the transaction that is not eliminated may be designated as the hedged transaction in a cash flow hedge as long as all of the hedge accounting criteria are satisfied.

2.2.1.6 Implicit Embedded Derivatives or Components of Embedded Derivatives

Entities are allowed to designate specific component risks of a hedged item in a qualifying hedging relationship. However, they are prohibited from designating as a hedged exposure an embedded component of an item that is already being measured at fair value, with changes in fair value recognized in earnings. Under ASC 815, if multiple embedded derivatives must be bifurcated from a host contract, they must be accounted for as one compound derivative (i.e., one unit of account) in accordance with ASC 815-15-25-7 unless the hybrid instrument is accounted for at fair value in its entirety. In addition, if a freestanding instrument composed of multiple derivatives meets the definition of a derivative in its entirety, the instrument is accounted for as one compound derivative because embedded derivatives are not bifurcated out of a host contract that is already measured at fair value, with changes in fair value recognized in earnings. While ASC 815-20-25-43(c)(7) specifically prohibits entities from identifying the hedged item as a component of a bifurcated embedded derivative, we believe that prohibition also extends to a component of a freestanding compound derivative.

In addition, ASC 815-20-25-43(c)(1) prohibits an entity from designating “an implicit fixed-to-variable swap (or similar instrument)” in a recognized variable-rate asset or liability as the hedged item in a fair value hedge. Even though the potential embedded derivative is not bifurcated and measured at fair value, this prohibition is actually based on the fact that a permissible hedging strategy already exists — a cash flow hedge of the variability in interest payments on the asset or liability (see further discussion in Section 2.3.1.1).

2.2.2 Items That May Be Designated as the Hedged Item

While the discussion in Section 2.2.1 covers items that entities are prohibited from designating as the hedged item in a hedging relationship, the discussion in this section focuses on those items that can be designated as such. Section 2.3 addresses the different types of risks related to those hedged items that may be identified as the hedged risk in a hedging relationship.

ASC 815-20

Hedged Item Criteria Applicable to Fair Value Hedges Only

25-11 An entity may designate a derivative instrument as hedging the exposure to changes in the fair value of an asset or a liability or an identified portion thereof (hedged item) that is attributable to a particular risk if all applicable criteria in this Section are met.

25-12 An asset or a liability is eligible for designation as a hedged item in a fair value hedge if all of the following additional criteria are met:

The hedged item is specifically identified as either all or a specific portion of a recognized asset or liability or of an unrecognized firm commitment.
The hedged item is a single asset or liability (or a specific portion thereof) or is a portfolio of similar assets or a portfolio of similar liabilities (or a specific portion thereof), in which circumstance:
1. If similar assets or similar liabilities are aggregated and hedged as a portfolio, the individual assets or individual liabilities shall share the risk exposure for which they are designated as being hedged. The change in fair value attributable to the hedged risk for each individual item in a hedged portfolio shall be expected to respond in a generally proportionate manner to the overall change in fair value of the aggregate portfolio attributable to the hedged risk. See the discussion beginning in paragraph 815-20-55-14 for related implementation guidance. An entity may use different stratification criteria for the purposes of impairment testing and for the purposes of grouping similar assets to be designated as a hedged portfolio in a fair value hedge.
2. If the hedged item is a specific portion of an asset or liability (or of a portfolio of similar assets or a portfolio of similar liabilities), the hedged item is one of the following:
  1. A percentage of the entire asset or liability (or of the entire portfolio). An entity shall not express the hedged item as multiple percentages of a recognized asset or liability and then retroactively determine the hedged item based on an independent matrix of those multiple percentages and the actual scenario that occurred during the period for which hedge effectiveness is being assessed.
  2. One or more selected contractual cash flows, including one or more individual interest payments during a selected portion of the term of a debt instrument (such as the portion of the asset or liability representing the present value of the interest payments in any consecutive two years of a four-year debt instrument). Paragraph 815-25-35-13B discusses the measurement of the change in fair value of the hedged item in partial-term hedges of interest rate risk using an assumed term.
  3. A put option or call option (including an interest rate cap or price cap or an interest rate floor or price floor) embedded in an existing asset or liability that is not an embedded derivative accounted for separately pursuant to paragraph 815-15-25-1.
  4. The residual value in a lessor’s net investment in a direct financing or sales-type lease.
The hedged item presents an exposure to changes in fair value attributable to the hedged risk that could affect reported earnings. The reference to affecting reported earnings does not apply to an entity that does not report earnings as a separate caption in a statement of financial performance, such as a not-for-profit entity (NFP), in accordance with paragraph 815-20-15-1. . . .

25-12A For a closed portfolio of prepayable financial assets or one or more beneficial interests secured by a portfolio of prepayable financial instruments, an entity may designate as the hedged item a stated amount of the asset or assets that are not expected to be affected by prepayments, defaults, and other factors affecting the timing and amount of cash flows if the designation is made in conjunction with the partial-term hedging election in paragraph 815-20-25-12(b)(2)(ii) (this designation is referred to throughout Topic 815 as the “last-of-layer method”).

