2.3 Risks That May Be Identified as the Hedged Risk
ASC 815 permits an entity to hedge the risk of changes in the entire fair value of
the hedged item or in all the item’s cash flows, but an entity may hedge certain
other risk components of the hedged item as well. The nature of the risks that may
be hedged depends on whether the hedged item is a financial asset or liability or a
nonfinancial asset or liability. An entity is permitted to hedge any of the risks
individually or in combination with other risks.
2.3.1 Financial Instruments — Risks That May Be Hedged
ASC 815-20
Hedged Item Criteria Applicable to Fair Value
Hedges Only
25-12(f) If the hedged item
is a financial asset or liability, a recognized loan
servicing right, or a nonfinancial firm commitment with
financial components, the designated risk being hedged
is any of the following:
- The risk of changes in the overall fair value of the entire hedged item
- The risk of changes in its fair value attributable to changes in the designated benchmark interest rate (referred to as interest rate risk)
- The risk of changes in its fair value attributable to changes in the related foreign currency exchange rates (referred to as foreign exchange risk)
- The risk of changes in its fair
value attributable to both of the following
(referred to as credit risk):
- Changes in the obligor’s creditworthiness
- Changes in the spread over the benchmark interest rate with respect to the hedged item’s credit sector at inception of the hedge.
- If the risk designated as being hedged is not the risk in paragraph 815-20-25-12(f)(1), two or more of the other risks (interest rate risk, foreign currency exchange risk, and credit risk) may simultaneously be designated as being hedged.
Hedged Transaction Criteria
Applicable to Cash Flow Hedges Only
25-15(j) If the hedged
transaction is the forecasted purchase or sale of a
financial asset or liability (or the interest payments
on that financial asset or liability) or the variable
cash inflow or outflow of an existing financial asset or
liability, the designated risk being hedged is any of
the following:
- The risk of overall changes in the hedged cash flows related to the asset or liability, such as those relating to all changes in the purchase price or sales price (regardless of whether that price and the related cash flows are stated in the entity’s functional currency or a foreign currency)
- For forecasted interest receipts or payments on an existing variable-rate financial instrument, the risk of changes in its cash flows attributable to changes in the contractually specified interest rate (referred to as interest rate risk). For a forecasted issuance or purchase of a debt instrument (or the forecasted interest payments on a debt instrument), the risk of changes in cash flows attributable to changes in the benchmark interest rate or the expected contractually specified interest rate. See paragraphs 815-20-25-19A through 25-19B for further guidance on the designation of interest rate risk in the forecasted issuance or purchase of a debt instrument.
- The risk of changes in the functional-currency-equivalent cash flows attributable to changes in the related foreign currency exchange rates (referred to as foreign exchange risk)
- The risk of changes in its cash
flows attributable to all of the following
(referred to as credit risk):
- Default
- Changes in the obligor’s creditworthiness
- Changes in the spread over the contractually specified interest rate or benchmark interest rate with respect to the related financial asset’s or liability’s credit sector at inception of the hedge.
If the risk designated as being hedged is not the risk in
paragraph 815-20-25-15(j)(1), two or more of the other
risks (interest rate risk, foreign exchange risk, and
credit risk) simultaneously may be designated as being
hedged.
The table below illustrates the types of interest
rate, credit, and foreign currency risks that may be hedged in connection with a
financial instrument. These include the risks of changes in the forecasted
issuances, purchases, or sales of a financial instrument; recognized loan
servicing rights; and nonfinancial firm commitments with financial components.
Each risk is discussed in more detail below the table.
|
Fair Value Hedge
|
Cash Flow Hedge
| |
|---|---|---|
|
Interest rate risk (see Section 2.3.1.1)
|
The risk of changes in fair value attributable to changes
in the designated benchmark interest rate.
|
Either of the following:
|
|
Credit risk (see Section 2.3.1.2)
|
The risk of changes in fair value attributable to changes
in the obligor’s credit and changes in the general
credit spread for the relevant credit sector.
|
The risk of changes in cash flows attributable to
(1) default, (2) changes in the obligor’s
creditworthiness, and (3) changes in the general credit
spread for the relevant credit sector. Note that items
(2) and (3) are relevant for forecasted purchases or
issuances of debt or for an existing debt instrument
whose contractual payment terms change with changes in
those factors.
