2.5 Hedge Effectiveness
ASC 815-20
25-75 To
qualify for hedge accounting, the hedging relationship, both
at inception of the hedge and on an ongoing basis, shall be
expected to be highly effective in achieving either of the
following:
- Offsetting changes in fair value attributable to the hedged risk during the period that the hedge is designated (if a fair value hedge)
- Offsetting cash flows attributable to the hedged risk during the term of the hedge (if a cash flow hedge), except as indicated in paragraph 815-20-25-50.
When the FASB issued Statement 133, one of its fundamental decisions was to require
entities to demonstrate that a hedging instrument is highly effective at offsetting
the changes in the fair value or cash flows of the hedged item before that hedging
relationship can qualify for the application of hedge accounting. Accordingly, hedge
accounting is permitted only if the changes in the fair value or cash flows of the
hedged item that are attributable to the hedged risk are expected to be offset by
the related changes in the fair value of the hedging instrument. To assess the
effectiveness of a hedging relationship, entities must compare the changes in the
fair value of the hedging instrument to the changes in the fair value or cash flows
of the hedged item that are related to the risk being hedged.
Entities may not apply hedge accounting unless the hedging
relationship is expected to be highly effective (1) at the inception of the hedging
relationship and (2) on an ongoing basis. Accordingly, for a relationship to qualify
for hedge accounting, the entity must perform an initial prospective hedge
effectiveness assessment upon hedge inception.8 Thereafter, the entity must perform prospective and retrospective assessments
of the hedging relationship’s effectiveness whenever it reports financial statements
or earnings and at least every three months. Although for most hedging relationships
the entity’s initial prospective assessment of hedge effectiveness must be a
quantitative analysis, the entity may elect to perform subsequent assessments either
quantitatively or qualitatively if certain conditions are satisfied (see ASC
815-20-35-2A).
Under ASC 815-20-25-3(b)(2)(iv), an entity is required to document,
upon a hedging relationship’s inception,9 “[t]he method that will be used to retrospectively and prospectively assess
the hedging instrument’s effectiveness in offsetting the exposure to changes in the
hedged item’s fair value (if a fair value hedge) or hedged transaction’s variability
in cash flows (if a cash flow hedge) attributable to the hedged risk.” An entity
should use the same method of assessing hedge effectiveness for all similar hedging
relationships; however, the election to perform subsequent qualitative assessments
may be made on a hedge-by-hedge basis. In some limited cases, an entity may perform
qualitative assessments of hedge effectiveness throughout the life of the hedging
relationship. See Section
2.5.2 for further discussion of the different methods of assessing
hedge effectiveness, including the criteria for determining when qualitative
assessments are appropriate.
ASC 815 does not explicitly define a quantitative threshold that would be considered
“highly effective”; however, in practice, a hedge is considered highly effective if
the change in the hedging instrument’s fair value provides offset of at least 80
percent and not more than 125 percent of the change in the fair value or cash flows
of the hedged item that are attributable to the risk being hedged.
2.5.1 Prospective Versus Retrospective Assessment
ASC 815-20
25-79 An entity shall
consider hedge effectiveness in two different ways — in
prospective considerations and in retrospective
evaluations:
- Prospective considerations. The entity’s expectation that the relationship will be highly effective over future periods in achieving offsetting changes in fair value or cash flows, which is forward looking, must be assessed on a quantitative basis at hedge inception unless one of the exceptions in paragraph 815-20-25-3(b)(2)(iv)(01) is met. Prospective assessments shall be subsequently performed whenever financial statements or earnings are reported and at least every three months. The entity shall elect at hedge inception in accordance with paragraph 815-20-25-3(b)(2)(iv)(03) whether to perform subsequent assessments on a quantitative or qualitative basis. See paragraphs 815-20-35-2A through 35-2F for additional guidance on qualitative assessments of hedge effectiveness. A quantitative assessment can be based on regression or other statistical analysis of past changes in fair values or cash flows as well as on other relevant information. The quantitative prospective assessment of hedge effectiveness shall consider all reasonably possible changes in fair value (if a fair value hedge) or in fair value or cash flows (if a cash flow hedge) of the derivative instrument and the hedged items for the period used to assess whether the requirement for expectation of highly effective offset is satisfied. The quantitative prospective assessment may not be limited only to the likely or expected changes in fair value (if a fair value hedge) or in fair value or cash flows (if a cash flow hedge) of the derivative instrument or the hedged items. Generally, the process of formulating an expectation regarding the effectiveness of a proposed hedging relationship involves a probability-weighted analysis of the possible changes in fair value (if a fair value hedge) or in fair value or cash flows (if a cash flow hedge) of the derivative instrument and the hedged items for the hedge period. Therefore, a probable future change in fair value will be more heavily weighted than a reasonably possible future change. That calculation technique is consistent with the definition of the term expected cash flow in FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements.