As part of the initial hedge documentation, an analysis shall be completed and documented to support the entity’s expectation that the hedged item (that is, the designated last of layer) is anticipated to be outstanding as of the hedged item’s assumed maturity date in accordance with the entity’s partial-term hedge election. That analysis shall incorporate the entity’s current expectations of prepayments, defaults, and other events affecting the timing and amount of cash flows associated with the closed portfolio of prepayable financial assets or beneficial interest(s) secured by a portfolio of prepayable financial instruments.
For purposes of its analysis, the entity may assume that as prepayments, defaults, and other events affecting the timing and amount of cash flows occur, they first will be applied to the portion of the closed portfolio of prepayable financial assets or one or more beneficial interests that is not part of the hedged item (that is, the designated last of layer).

Pending Content (Transition Guidance: ASC 815-20-65-6)

25-12A [See Section 9.7.]

Hedged Transaction Criteria Applicable to Cash Flow Hedges Only

25-13 An entity may designate a derivative instrument as hedging the exposure to variability in expected future cash flows that is attributable to a particular risk. That exposure may be associated with either of the following:

An existing recognized asset or liability (such as all or certain future interest payments on variable-rate debt)
A forecasted transaction (such as a forecasted purchase or sale).

Note that the glossary definition of transaction is intended to clearly distinguish a transaction from an internal cost allocation or an event that happens within an entity.

25-14 For purposes of this Subtopic and Subtopic 815-30, the individual cash flows related to a recognized asset or liability and the cash flows related to a forecasted transaction are both referred to as a forecasted transaction or hedged transaction.

25-15 A forecasted transaction is eligible for designation as a hedged transaction in a cash flow hedge if all of the following additional criteria are met:

The forecasted transaction is specifically identified as either of the following:
1. A single transaction
2. A group of individual transactions that share the same risk exposure for which they are designated as being hedged. A forecasted purchase and a forecasted sale shall not both be included in the same group of individual transactions that constitute the hedged transaction.
The occurrence of the forecasted transaction is probable.
The forecasted transaction meets both of the following conditions:
1. It is a transaction with a party external to the reporting entity (except as permitted by paragraphs 815-20-25-30 and 815-20-25-38 through 25-40).
2. It presents an exposure to variations in cash flows for the hedged risk that could affect reported earnings. . . .

The designated hedged item in a hedging relationship can be all or a portion of an existing asset or liability, an unrecognized firm commitment, a forecasted transaction, or the net investment in a foreign operation. Sometimes, an entity may designate a portfolio of existing assets, liabilities, or forecasted transactions (see Section 2.2.2.2). In all cases, the hedged item must present an exposure that could affect reported earnings, but it cannot be one of the prohibited items discussed in Section 2.2.1. In a fair value hedge, the hedged item must have an exposure to changes in market prices that can affect the fair value of an existing asset, a liability, or an unrecognized firm commitment and thereby potentially affect the entity’s earnings. The hedged item in a cash flow hedge is a variable-rate financial asset or liability or a forecasted transaction that exposes an entity to variability in cash flows that could affect earnings. See Chapters 3 and 4 for a more thorough discussion of fair value hedging and cash flow hedging, respectively. The hedged item in a net investment hedge is a net investment in foreign operations (typically a foreign subsidiary). See Section 5.4 for a more thorough discussion of net investment hedges.

The following are some examples of hedged items that may be designated and the hedging model that would typically apply:

Hedged Item	Type of Hedge
Fixed-rate debt (asset or liability)	Fair value
Inventory	Fair value
Fixed-price supply contract (not a derivative)	Fair value
Foreign-currency-denominated debt	Fair value or cash flow
Variable-rate debt (asset or liability)	Cash flow
Forecasted issuance of debt	Cash flow
Forecasted sale of inventory	Cash flow
Forecasted purchase of commodity	Cash flow
Net investment in foreign operations	Net investment

2.2.2.1 Hedging Portions of Items

ASC 815 allows an entity to designate a portion of an item as the hedged item in a hedging relationship. That portion can be expressed as a percentage of the item or as specifically identified components or cash flows of the item, depending on the type of item and type of hedge. In addition, an entity may identify a portion of a qualifying portfolio of items as the hedged item (see Section 2.2.2.2 for a discussion of qualifying portfolios of hedged items).

The table below shows portions of items (or qualifying portfolios of items) that entities can designate as hedged items in each type of hedging relationship.

Type of Hedge	Eligible Portions
Fair value	A percentage of an item (e.g., 80 percent of a $100,000 bond) One or more selected contractual cash flows (e.g., the interest payments on the first two years of debt that matures in five years) A put or call option embedded in an existing asset or liability, if that embedded option is not bifurcated in accordance with ASC 815-15-25-1 The residual value in a lessor’s net investment in a direct financing or sales-type lease A stated dollar amount of a closed portfolio of prepayable financial assets, or one or more beneficial interests secured by a portfolio of prepayable financial instruments (i.e., a last-of-layer hedge)6
Cash flow	Any specified cash flows
Net investment	A stated amount of the beginning balance of a net investment in foreign operations

2.2.2.1.1 Fair Value Hedges — Portions

ASC 815-20

Example 2: Portions and Portfolios of Individual Items as Hedged Item

55-81 This Example illustrates the application of paragraph 815-20-25-12.

55-82 An entity that issues $100 million of fixed-rate debt may wish to hedge 50 percent of its fair value exposure to interest rate risk, as permitted by paragraph 815-20-25-12(b)(2). To accomplish that, the entity could enter into an interest rate swap with a notional amount of $50 million. The paragraph 815-20-25-104(a) criterion is satisfied because the entity has designated as a fair value hedge 50 percent of the contractual principal amount as the hedged item and has entered into an interest rate swap with a notional amount that matches the hedged principal amount.