|
|
Foreign currency risk (see Section 2.3.1.3)
|
The risk of changes in fair value attributable to changes
in the related foreign currency exchange rates.
|
The risk of changes in functional-currency-equivalent
cash flows attributable to changes in related foreign
currency exchange rates.
|
|
Overall risk (see Section 2.3.1.4)
|
The risk of overall changes in fair value.
|
The risk of overall changes in cash flows.
|
An entity is permitted to designate more than one of the above component risks as
the combined risks in a single hedging relationship. For example, if an entity
has issued foreign-currency-denominated variable-rate debt, it may hedge its
exposure to changes in cash flows that are attributable to both interest rate
risk and foreign currency risk in a single hedging relationship. The most common
hedging strategy to achieve that objective would involve a cross-currency
interest rate swap (see further discussion of this hedging strategy in
Section 5.3.1.2).
2.3.1.1 Interest Rate Risk
An entity is permitted to
hedge the interest rate risk in a financial instrument. There are multiple
definitions of interest rate risk, depending on whether the hedged item is
an existing fixed-rate debt instrument, an existing variable-rate debt
instrument, or the forecasted issuance or purchase of a debt instrument. The
table below illustrates how interest rate risk is defined relative to the
item being hedged.
|
Hedged Item
|
Type of Hedge
|
Risk
|
|---|---|---|
|
Existing fixed-rate debt instrument
|
Fair value
|
Benchmark interest rate
|
|
Existing variable-rate debt instrument
|
Cash flow
|
Contractually specified interest rate
|
|
Forecasted issuance or purchase of fixed-rate debt
instrument
|
Cash flow
|
Benchmark interest rate
|
|
Forecasted issuance or purchase of variable-rate debt
instrument
|
Cash flow
|
Expected contractually specified interest rate
|
When issuing Statement 138, the FASB decided that interest rate risk and credit risk were separable components of the overall risk in a debt instrument. This decision was based on feedback received after the issuance of FASB Statement 133 indicating that (1) the separation of such risks would
be consistent with the common understanding of market participants and (2)
hedging activities that existed at the time (and still exist today) were
based on hedges of a benchmark interest rate. In addition, the feedback
indicated that it would be difficult to measure the impact of changes in
market credit sector spreads because consistent data on such spreads was not
readily available in the market.
In most interest rate
derivatives, the underlying is a benchmark interest rate. For example, most
interest rate swaps have a floating leg that is indexed to SOFR, which
essentially replaced LIBOR as the most common rate for interest rate
derivatives after reference rate reform. Other common interest rate
derivatives are options and forwards related to U.S. Treasury obligations.
However, the interest rate on debt instruments is typically composed of two
components: a benchmark or contractually specified interest rate and a
credit spread. For variable-rate debt instruments, it is easy to observe the
two components because the terms of the debt separately identify the
contractually specified interest rate and the credit spread (which is
typically fixed for the life of the debt arrangement). For fixed-rate debt
instruments, the interest rate on the debt does not typically equal the
benchmark interest rate, so the credit spread can be determined as the
difference between the overall interest rate and the benchmark interest
rate.
When it issued Statement
138, the FASB designated the LIBOR and U.S. Treasury rates as the benchmark
interest rates in the United States. In July 2013, the FASB issued
ASU
2013-10, which established the Fed Funds Effective Rate
Overnight Index Swap Rate (also referred to as the OIS Rate) as a benchmark
interest rate. In August 2017, the FASB issued ASU 2017-12,
which established the Securities Industry and Financial Markets Association
(SIFMA) Municipal Swap Rate. And in October 2018, in response to concerns
about the sustainability of LIBOR and the contemplated shift to an
alternative reference rate, the Board issued ASU 2018-16, which established
the SOFR OIS rate. As of the issuance date of this Roadmap, the acceptable
benchmark interest rates in the United States, as listed in ASC
815-20-25-6A, are as follows:
|
Rate
|
Origin
|
|---|---|
|
U.S. Treasury
|
FASB Statement 138 — June 2000
|
|
LIBOR
|
FASB Statement 138 — June 2000
|
|
Fed Funds OIS
|
ASU 2013-10 — July 2013
|
|
SIFMA Municipal Swap
|
ASU 2017-12 — August 2017
|
|
SOFR OIS
|
ASU 2018-16 — October 2018
|
Changing Lanes
In April 2022, the FASB issued a proposed
ASU that would “amend the definition of the SOFR
Swap Rate so that it is no longer limited to the OIS rate based on
SOFR but would include other rates based on SOFR, such as SOFR
term.” However, in October 2022, the Board decided not to amend the
definition of the “SOFR Swap Rate.”