- Retrospective evaluations. An assessment of effectiveness may be performed on a quantitative or qualitative basis on the basis of the entity’s election at hedge inception in accordance with paragraph 815-20-25-3(b)(2)(iv)(03). That assessment shall be performed whenever financial statements or earnings are reported, and at least every three months. See paragraphs 815-20-35-2 through 35-4 for further guidance. At inception of the hedge, an entity electing a dollar-offset approach to perform retrospective evaluations on a quantitative basis may choose either a period-by-period approach or a cumulative approach in designating how effectiveness of a fair value hedge or of a cash flow hedge will be assessed retrospectively under that approach, depending on the nature of the hedge documented in accordance with paragraph 815-20-25-3. For example, an entity may decide that the cumulative approach is generally preferred, yet may wish to use the period-by-period approach in certain circumstances. See paragraphs 815-20-35-5 through 35-6 for further guidance.
ASC 815-20-25-79 requires an entity to “consider hedge effectiveness in two
different ways — in prospective considerations and in retrospective
evaluations.”
As indicated in ASC 815-20-25-79(a), prospective considerations address the
“expectation that the [hedging] relationship will be highly effective over
future periods in achieving offsetting changes in fair value or cash flows.”
Unless a hedging relationship meets one of the exceptions that permits an
assumption of perfect effectiveness (see Sections 2.5.2.2.1 through
2.5.2.2.5), the entity will need to perform an initial
quantitative prospective effectiveness assessment of the hedging relationship.
Although the entity will not have actual results from the hedging relationship
on which to base its effectiveness assessment at the inception of the
relationship, it needs to obtain evidence showing that it expects the hedge to
be highly effective at producing offsetting fair values or cash flows.
Thereafter, the entity must perform prospective effectiveness assessments
whenever financial statements or earnings are reported and at least every three
months. In accordance with ASC 815-20-25-3(b)(2)(iv)(03), at hedge inception,
the entity must indicate whether it will perform subsequent effectiveness
assessments on a quantitative or qualitative basis. See Section
2.5.2.2 for a discussion of qualitative assessments of hedge
effectiveness.
By contrast, when performing retrospective evaluations, the entity considers the
effectiveness of a hedging relationship up to the assessment date. ASC
815-20-35-2 states, in part, that “[i]f a fair value hedge or cash flow hedge
initially qualifies for hedge accounting, the entity would continue to assess
whether the hedge meets the effectiveness test on either a quantitative basis
(using either a dollar-offset test or a statistical method such as regression
analysis) or a qualitative basis. . . . At least quarterly, the hedging entity
shall determine whether the hedging relationship has been highly effective in
having achieved offsetting changes in fair value or cash flows through the date
of the periodic assessment.”
To apply hedge accounting in a reporting period, an entity needs to perform (1) a
prospective assessment at the beginning of the period that supports the
conclusion that the hedge will be highly effective and (2) a
retrospective assessment at the end of the period that supports the conclusion
that the hedge was indeed highly effective during the period. If the results of
either assessment indicate that the hedging relationship is not highly
effective, hedge accounting cannot be applied for that reporting period.