55-83 If $100 million of fixed-rate debt were issued in increments of $1,000 individual bonds, the entity could aggregate 50,000 of those individual bonds as a portfolio to equal the notional amount of the swap, as permitted by paragraph 815-20-25-12(b)(1) (for the purposes of this Example, it is assumed that the hedge satisfies the portfolio requirements of that paragraph).

Of its guidance on the three types of hedges, ASC 815 provides the most details on the identification of acceptable portions of items that may be designated as the hedged item in a fair value hedge. ASC 815-20-25-12(b)(2) lists four acceptable portions of items, which are discussed below.

2.2.2.1.1.1 Proportions

Under ASC 815-20-25-12(b)(2)(i), an entity may designate as the hedged item “[a] percentage of the entire asset or liability (or of the entire portfolio).” For example, assume that an entity owns a $1 million fixed-rate, five-year debt security. It enters into a five-year receive-variable, pay-fixed interest rate swap with an $800,000 notional amount, and all other terms of the interest rate swap match the terms of the debt. The entity could designate 80 percent, or $800,000, of the debt security as the hedged item in a fair value hedging relationship. We believe that in the hedge designation documentation, the hedged item can be expressed either as a percentage or as a fixed dollar amount; however, if the hedged item is expressed only as a percentage of the item that is being hedged, the documentation should acknowledge that fact and indicate the total amount of the asset or liability. In this example, the hedged item could be designated as “80% of the $1 million debt security.”

Connecting the Dots

The examples in ASC 815-20-55-82 and 55-83 discuss hedging a percentage of a single item as well as a portfolio of individual bonds. We believe that if items in a portfolio are fungible, an entity may hedge a specified dollar amount of that portfolio, as opposed to a fixed percentage. For example, consider the example in ASC 815-20-55-83 in which an entity issues $100 million of fixed-rate debt in increments of $1,000 bonds. We believe that if those bonds all have the exact same terms and are interchangeable, the entity could designate as the hedged item a fixed dollar amount of the issuance (e.g., $50 million), but it does not necessarily have to specify which individual bonds are the hedged bonds. In that scenario, if the entity were to repurchase some of the bonds, the hedged item would remain intact as a fixed dollar amount as long as the designated hedged amount was still outstanding.

ASC 815-20

Prohibition of Preset Hedge Coverage Ratios

55-63 Subtopic 860-50 requires that if an entity subsequently measures servicing assets and servicing liabilities using the amortization method, any impairment of servicing assets, which is the amount by which the carrying amount of the servicing assets for an individual stratum exceeds their fair value, be recognized in current earnings. However, an increase in the fair value above the carrying amount of servicing assets for an individual stratum may not be recognized in current earnings.

55-64 Entities that service certain types of financial assets may wish to designate as the hedged item in a fair value hedge a prespecified percentage of the total change in fair value of those servicing rights (attributable to the hedged risk) that varies based on changes in a specified independent variable. Because the prespecified percentage for each specified independent variable can be presented in a rectangular array, that method of determining the hedged item retroactively based on the actual independent variable is sometimes referred to as the matrix method. Under that approach, at the end of the hedge assessment period, the entity would determine the hedged item and assess hedge effectiveness by determining retrospectively which hedge coverage ratio would be applied to the servicing right asset to identify the hedged item for that period. That approach is in contrast to designating the hedged item at the inception of the hedge by specifying a single percentage of that recognized servicing right asset as the hedged item.

55-65 In a fair value hedge of a portion of a recognized servicing right asset subsequently measured using the amortization method and its related impairment analysis, an entity may not designate the hedged item at the inception of the hedge by initially specifying a series of possible percentages of the servicing right asset (that is, preset hedge coverage ratios) and then determining at the end of the assessment period what specific percentage of the servicing right asset is the actual hedged item for that period based on the change in a specified independent variable during that period. Such a matrix method would not be a valid application of the provisions of this Subtopic.

55-66 Paragraph 815-20-25-12(b)(2)(i) precludes an entity from expressing the hedged item as multiple percentages of a recognized asset or liability and then retroactively determining the hedged item based on an independent matrix of those multiple percentages and the actual scenario that occurred during the period for which hedge effectiveness is being assessed.

55-67 There is a limited exception under paragraph 815-20-25-10 in which a collar that is comprised of one purchased option and one written option that have different notional amounts is designated as the hedging instrument, and the hedged item is specified as two different proportions of the same asset based on the upper and lower rate or price range of the asset referenced in those two options.

Generally speaking, only a single percentage of an entire asset or liability (or of the entire portfolio) may be designated as the hedged item in a fair value hedging relationship. DIG Issue F8 addressed a potential strategy for hedging an asset in which an entity establishes a matrix of different prespecified percentages of the asset on the basis of the performance of specified independent variables during the hedge period. Under the proposed strategy, the entity would refer to the table at the end of the hedge period to determine what portion of the asset was the hedged item. This strategy of hedging multiple potential percentages of items, which the DIG discussed in the context of mortgage servicing rights, was deemed to be inappropriate. That conclusion is codified in ASC 815-20-25-12(b)(2)(i), which states that “[a]n entity shall not express the hedged item as multiple percentages of a recognized asset or liability and then retroactively determine the hedged item based on an independent matrix of those multiple percentages and the actual scenario that occurred during the period for which hedge effectiveness is being assessed.”