See Sections 3.2.1 and 4.2.1.2 for
further discussion of hedging the benchmark interest rate and how that
affects the application of hedge accounting for fair value hedges and cash
flow hedges, respectively.
ASU 2017-12 amended ASC 815 to remove the notion of a benchmark interest rate
for variable-rate debt instruments and replaced it with the concept of a
contractually specified interest rate. In many cases, this change is of
little significance because most variable-rate debt instruments have an
interest rate that only resets on the basis of one predefined interest rate
index. ASC 815 has never permitted an entity to hedge a benchmark interest
rate component of a variable-rate debt instrument that is explicitly indexed
to a rate that is not a qualifying benchmark interest rate. Since the hedge
of a variable-rate debt instrument is a hedge of potential changes in
interest cash flows, it is more relevant to hedge the variables that can
actually affect those cash flows. Accordingly, an entity that wants to hedge
the interest rate risk in a variable-rate debt instrument can hedge the risk
related to the contractually specified interest rate. If the hedged item is
the forecasted issuance of a variable-rate debt instrument, an entity can
designate as the hedged risk the changes in cash flows that are attributable
to changes in the expected contractually specified interest rate.
If a change in the benchmark interest rate is designated as the hedged risk
in either a fair value or a cash flow hedge, the evaluation of the hedge’s
effectiveness should encompass only changes in the benchmark interest rate
(i.e., changes in credit spreads over the benchmark rate should be
excluded). Similarly, if the contractually specified interest rate (or
expected contractually specified interest rate) is designated as the hedged
risk in a cash flow hedge, the evaluation of the hedge’s effectiveness
should take into account only changes in that interest rate.
2.3.1.1.1 Prohibition Against Hedging Interest Rate Risk — HTM Securities
ASC 815-20-25-43(c)(2) and (d)(2) prohibit entities from hedging interest
rate risk related to a held-to-maturity (HTM) security on the premise
that entities with the intent and ability to hold a debt security to
maturity should be indifferent to changes in market interest rates. In
fact, hedging such a security for changes in interest rates may
contradict the notion that the entity is holding it purely for the
collection of cash flows. Unless there is a default by the obligor, the
fair value of an HTM security will always equal its par amount on the
maturity date. However, such a security may be hedged for credit risk
and foreign currency risk since those risks could affect the security’s
fair value or cash flows upon maturity. In addition, an entity may hedge
the fair value of a prepayment option in an HTM security.
2.3.1.1.2 Prohibition Against Hedging Interest Rate Risk — Prepayment Option
An entity that designates the prepayment option
component of a debt instrument as the hedged item in a fair value hedge
(see Section 2.2.2.1.1.3) is prohibited from designating
interest rate risk as the hedged risk. In addition, ASC 815-20-25-6
notes that prepayment risk is also not an acceptable risk to designate:
An entity shall not simply designate prepayment
risk as the risk being hedged for a financial asset. However, it
can designate the option component of a prepayable instrument as
the hedged item in a fair value hedge of the entity’s exposure
to changes in the overall fair value of that prepayment option,
perhaps thereby achieving the objective of its desire to hedge
prepayment risk.
2.3.1.2 Credit Risk
An entity’s borrowing rate is the benchmark interest rate plus or minus the
entity’s own sector credit spread, if any. Its credit spread is the risk
premium required over the benchmark rate and is based on the difference
between (1) the credit risk that is implicit in the benchmark rate and (2)
the credit risk of the entity. The same principle applies to
interest-bearing assets. In a credit risk hedge, the relevant credit spread
to be considered is that of the issuing entity. Under ASC 815, credit risk
includes the risk of a widening or compression of a sector spread relative
to the benchmark interest rate with respect to the hedged item’s credit
sector upon inception of the hedge.