If an entity uses different methods for its prospective and retrospective hedge
effectiveness assessments and the results of the retrospective assessment
indicate that the hedging relationship was not highly effective in one period,
the entity may not automatically be precluded from applying hedge accounting in
the following period if the results of the prospective effectiveness assessment
indicate that the hedging relationship is expected to be highly effective in
future periods. An entity is not necessarily required to dedesignate a hedging
relationship upon a “failed” hedge effectiveness assessment. However, if there
are repeated failures, the entity may be required to reassess its expectations
about whether the hedging relationship will continue to be highly effective in
the future and reconsider whether the hedging instrument would be better used in
a different hedging relationship. Note that hedge accounting cannot be applied
in any period in which the results of a retrospective assessment indicated that
the hedging relationship was not highly effective.
As discussed above, at the inception of a hedging relationship, an entity must
define and document the methods it will use to assess the hedge’s effectiveness,
both prospectively and retrospectively. The method that an entity uses to
perform its prospective effectiveness assessments may differ from its method for
performing retrospective effectiveness assessments; however, for similar hedges,
an entity must use the same method for all of its prospective assessments and
the same method for all of its retrospective assessments throughout the term of
the hedging relationship. Most entities use the same method for both the
prospective and retrospective effectiveness assessments. For example, if an
entity chooses to perform a regression analysis for both its prospective and
retrospective effectiveness assessments, at the end of the reporting period, the
entity would use that regression analysis in (1) the retrospective effectiveness
assessment for the period just ended and (2) the prospective effectiveness
assessment for the following period.
As discussed in Section 2.5.4, entities cannot change their
methods of assessing hedge effectiveness from one period to the next unless the
hedge designation is terminated and a new hedge is established. For example, an
entity cannot document at hedge inception that it will assess effectiveness
retrospectively by using the period-by-period dollar-offset method and then, in
the next reporting period, change its effectiveness assessment method to the
cumulative dollar-offset method unless, at the time the change is made, the
entity terminates the original hedging relationship and redesignates a new
hedging relationship. Instead, the entity must continue to use the
period-by-period dollar-offset method for the duration of the hedging
relationship. In addition, as discussed in Section 2.5.3,
an entity should assess effectiveness for similar hedges in a similar manner;
use of different methods for similar hedges must be justified.
2.5.2 Methods of Effectiveness Assessment
2.5.2.1 Quantitative Methods of Assessment
ASC 815-20-25-79(a) states, in part, that “[a] quantitative assessment can be
based on regression or other statistical analysis of past changes in fair
values or cash flows as well as on other relevant information.” The two most
common statistical methods of assessing a hedge’s level of effectiveness are
the dollar-offset method and regression analysis. As part of addressing
considerations related to the purpose of a hedge effectiveness assessment
(i.e., to determine how effective a hedging instrument is and will be at
offsetting the hedged risk), the discussion below summarizes the types of
quantitative analyses that are generally performed and the data inputs an
entity needs to perform each type of analysis. Note that different methods
may be used, depending on the type of hedge and the nature of the hedging
instrument.
The discussion below regarding quantitative effectiveness assessment methods
focuses on hedging relationships that involve derivative instruments as the
hedging instrument. In the limited cases in which a nonderivative instrument
can be designated as the hedging instrument in a qualifying relationship,
entities often assume that (1) a hedge is perfectly effective (see
Section 2.5.2.2.4) or (2) if it is not, any
quantitative assessment is not typically complex (see Section
2.5.2.1.2.5).
2.5.2.1.1 Models for Assessment
2.5.2.1.1.1 Dollar-Offset Method
The dollar-offset method is the simplest assessment method to apply,
but it is mostly used for retrospective effectiveness assessments
that take into account data over the life of the hedging
relationship. Under the dollar-offset method, an entity compares the
change in the fair value of the derivative to the change in the fair
value or cash flows of the hedged item that is attributable to
changes in the designated risk.
Example 2-19
Entity H hedges changes in the fair value of
its investment in a fixed-rate AFS debt security
that are attributable to changes in the benchmark
interest rate. It designates a receive-floating,
pay-fixed interest rate swap as the hedging
instrument. In a given period, the security
appreciates in value by $1,000 as a result of
changes in the benchmark interest rate, while the
interest rate swap declines in value by $875.
Entity H calculates the ratio of the changes in
the values of the two instruments by dividing the
change in the fair value of the derivative by the
change in the fair value of the hedged item that
is attributable to the hedged risk — that is, 87.5
percent. Entity H concludes that the hedge has
been highly effective because the ratio falls
within the acceptable range of 80 to 125 percent.