ASC 815-20

Different Proportions of the Same Asset as a Hedged Item

25-10 In a hedging relationship in which a collar that is comprised of a purchased option and a written option that have different notional amounts is designated as the hedging instrument and the hedge’s effectiveness is assessed based on changes in the collar’s intrinsic value, the hedged item may be specified as two different proportions of the same asset referenced in the collar, based on the upper and lower price ranges specified in the two options that make up the collar. That is, the quantities of the asset designated as being hedged may be different based on those price ranges in which the collar’s intrinsic value is other than zero. This guidance shall be applied only to collars that are a combination of a single written option and a single purchased option for which the underlying in both options is the same. This guidance shall not be applied by analogy to other derivative instruments designated as hedging instruments. Although the quantities of the asset designated as being hedged may be different based on the upper and lower price ranges in the collar, the actual assets that are the subject of the hedging relationship may not change. The quantities that are designated as hedged for a specific price or rate change shall be specified at the inception of the hedging relationship and shall not be changed unless the hedging relationship is dedesignated and a new hedging relationship is redesignated. Since the hedge’s effectiveness is based on changes in the collar’s intrinsic value, the assessment of hedge effectiveness shall compare the actual change in intrinsic value of the collar to the change in value of the prespecified quantity of the hedged asset that occurred during the hedge period.

Example 9: Definition of Hedged Item When Using a Zero-Cost Collar With Different Notional Amounts

55-123 Entity B forecasts that it will purchase inventory that will cost 100 million foreign currency (FC) units. Entity B’s functional currency is the U.S. dollar (USD). To limit the variability in USD-equivalent cash flows associated with changes in the USD-FC exchange rate, Entity B constructs a currency collar as follows:

A purchased call option providing Entity B the right to purchase FC 100 million at an exchange rate of USD 0.885 per FC 1.
A written put option obligating Entity B to purchase FC 50 million at an exchange rate of USD 0.80 per FC 1.

55-124 The purchased call option provides Entity B with protection when the USD-FC exchange rate increases above USD 0.885 per FC 1. The written put option partially offsets the cost of the purchased call option and obligates Entity B to give up some of the foreign currency gain related to the forecasted inventory purchase as the USD-FC exchange rate decreases below USD 0.80 per FC 1. (For both options, the underlying is the same — the USD-FC exchange rate.) Assuming that a net premium was not received for the combination of options and all the other criteria in paragraphs 815-20-25-89 through 25-90 have been met, if Entity B chooses to use the combination of options as a hedging instrument, it is not required to comply with the provisions contained in paragraph 815-20-25-94 related to written options.

55-125 Entity B would like to designate the combination of options as a hedge of the variability in USD-equivalent cash flows of its forecasted purchase of inventory denominated in FC. Assume Entity B specifies in the hedge effectiveness documentation that the collar’s time value would be excluded from the assessment of hedge effectiveness.

55-126 The hedging relationship involving the currency collar designated as a hedge of the effect of fluctuations in the USD-FC exchange rate qualifies for cash flow hedge accounting. In that example, the hedged risk is the risk of changes in USD-equivalent cash flows attributable to foreign currency risk (specifically, the risk of fluctuations in the USD-FC exchange rate). The foreign currency collar is hedging the variability in USD-equivalent cash flows for 100 percent of the forecasted FC 100 million purchase price of inventory for USD-FC exchange rate movements above USD 0.885 per FC 1 and variability in USD-equivalent cash flows for 50 percent of the forecasted FC 100 million purchase price of inventory for USD-FC exchange rate movements below USD 0.80 per FC 1. Cash flow hedge effectiveness will be determined based on changes in the underlying (the USD-FC exchange rate) that cause changes in the collar’s intrinsic value (that is, changes below USD 0.80 per FC 1 and above USD 0.885 per FC 1). Because the hedge’s effectiveness is based on changes in the collar’s intrinsic value, hedge effectiveness must be assessed based on the actual exchange rate changes by comparing the change in intrinsic value of the collar to the change in the specified quantity of the forecasted transaction for those changes in the underlying.

DIG Issue E18 (codified in ASC 815-20-25-10 and ASC 815-20-55-123 through 55-126) addressed a hedging strategy in which a zero-cost collar with different notional amounts is designated as a hedging instrument. Issue E18 provided examples that involved zero-cost collars in which the notional amount of the purchased option was greater than that of the written option. In these cases, it was considered acceptable to designate the hedged item as two different proportions of the same asset to match the different notional amounts of the two components of the collar.

Connecting the Dots

The guidance in ASC 815-20-25-10 appears to conflict with that in ASC 815-20-25-12(b)(2)(i): ASC 815-20-25-10 allows different notional amounts of the same asset to be designated as the hedged item, but ASC 815-20-25-12(b)(2)(i) does not. As discussed above, these requirements resulted from two DIG Issues that provided examples of specific hedging strategies. The principle from DIG Issue F8 appears to be the general rule (i.e., an entity may not designate more than one proportion of an item as the hedged item), while DIG Issue E18 presents a limited exception to that rule. ASC 815-20-55-67 (derived from DIG Issue F8) states that “[t]here is a limited exception under paragraph 815-20-25-10,” while ASC 815-20-25-10 (derived from DIG Issue E18) states, in part, that “[t]his guidance shall be applied only to collars that are a combination of a single written option and a single purchased option for which the underlying in both options is the same. This guidance shall not be applied by analogy to other derivative instruments designated as hedging instruments.”