The fair value of fixed-rate debt instruments is affected by
both the obligor’s default risk and changes in credit sector spreads.
Generally speaking, variable-rate debt instruments have a fixed spread over
the contractually specified interest rate. For example, an entity may issue
debt that is repriced every three months to achieve a rate that is equal to
the three-month term SOFR plus 1.5 percent. In such a case, the only real
potential for credit risk to affect the actual cash flows is if a default
occurs. However, for the forecasted issuance or purchase of debt
instruments, the credit risk that can affect future cash flows includes all
the components of credit risk.
2.3.1.3 Foreign Currency Risk
An entity with a financial instrument denominated in a
foreign currency is exposed to changes in the exchange rate between that
foreign currency and its functional currency. Changes in foreign currency
exchange rates can actually affect both the instrument’s fair value and the
cash flows related to the instrument on a functional currency basis.
Accordingly, an entity will sometimes have a choice between designating a
hedge as a fair value hedge or a cash flow hedge. See Chapter 5 for a more thorough discussion of foreign currency
hedging under both the fair value and cash flow hedging models.
2.3.1.4 Overall Risk
An entity is not required to hedge any individual component
risks that would affect the fair value or cash flows of a financial
instrument. Instead, it may designate as the hedged risk the overall changes
in (1) the fair value or (2) the cash flows of the hedged item. In fact, in
some cases, an entity is only permitted to designate either the overall
changes in the fair value or the overall changes in the cash flows (i.e., it
is unable to designate any other type of hedged risk). For example, as noted
in Section 2.3.1.1.2, if an entity designates the prepayment
option in a debt instrument as the hedged item, it must hedge the total
changes in that option’s fair value. However, the entity is prohibited from
hedging (1) a fixed-rate HTM security for overall changes in its fair value
(in accordance with ASC 815-20-25-12(d)) and (2) a variable-rate HTM
security for total changes in cash flows (in accordance with ASC
815-20-25-15(f)).
2.3.2 Nonfinancial Items — Risks That May Be Hedged
ASC 815-20
Hedged Item Criteria Applicable to
Fair Value Hedges Only
25-12(e) If the hedged item
is a nonfinancial asset or liability (other than a
recognized loan servicing right or a nonfinancial firm
commitment with financial components), the designated
risk being hedged is the risk of changes in the fair
value of the entire hedged asset or liability
(reflecting its actual location if a physical asset).
That is, the price risk of a similar asset in a
different location or of a major ingredient shall not be
the hedged risk. Thus, in hedging the exposure to
changes in the fair value of gasoline, an entity may not
designate the risk of changes in the price of crude oil
as the risk being hedged for purposes of determining
effectiveness of the fair value hedge of gasoline.
Hedged Transaction Criteria Applicable to Cash Flow
Hedges Only
25-15(i) If the hedged
transaction is the forecasted purchase or sale of a
nonfinancial asset, the designated risk being hedged is
any of the following:
- The risk of changes in the functional-currency-equivalent cash flows attributable to changes in the related foreign currency exchange rates
- The risk of changes in the cash flows relating to all changes in the purchase price or sales price of the asset reflecting its actual location if a physical asset (regardless of whether that price and the related cash flows are stated in the entity’s functional currency or a foreign currency), not the risk of changes in the cash flows relating to the purchase or sale of a similar asset in a different location.
- The risk of variability in cash flows attributable to changes in a contractually specified component. (See additional criteria in paragraphs 815-20-25-22A through 25-22B for designating the variability in cash flows attributable to changes in a contractually specified component as the hedged risk.)
The table below illustrates the types of risks
that may be hedged relative to nonfinancial items. Each risk is discussed in
more detail after the table.