Before the issuance of ASU 2017-12, entities had to measure and
recognize the ineffectiveness of qualifying hedging relationships,
so the use of the dollar-offset method was a bit more common than we
expect it will be after the adoption of ASU 2017-12.
When using the dollar-offset method, an entity must choose to
determine the dollar-offset on the basis of either (1) changes in
the fair values (or cash flows) for the period under evaluation (a
period-by-period approach) or (2) the cumulative changes that have
occurred since the inception of the hedging relationship. The entity
should note which approach it elects in the hedge designation
documentation it prepares at hedge inception.
If an entity elects to apply a period-by-period approach, the
evaluation period cannot exceed three months. Under such an
approach, patterns of changes in the fair values (or cash flows) of
the hedging instrument or the hedged item (or hedged transaction)
that occurred in periods before the assessment period are not
relevant.
For example, assume
that an entity uses a derivative to hedge the fair value of a debt
instrument. The table below illustrates the changes in the fair
values of a derivative and a hedged item that are attributable to
the hedged risk and the hedge effectiveness dollar-offset ratios
under both a period-by-period assessment and a cumulative
assessment. (The numbers in green indicate that the percent offset
is within the acceptable range of 80 to 125 percent and the hedge is
highly effective; the numbers in red mean that the percent offset is
outside the acceptable range and the hedge is not highly effective.)
As illustrated above, if an entity applies the dollar-offset method
to assess hedge effectiveness, its election to use the
period-by-period approach instead of the cumulative approach may
affect whether the hedging relationship is considered highly
effective and can qualify for hedge accounting for the current
assessment period. If the entity elected to use the period-by-period
approach, the hedging relationship would not be highly effective for
the quarters ended December 31, 20X0, and March 31, 20X1. If the
entity elected to use the cumulative approach, the hedging
relationship would not be highly effective only for the quarter
ended March 31, 20X1.
2.5.2.1.1.2 Regression Analysis
Regression analysis is a technique for predicting the extent to which
the change in one variable (the independent variable) will result in
a change in another variable (the dependent variable). In assessing
hedge effectiveness, an entity regresses the data related to the
derivative and the hedged item against each other and evaluates the
results of the regression analysis to determine whether the hedge is
expected to be highly effective (prospective) or has been highly
effective (retrospective), or both. For example, if an entity wants
to use forward contracts to purchase crude oil to hedge forecasted
jet fuel purchases, it might use historical price changes for jet
fuel as the dependent variable and historical price changes for
crude oil as the independent variable. In fact, some entities use
regression analysis to determine their risk mitigation strategies
regardless of whether they intend to apply hedge accounting.
As indicated in ASC 815-20-35-3, if, at the inception of a hedging
relationship, an entity elects to use the same regression analysis
approach for both prospective and retrospective effectiveness
assessments, those regression analysis calculations should generally
incorporate the same number of data points during the term of that
hedging relationship. An entity should use enough data points, but
not an inappropriately excessive number, to create a statistically
sound analysis. Use of at least 30 data points is recommended. The
entity also must periodically update its regression (or other
statistical) analysis.
For a hedging relationship to be considered highly
effective under a regression analysis, (1) R2 should be
equal to or greater than 0.8, (2) the slope should be between
negative 0.8 and negative 1.25,10 and (3) the F and t statistics should be evaluated at a 95
percent confidence level. These terms are defined below.
The formula for a linear regression is y = mx + b +
x1:
- y represents the dependent variable.
- m represents the slope of the line.
- x represents the independent variable.
- b represents the y intercept.
- x1 represents the error term.
The table below
discusses how to evaluate the validity of a linear regression.
|
Factors Indicating That a
Regression Analysis Is Valid
|
Confidence Level or Numerical
Requirement
|
How to Evaluate the Confidence
Level or Numerical Requirement
|
|---|---|---|
|
R2
|
≥ 0.8
|
The R2 output
should be greater than or equal to 0.8.