2.2.2.1.1.2 One or More Selected Contractual Cash Flows

Under ASC 815-20-25-12(b)(2)(ii), an entity may also hedge one or more selected contractual cash flows of an item (or qualifying portfolio of items). For instance, an entity may designate a hedge of individual interest payments in a debt instrument, which is also known as a partial-term hedge (see further discussion of partial-term hedges in Section 3.2.1.1). If an entity issues five-year fixed-rate debt with semiannual interest payments and principal due at maturity, it could enter into a pay-variable, receive-fixed interest rate swap to hedge its interest rate risk for any portion of that five-year period and identify the interest payments that occur during the swap period as the hedged item.

Example 2-2

Hedging Selected Contractual Cash Flows With a Forward-Starting Swap

Company R is replacing maturing debt with a new $100 million 10-year fixed-rate borrowing. It believes that interest rates will be volatile for the next three years and will decline in years 4–10. Company R issues the new debt with a fixed rate of 8.25 percent on January 1. Interest on the debt is payable annually beginning December 31. Concurrently with issuing the debt, R enters into a forward-starting interest rate swap to convert the last seven years of the debt from a fixed rate to a variable rate.

The swap is designated as a hedge of selected contractual cash flows of the 10-year debt (i.e., R designates the last seven contractual interest payments and the final principal payment due at maturity as the hedged items). The risk being hedged is the fair value exposure related to changes in interest rates on the payments in years 4–10. In this case, because (1) the swap’s maturity date matches the debt’s maturity date and (2) all of the interest payments on the debt during the term of the swap are designated as being hedged, changes in the swap’s fair value will be similar to change in the fair value of the specified cash flows being hedged.

In accordance with ASC 815-20-25-12(b)(2)(ii), an entity can hedge any consecutive interest payments during the term of a debt instrument. Thus, if R only wanted to hedge interest rate risk for years 4–7, it could enter into a forward-starting interest rate swap to convert years 4–7 of the debt from a fixed rate to a variable rate and then designate the forward-starting swap as a hedge of those specified contractual cash flows (i.e., the interest payments for years 4–7 of the 10-year debt). In addition, an entity is permitted to have more than one separately designated partial-term hedging relationship outstanding at the same time for the same debt instrument as long as the same contractual cash flows are not designated in more than one hedging relationship at a time. See Section 3.2.1.1 for further discussion of partial-term hedging.

2.2.2.1.1.3 Embedded Options That Are Not Bifurcated

Under ASC 815-20-25-12(b)(2)(iii), an entity may designate an option that is embedded in an existing asset or liability as the hedged item in a hedging relationship. Although that guidance specifically mentions call and put options (including caps and floors), we do not believe that eligibility is limited to those types of embedded options. In the assessment of which items may be designated as hedged items, the important consideration is that eligibility is limited to options embedded in existing assets or liabilities that are not bifurcated and accounted for separately under ASC 815-15-25-1. In addition, the component being hedged must have the potential to affect earnings and cannot be one of the prohibited items discussed in Section 2.2.1. For example, the issuer of convertible debt cannot hedge the conversion option in its debt because doing so would be hedging a transaction in the issuer’s own equity (see Section 2.2.1.4). If an entity chooses to hedge a prepayment option (put or call), there are some limits on the types of risk that may be hedged (see Section 2.3.1).

2.2.2.1.1.4 Residual Value in a Lessor’s Net Investment in a Direct Financing or Sales-Type Lease

Under ASC 815-20-25-12(b)(2)(iv), an entity may designate as the hedged item in a hedging relationship the residual value in a lessor’s net investment in direct financing and sales-type leases. In both types of leases, the lessor’s net investment is composed of the lease receivable and the present value of the unguaranteed residual value. ASC 815-20-25-12(b)(2)(iv) allows an entity to identify the unguaranteed residual value as a hedgeable portion of the net investment in the lease. The lease payments can also be separately designated as a hedged item as specified contractual cash flows (discussed in Section 2.2.2.1.1.2).

2.2.2.1.2 Cash Flow Hedges — Portions

Less guidance exists on hedging portions of items in a cash flow hedge. While the guidance in ASC 815-20-25-13 through 25-15 does not include the terms “portion” or “proportion,” ASC 815-20-25-13 does address hedging the exposure to variability in expected future cash flows related to an existing recognized asset or liability “such as all or certain interest payments on variable-rate debt.” Because it mentions “certain interest payments” but not percentages of certain cash flows, this guidance could be interpreted as explicitly allowing only partial-term hedges of an entire asset, a liability, or a portfolio of assets or liabilities, as opposed to a proportion of certain cash flows of an asset or liability. However, we do not believe that the criteria for cash flow hedging were meant to be more restrictive than those for fair value hedging.

2.2.2.1.3 Net Investment Hedges — Portions

ASC 815-35

35-27 If an entity documents that the effectiveness of its hedge of the net investment in a foreign operation will be assessed based on the beginning balance of its net investment and the entity’s net investment changes during the year, the entity shall consider the need to redesignate the hedging relationship (to indicate what the hedging instrument is and what numerical portion of the current net investment is the hedged portion) whenever financial statements or earnings are reported, and at least every three months. An entity is not required to redesignate the hedging relationship more frequently even when a significant transaction (for example, a dividend) occurs during the interim period. Example 1 (see paragraph 815-35-55-1) illustrates the application of this guidance.