|
Fair Value Hedge
|
Cash Flow Hedge
| |
|---|---|---|
|
Contractually specified component risk
(see Section 2.3.2.1)
|
N/A
|
The risk of changes in the cash flows
associated with a forecasted purchase or sale of a
nonfinancial asset that are related to changes in a
contractually specified component of the overall
price
|
|
Foreign currency risk (see Section
2.3.2.2)
|
N/A
|
The risk of changes in the
functional-currency-equivalent cash flows attributable
to changes in related foreign currency exchange
rates
|
|
Overall risk (see Section
2.3.2.3)
|
The risk of overall changes in fair
value
|
The risk of overall changes in cash
flows
|
2.3.2.1 Contractually Specified Component Risk
ASC 815-20
25-22A For
existing contracts, determining whether the
variability in cash flows attributable to changes in
a contractually specified component may be
designated as the hedged risk in a cash flow hedge
is based on the following:
- If the contract to purchase or sell a nonfinancial asset is a derivative in its entirety and an entity applies the normal purchases and normal sales scope exception in accordance with Subtopic 815-10, any contractually specified component in the contract is eligible to be designated as the hedged risk. If the entity does not apply the normal purchases and normal sales scope exception, no pricing component is eligible to be designated as the hedged risk.
- If the contract to purchase or sell a nonfinancial asset is not a derivative in its entirety, any contractually specified component remaining in the host contract (that is, the contract to purchase or sell a nonfinancial asset after any embedded derivatives have been bifurcated in accordance with Subtopic 815-15) is eligible to be designated as the hedged risk.
25-22B An
entity may designate the variability in cash flows
attributable to changes in a contractually specified
component in accordance with paragraph
815-20-25-15(i)(3) to purchase or sell a
nonfinancial asset for a period longer than the
contractual term or for a not-yet-existing contract
to purchase or sell a nonfinancial asset if the
entity expects that the requirements in paragraph
815-20-25-22A will be met when the contract is
executed. Once the contract is executed, the entity
shall apply the guidance in paragraph 815-20-25-22A
to determine whether the variability in cash flows
attributable to changes in the contractually
specified component can continue to be designated as
the hedged risk. See paragraphs 815-20-55-26A
through 55-26E for related implementation
guidance.
Before the issuance of ASU 2017-12, foreign currency risk was the only
component of the forecasted purchase or sale price of a nonfinancial asset
that was acceptable as a hedged risk. The amendments in ASU 2017-12 gave
entities the ability to hedge a contractually specified component of the
ultimate price of the forecasted purchase or sale of the nonfinancial asset.
The ASU amended ASC 815 to allow an entity to designate the “risk of
variability in cash flows attributable to changes in a contractually
specified component” as the hedged risk in a cash flow hedge of a forecasted
purchase or sale of a nonfinancial asset. ASU 2017-12 defines a
contractually specified component as “[a]n index or price explicitly
referenced in an agreement to purchase or sell a nonfinancial asset other
than an index or price calculated or measured solely by reference to an
entity’s own operations.”
Under the ASU, a contractually specified component risk may be hedged, which
allows entities to hedge purchases and sales of nonfinancial assets in
situations in which a contract has a pricing formula with one or more
variable components. For example, a purchase contract may have a base
component price for a related commodity and other variable pricing
components associated with actual transportation costs at the time of
delivery, different fixed spreads based on different grades of the
commodity, or both. In addition, entities that purchase or sell nonfinancial
assets of varying qualities or grades or at different locations can now
designate those purchases or sales in a single hedging relationship if the
price of the nonfinancial assets have a common contractually specified price
component.
2.3.2.1.1 Contractually Specified Component of Existing Contract
An entity may wish to designate as the hedged risk the variability in the
cash flows attributable to changes in a contractually specified
component in the purchase or sale of a nonfinancial asset. The ability
to make such a designation depends on the nature of the contract:
- If the contract is a derivative in its entirety and the entity applies the “normal purchases and normal sales” derivative scope exception in ASC 815-10-15-13(b), it may designate any contractually specified component in the contract as the hedged risk (failure to apply the normal purchases and normal sales scope exception precludes designation of any contractually specified component in the contract). For further discussion of the application of the normal purchases and normal sales scope exception, see Section 2.3.2 of Deloitte’s Roadmap Derivatives.
- If the contract is not a derivative in its entirety, the entity may designate any contractually specified component in the host contract as the hedged risk, other than any pricing component that is an embedded derivative that is bifurcated and accounted for separately.
According to ASC 815-20-55-26A, “[t]he definition of a
contractually specified component is considered to be met if the
component is explicitly referenced in agreements that support the price
at which a nonfinancial asset will be purchased or sold.”
Sometimes it is easy to determine whether an entity has
a contractually specified component in an existing contract to purchase
or sell a nonfinancial asset. An example would be an annual aluminum
supply contract7 in which each month’s purchases are based on the average price per
pound, as quoted on the London Metals Exchange (LME), plus the monthly
average of the Midwest Transaction Premium, as published by Platts
Metals Daily, plus $0.15 per pound. In this case, an entity could
identify any of the following as contractually specified components of
the forecasted purchases of aluminum:
- The LME aluminum price.
- The Midwest Transaction Premium.
- A combination of both of the above components (commonly referred to as the Midwest Transaction Price).
Questions have also arisen about what sorts of
agreements qualify as contracts that support the price at which a
nonfinancial asset will be purchased or sold. We believe that a legally
binding agreement between a buyer and seller that explicitly refers to a
formula with a specific index or indexes needs to exist before the
actual purchase or sale of the nonfinancial asset. However, ASC 815 also
allows an entity to hedge a contractually specified component of a
contract that does not yet exist. See Section 2.3.2.1.2 for a discussion of the criteria for
hedging a contractually specified component of a contract that does not
yet exist.
Changing Lanes
In September 2024, the FASB issued a
proposed ASU
that would make targeted hedge accounting improvements. The
proposed amendments would eliminate the term “contractually
specified components” and permit entities to hedge variable
price components of the forecasted purchase or sale of a
nonfinancial asset as long as the components meet the clearly
and closely related criteria as described in the normal
purchases and normal sales scope exception. Entities would be
able to designate such variable price components regardless of
whether the transaction will be executed in a spot or forward
market. In addition, the proposed ASU would allow entities to
designate a variable price component in a contract that is
accounted for as a derivative as long as the component is either
(1) explicitly referenced in the pricing formula in the contract
and clearly and closely related to the asset being purchased or
sold or (2) a clearly and closely related subcomponent of a
qualifying component that is explicitly referenced in the
pricing formula. As of the date of this publication, the FASB
has not issued a final ASU.
2.3.2.1.2 Contractually Specified Component of a Contract That Does Not Yet Exist
An entity is permitted to designate a hedge of a contractually specified
component related to the forecasted purchases or sales of a nonfinancial
asset (1) for a period that extends beyond the existing contractual term
or (2) in circumstances in which a contract does not yet exist to sell
or purchase the nonfinancial asset, the criteria specified for existing
contracts will be met in a future contract, and all the other cash flow
hedging requirements are met (see ASC 815-20-25-22B).
However, an entity is generally not permitted to hedge a contractually
specified component of a forecasted purchase or sale on the spot market.
Most transactions in the spot market are simply purchases or sales of a
nonfinancial asset at the current market price without a preexisting
contract that contains a pricing formula.
ASC 815-20-55-26A illustrates how a contractually specified component of
a purchase could exist in a spot market and provides an example of an
entity that intends to buy a commodity in such a market. That guidance
states, in part, that “[i]f as part of the governing agreements of the
transaction or commodities exchange it is noted that prices are based on
a pre-defined formula that includes a specific index and a basis, those
agreements may be utilized to identify a contractually specified
component.” It is our current understanding that few, if any, spot
markets operate in a manner in which the pricing of the commodity traded
in the market is based on a predefined formula.
Changing Lanes
In November 2019, the FASB issued a
proposed ASU of Codification improvements
to hedge accounting. One of the proposed improvements would
allow documentation that was obtained either before or after the
transaction is consummated to provide evidence of a
contractually specified component of the purchase price. A spot
transaction receipt, or other documentation that supports the
price at which a nonfinancial asset is purchased or sold would
qualify as evidence, as long as the pricing formula that
includes the contractually specified component is based on how
the price is determined in the nonfinancial asset’s market.
On the basis of questions raised by stakeholders
about the proposed guidance, the Board changed the scope of the
project; as discussed in the Changing Lanes in Section 2.3.2.1.1 in September
2024, the FASB issued a proposed
ASU that would eliminate the concept of a
contractually specified component and instead allow entities to
hedge a clearly and closely related component of the forecasted
purchase or sale price of a nonfinancial asset. As of the date
of this publication, the FASB has not issued a final ASU.