A hedge of a net investment in foreign operations is typically expressed as a specific currency unit amount of the net investment. Frankly, it would not be practical to designate a fixed percentage of an overall net investment as a hedged item because of the nature of the ongoing accounting for a foreign subsidiary. The net investment in a foreign subsidiary typically changes in each reporting period on the basis of net income or loss of the subsidiary and equity transactions with the entity. Accordingly, entities generally designate a portion of the beginning balance of a net investment in foreign operations. While ASC 815-35-35-27 addresses potential redesignations of a hedge of a net investment in a foreign operation, it also provides some guidance on how a net investment hedge may be designated. That guidance states that the designation of the hedging relationship would “indicate what the hedging instrument is and what numerical portion of the current net investment is the hedged portion.”

2.2.2.2 Hedging Portfolios of Items

ASC 815-20

Hedged Item Criteria Applicable to Fair Value Hedges Only

25-12(b)(1) If similar assets or similar liabilities are aggregated and hedged as a portfolio, the individual assets or individual liabilities shall share the risk exposure for which they are designated as being hedged. The change in fair value attributable to the hedged risk for each individual item in a hedged portfolio shall be expected to respond in a generally proportionate manner to the overall change in fair value of the aggregate portfolio attributable to the hedged risk. See the discussion beginning in paragraph 815-20-55-14 for related implementation guidance. An entity may use different stratification criteria for the purposes of Topic 860 impairment testing and for the purposes of grouping similar assets to be designated as a hedged portfolio in a fair value hedge.

Hedged Transaction Criteria Applicable to Cash Flow Hedges Only

25-15(a) The forecasted transaction is specifically identified as either of the following:

A single transaction
A group of individual transactions that share the same risk exposure for which they are designated as being hedged. A forecasted purchase and a forecasted sale shall not both be included in the same group of individual transactions that constitute the hedged transaction.

Groups of similar items may be aggregated and identified as the hedged item in a single hedging relationship. Portfolio hedging is only available for fair value hedges and cash flow hedges but not for net investment hedges. The eligibility criteria are similar for both fair value and cash flow hedges in that the items that are included in a portfolio all need to share the same risk exposure for which they are being hedged (e.g., assets and liabilities cannot be included in the same hedged portfolio).

2.2.2.2.1 Hedging Portfolios — Fair Value Hedging

ASC 815-20

Determining Whether Risk Exposure Is Shared Within a Portfolio

55-14 This implementation guidance discusses the application of the guidance in paragraph 815-20-25-12(b)(1) that the individual assets or individual liabilities within a portfolio hedged in a fair value hedge shall share the risk exposure for which they are designated as being hedged. If the change in fair value of a hedged portfolio attributable to the hedged risk was 10 percent during a reporting period, the change in the fair values attributable to the hedged risk for each item constituting the portfolio should be expected to be within a fairly narrow range, such as 9 percent to 11 percent. In contrast, an expectation that the change in fair value attributable to the hedged risk for individual items in the portfolio would range from 7 percent to 13 percent would be inconsistent with the requirement in that paragraph.

55-14A If both of the following conditions exist, the quantitative test described in paragraph 815-20-55-14 may be performed qualitatively and only at hedge inception:

The hedged item is a closed portfolio of prepayable financial assets or one or more beneficial interests designated in accordance with paragraph 815-20-25-12A.
An entity measures the change in fair value of the hedged item based on the benchmark rate component of the contractual coupon cash flows in accordance with paragraph 815-25-35-13.

Using the benchmark rate component of the contractual coupon cash flows when all assets have the same assumed maturity date and prepayment risk does not affect the measurement of the hedged item results in all hedged items having the same benchmark rate component coupon cash flows.

Pending Content (Transition Guidance: ASC 815-20-65-6)

55-14A [See Section 9.7.]

55-15 In aggregating loans in a portfolio to be hedged, an entity may choose to consider some of the following characteristics, as appropriate:

Loan type
Loan size
Nature and location of collateral
Interest rate type (fixed or variable)
Coupon interest rate or the benchmark rate component of the contractual coupon cash flows (if fixed)
Scheduled maturity or the assumed maturity if the hedged item is measured in accordance with paragraph 815-25-35-13B
Prepayment history of the loans (if seasoned)
Expected prepayment performance in varying interest rate scenarios.

In a fair value portfolio hedge, each portfolio item’s fair value should be expected to respond in a proportionate manner to the overall changes in the aggregate portfolio’s fair value that are attributable to the hedged risk. As noted in ASC 815-20-55-14, the change in the fair value that is attributable to the hedged risk of each item within a portfolio should be expected to be proportional (“within a fairly narrow range”) to the change in the fair value that is attributable to the hedged risk of the overall portfolio. To illustrate this concept, ASC 815-20-55-14 discusses a portfolio whose fair value changes because of changes in the designated risk. ASC 815-20-55-14 addresses the appropriateness of the following two ranges of changes in the fair values of individual portfolio items in proportion to the changes in the overall portfolio’s fair value that are attributable to the hedged risk:

Range of Changes in the Fair Value of Individual Portfolio Items Attributable to the Hedged Risk	Is Portfolio Acceptable as a Hedged Item?
90–110%	Yes
70–130%	No

Connecting the Dots

On the basis of the two examples in ASC 815-20-55-14, we believe that the changes in the fair values of individual items in a portfolio that are attributable to the hedged risk should be within 80 to 125 percent of the overall change in the portfolio’s fair value that is attributable to that risk, on a proportional basis. In the determination of whether the instruments in the portfolio are similar (i.e., “a similarity analysis”), comparisons to the expected change in the hedging instrument’s fair value are not relevant. In other words, while there is a requirement that a hedging instrument is expected to be highly effective at offsetting the change in a hedged item’s fair value that is attributable to the designated risk (see Section 2.5), there is no requirement to evaluate whether the hedging instrument would be highly effective at offsetting the change in the fair value of each individual item in the portfolio that is attributable to the designated risk.