2.3.2.1.3 Contractually Specified Component Prohibited for Fair Value Hedge
ASC 815 does not permit the changes in the fair value of
a component or major ingredient of a nonfinancial asset to be the
designated risk in a fair value hedge. The only acceptable risk
designation for a fair value hedge of a nonfinancial asset is the
overall changes in fair value. However, as discussed in Section 2.3.2.1.1, an entity is allowed to hedge
components of the price of a forecasted purchase or sale of a
nonfinancial asset if that price component is contractually
specified.
Example 2-6
Reprise manufactures tweezers made from aluminum
and other alloys. It cannot designate the aluminum
component of the tweezers in inventory as the
hedged item in a fair value hedge because ASC 815
precludes fair value hedges of a component or
major ingredient of a nonfinancial asset or
liability. Reprise could, however, designate an
aluminum-based derivative as a hedge of the entire
change in the fair value of the tweezer inventory
if the derivative is expected to be highly
effective at offsetting changes in the inventory’s
fair value.
Reprise also would potentially be able to
designate a cash flow hedge of a contractually
specified component of a forecasted purchase of
raw materials or a sale of finished goods. For
example, Reprise could designate the aluminum
component of a forecasted sale of tweezers as the
hedged risk if the price of aluminum was a
contractually specified component of the sale
price of the tweezers.
2.3.2.2 Foreign Currency Risk
Purchases and sales of nonfinancial assets that occur in a currency other
than an entity’s functional currency expose the entity to changes in price
when foreign currency exchange rates change, even if the stated transaction
price of the underlying asset does not change. The entity’s real economic
risk is that the ultimate price of a foreign-currency-denominated forecasted
purchase or sale can change because of fluctuations in foreign currency
exchange rates. Also, any related receivable or payable that results from
that purchase or sale represents a financial instrument that is still
exposed to foreign currency risk until it is settled.
ASC 815 permits entities to hedge the risk of changes in
functional-currency-equivalent cash flows that are attributable to changes
in foreign currency exchange rates related to the forecasted purchases and
sales of nonfinancial assets.
The fair values of
nonfinancial assets are not exposed to the risk of changes in foreign
currency exchange rates because those assets (1) are not denominated in any
currency and (2) do not result in any contractual cash flows. Accordingly,
an entity cannot designate a fair value hedge of the foreign currency risk
exposure of its nonfinancial assets.
See further discussion of foreign currency hedges in
Chapter 5.
2.3.2.3 Overall Risk
An entity is not required to hedge any individual component
risks that would affect the fair value or cash flows associated with a
nonfinancial asset, including the forecasted purchases and sales of
nonfinancial assets. The entity is always permitted to designate as the
hedged risk the changes in the overall fair value or overall cash flows of
the hedged item that reflect its actual location if it is a physical asset.
Note, however, that the entity may exclude foreign currency risk from its
designation of the hedged risk if it is going to purchase or sell a
nonfinancial asset in a foreign currency and is only concerned about the
price risk of the underlying asset.
Example 2-7
Company M, whose functional currency
is the euro (EUR), uses crude oil in the manufacture
of certain products. In international commerce, the
price of crude oil is denominated only in USD.
Company M hedges its probable forecasted purchases
of crude oil by using derivatives indexed to crude
oil and determines that the derivatives are highly
effective at offsetting its exposure to variability
in the cash flows arising from its crude oil
purchases in USD.
In its hedge documentation, M can specify that it is
excluding the foreign currency risk associated with
making USD crude oil purchases from its designation
of the hedged risk. In other words, its objective is
to hedge variability in the cash flows that may
arise from changes in the forecasted commodity price
in USD, not changes in the price that are
attributable to changes in the exchange rate from
USD to EUR. Company M can designate as the hedged
risk the changes in cash flows related to all
changes in the purchase price of crude oil in the
currency in which the forecasted transaction will
occur (USD), while ignoring its USD to EUR currency
exposure.
The risk of changes in overall fair value is the only risk that can be
designated in a fair value hedge of a nonfinancial asset, other than a
recognized loan servicing right or nonfinancial firm commitment with
financial components.
2.3.3 Net Investment Hedges — Risk That May Be Hedged
The only risk that an entity can hedge in connection with a
net investment in foreign operations is the exposure to foreign currency
risk. See further discussion of net investment hedging in Chapter 5.
Footnotes
7
Assume that the contract is not accounted for as
a derivative because it qualifies for and is designated as a
normal purchases and normal sales contract.