Assume that an entity is attempting to hedge the risk of changes in the fair value of a portfolio of three fixed-rate debt instruments. To designate the portfolio as a hedged item in a hedging relationship, the entity must perform an analysis to determine whether the fixed-rate debt instruments are similar. The table below depicts a scenario in which the entity assumes an increase in the designated benchmark interest rate (i.e., the proposed designated hedged risk) of 200 basis points. It shows the expected changes in the fair values of (1) each of the three fixed-rate debt instruments and (2) the overall portfolio. Since the fair value of the overall portfolio changed by 11.6 percent, the change in the fair value of each item in the portfolio is expected to be within a 9.3 to 14.5 percent band. (The lower end of the acceptable range is 80 percent of the portfolio’s overall fair value change of 11.6 percent; the upper end of the acceptable range is 125 percent of the 11.6 percent change.) Because the fair value of the four-year debt in the portfolio shown below is expected to change by 20 percent, which is outside of the computed acceptable range, the items in the portfolio would not be considered similar, and the overall portfolio would not qualify as a hedgeable item.

When designating a portfolio as a hedged item, an entity should consider the characteristics of the individual items and how those characteristics would respond to changes in the designated risk. For example, in aggregating loans in a portfolio to be hedged, an entity may choose to consider some of the following characteristics: loan type and size, the nature and location of collateral, interest rate type (fixed or variable) and the coupon interest rate (if fixed), scheduled maturity, prepayment history of the loans (if seasoned), and expected prepayment performance in varying interest rate scenarios.

An entity may have difficulty tracking portfolios and the individual items in a portfolio if there are underlying differences in how those items respond to changes in fair value or cash flows that result from changes in the designated risk. For example, if changes in the fair values of certain items in the portfolio are no longer expected to respond within a range of 80 to 125 percent of the overall portfolio’s fair value change, the entity will have to remove those items and dedesignate a related proportion of the hedging derivative.

The analysis of whether all of the items in a portfolio are similar should be performed at the inception of the hedging relationship, and it should be reperformed on an ongoing basis during the life of the hedge as frequently as hedge effectiveness assessments are performed. The similarity analysis will generally be quantitative, but sometimes a qualitative analysis may be sufficient. An entity’s ability to use a qualitative analysis will depend on the items in the portfolio and the risk being hedged. ASC 815-20-55-14A specifically addresses a last-of-layer hedge in which an entity measures the change in fair value of the hedged item on the basis of the benchmark component of the contractual coupon cash flows. For such hedges, an entity may assume that all of the items are similar on the basis of a qualitative analysis that is only performed at the inception of the hedge. See further discussions of last-of-layer hedging in Section 3.2.1.4).

When an entity constructs a portfolio to be hedged, it may also want to consider how differences in the designated risk and certain fair value hedge measurement alternatives would affect the similarity analysis. For example, if an entity (1) designates as the hedged risk the changes in fair value due to changes in the designated benchmark interest rate (see Section 2.3.1.1) and (2) elects to calculate the changes in fair value by using cash flows based on the benchmark rate component of the contractual coupon cash flows (see Section 3.2.1), it would assume that all individual items with the same maturity would have the same coupon rate for analysis purposes. If the individual items were prepayable during the term of the hedge, the entity could also elect to consider only how changes in the designated benchmark rate would affect each borrower’s decision to prepay its obligation. In addition, an entity that elects to designate a partial-term hedge could use the same assumed maturity date for all of the items in the portfolio. Electing to apply a combination of all of these risk designation and measurement alternatives could eliminate many or all of the differences in how the individual items that make up the portfolio would respond to changes in the designated risk.

Example 2-3

Hedging Net Exposures

Entity B, a bank, has an investment in $100 million of fixed-rate debt securities and $60 million of fixed-rate debt outstanding; its net exposure is $40 million of fixed-rate assets. Although B would like to designate the net exposure as the hedged item, ASC 815 requires entities to designate and hedge risks on a gross basis and does not permit them to macro hedge their exposures (effectively, macro hedging is the accumulation of risks, such as long and short positions with a hedge of the net position).

Accordingly, B must instead identify an item (or portfolio of items) to hedge that comprises part of that net exposure. While B could not designate its net exposure of $40 million as the hedged item, it could achieve a similar outcome by designating $40 million of its investment in fixed-rate debt securities as the hedged item.

Example 2-4

Hedging Both the Purchase of Materials and the Sale of Product

Entity X, a manufacturing company, hedges the forecasted purchase of raw materials and separately hedges the forecasted sales of the manufactured product. Since X has exposure to two distinct price risks, it is permitted under ASC 815 to use cash flow hedge accounting for both the forecasted purchase of raw materials and the forecasted sales of the manufactured product. However, X would not be permitted to hedge (1) inventory on hand in a fair value hedge and (2) the forecasted sale of that inventory as a cash flow hedge because, by doing so, it would be hedging the same risk exposure twice.

2.2.2.2.1.1 Hedging Portfolios of Mortgage Servicing Rights

ASC 815-20

55-16 Paragraph 815-20-25-12(b)(1) provides criteria under which similar assets or similar liabilities may be aggregated and hedged as a portfolio under a fair value hedge, requiring, in part, that the individual assets or individual liabilities share the risk exposure for which they are designated as being hedged. Servicers of financial assets that designate a hedged portfolio by aggregating servicing rights within one or more risk strata used under paragraph 860-50-35-9 would not necessarily comply with the requirement in paragraph 815-20-25-12(b)(1) for portfolios of similar assets because the risk strata under paragraph 860-50-35-9 can be based on any predominant risk characteristic, including date of origination or geographic location.

Under ASC 860, entities that recognize mortgage servicing rights under the amortization method (i.e., not remeasured at fair value) are required to perform an impairment analysis by stratifying each class of mortgage servicing rights on the basis of one or more of the predominant risk characteristics of the underlying financial assets, as discussed in ASC 860-50-35-9. The criteria for determining stratification of mortgage servicing rights are not consistent with the criteria for determining whether items in a portfolio would be considered similar under ASC 815; therefore, compliance with the stratification criteria under ASC 860 would not ensure that the items in the portfolio would be considered similar under ASC 815. Accordingly, the entity would still need to separately assess whether the servicing rights would be considered similar under the criteria in ASC 815 before it could determine whether the portfolio was eligible for designation as a hedged item in a fair value hedge.

2.2.2.2.2 Hedging Portfolios — Cash Flow Hedging

ASC 815-20

55-22 Under the guidance in this Subtopic, a single derivative instrument of appropriate size could be designated as hedging a given amount of aggregated forecasted transactions, such as any of the following:

Forecasted sales of a particular product to numerous customers within a specified time period, such as a month, a quarter, or a year
Forecasted purchases of a particular product from the same or different vendors at different dates within a specified time period
Forecasted interest payments on several variable-rate debt instruments within a specified time period.

55-23 At the time of hedge designation only, the transactions in each group must share the risk exposure for which they are being hedged. For example, the interest payments in the group in (c) in the preceding paragraph shall vary with the same index to qualify for hedging with a single derivative instrument.

The designated hedged item in a cash flow hedge may be a group of items that share the same risk exposure for which they are being hedged. As discussed in Section 2.2.2.2.1, this concept of sharing the same risk exposure also exists when hedging a portfolio of items in a fair value hedge. While the quantitative similarity analysis discussed in Section 2.2.2.2.1 is not explicitly required by the guidance on cash flow hedges of a portfolio of items, we believe that a similar concept should be applied. Accordingly, if the items included in the portfolio are not identical, the entity should prepare an analysis that demonstrates that all of the individual items in the portfolio would react similarly to changes in the hedged risk.

Example 2-5

Hedging Loans With Different Indexes

Bank B has a $1 billion portfolio of 10-year variable-rate loans that are indexed to various contractually specified interest rate indexes, including LIBOR, prime, and the federal funds rates. It enters into an interest rate swap to hedge the cash flow exposure related to the future interest receipts. The swap is a $1 billion notional, 10-year pay-LIBOR, receive-fixed interest rate swap. The repricing dates of the swap match the interest receipt dates of the loans. Although B would like to hedge the loans as a single portfolio, it cannot do so because, at the time of the hedge designation, the forecasted interest receipts of the loans in the portfolio vary with different interest rate indexes (i.e., LIBOR, prime, and federal funds rates) and therefore do not share the same risk exposure. However, B could divide its loan portfolio into smaller groups of loans so that each loan within a group would be indexed to the same contractually specified rate. Each group could then qualify to be designated as the hedged item in a separate cash flow hedge under ASC 815-20-25-15 (as long as all other cash flow hedging criteria are met).

Under ASC 815-20-25-15, for a group of individual transactions to be designated as the hedged transaction in a cash flow hedge, the individual transactions in the portfolio must share the same risk exposure for which they are designated as being hedged. While ASC 815-20-55-22(c) does indicate that an entity may designate “[f]orecasted interest payments on several variable-rate debt instruments within a specified time period” as the hedged item, ASC 815-20-55-23 provides the following caveat: “the interest payments in the group in (c) in the preceding paragraph shall vary with the same index to qualify for hedging with a single derivative instrument.”

Many cash flow hedging strategies involve a group of forecasted transactions with terms that are not fixed or known at the inception of the hedging relationship. The designation documentation should identify the hedged forecasted transactions in a single hedging relationship at a level of specificity that would only include future transactions that would be similar to each other at the time of occurrence. Hedging groups of forecasted transactions is discussed in further detail in Chapter 4.

Footnotes

The words intercompany and intra-entity are interchangeable. However, since the Codification mostly uses the term “intra-entity,” we use that term for the remainder of this Roadmap.

There is an exception for certain foreign-currency-denominated forecasted intra-entity transactions.

Equity means the instrument is classified in the hedging entity’s stockholders’ equity.

See footnote 3.

ASU 2022-01 replaces the last-of-layer hedge with the portfolio layer method hedge, under which the closed portfolio of financial assets are not limited to prepayable financial assets. See further discussion of the portfolio layer method and the effective date of ASU 2022-01 in Chapter 9.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.