R2 is the coefficient of determination,
which is the square of the coefficient of
correlation, or r. The r value indicates the
linear relationship between two variables. It can
range from –1 to +1. R2 represents the
proportion of variability in y that is
explained by x. The higher the value, the
higher the indication that y is related to
x.
|
|
m (slope factor)
|
Between –0.8 and –1.25
|
The slope (m) of a line is the
change in y over the change in x.
The slope should be within the range specified. An
increasing or decreasing value indicates the
positive or negative change in y for every
change in x. For example, a slope of +1
would indicate that y is increasing at a
positive rate for each change in x. In a
hedging relationship, a hedge is used to offset
changes in the value of the hedged item;
therefore, a regression equation for a hedging
relationship should have a negative slope within
the specified range if changes in the fair value
of the derivative are compared with changes in the
fair value or cash flows of the hedged item.
However, if an entity is using the
hypothetical-derivative method (see Section
2.5.2.1.2.4), the slope should be
positive.
|
|
t statistic
|
95 percent confidence level
|
The t statistic for the x
coefficient is used to evaluate the probability
that the slope is zero. A slope of zero indicates
that there is no relationship between the x
and y variables. A high t statistic
for the x coefficient, positive or
negative, generally is a good indicator that there
is correlation and thus a linear relationship
exists. This statistic may be further evaluated by
examining the p-value — a statistical
output of the t statistic calculation. A
low p-value associated with the t
statistic for the x variable (e.g., less
than 5 percent) indicates that there is a low
probability that the slope is zero and, thus, a
high probability that the independent variable is
useful in the prediction of the dependent
variable.
|
|
F statistic
|
95 percent confidence level
|
The F statistic is used to evaluate the
probability that there is no linear relationship
between the x and y variables. For a
relationship to achieve a 95 percent confidence
level, the significance of F should be less
than 5 percent. In such a case, there is a less
than 5 percent probability that no linear
relationship is present.
|
Note that statistical problems with data (e.g., serial correlation or
nonconstant variance of the error terms) may result in inaccurate
estimates of t, F, and R2. When this
occurs, consultation with statistical analysis experts is often
advisable.
Entities should challenge all statistical model assumptions to ensure
that they remain valid under current market and business conditions.
Even if an entity does not elect the dollar-offset method as one of
its methods of assessing hedge effectiveness, it still may need to
be aware of the dollar-offset results; this is because a continued
“failure” of that method (i.e., if the dollar offset indicates that
the effectiveness of the hedging relationship was not in the 80–125
percent range) would call into question the reliability of the
results produced by the statistical models. This periodic “reality
check” is necessary because a statistical analysis, such as
regression, inherently smooths historical data and may not
appropriately reflect current market or business conditions. One way
of challenging the validity of the model’s assumptions is to monitor
the results of dollar offset. Another potential alternative would be
to analyze the data points used as inputs in the regression analysis
to identify whether the relationship between the most recent data
points indicates that current market or business conditions are
inconsistent with historical trends. In that case, the entity might
then perform dollar-offset tests.
In accordance with the documentation requirements of ASC 815 and as
an appropriate risk management practice, entities should establish
policies and procedures that address the possibility that a
statistical method, such as regression, could indicate that a
hedging relationship is, or is expected to be, highly effective
while a dollar-offset analysis (i.e., the determination of the
actual offset) indicates that the relationship has not been highly
effective. Such policies may dictate that falling below a certain
level of offset, as indicated by a dollar-offset analysis, for a
specified period will trigger reassessment by an appropriate level
of management of the validity of the inputs used in the statistical
model. That reassessment would need to take into account current
market and business conditions. In some instances, consultation with
statistical analysis experts may be advisable. An entity’s process
for challenging the validity of a regression analysis should be well
documented and consistently applied.
ASC 815-20-25-79 states, in part:
The quantitative prospective
assessment of hedge effectiveness shall consider all reasonably
possible changes in fair value (if a fair value hedge) or in
fair value or cash flows (if a cash flow hedge) of the
derivative instrument and the hedged items for the period used
to assess whether the requirement for expectation of highly
effective offset is satisfied. The quantitative prospective
assessment may not be limited only to the likely or expected
changes in fair value (if a fair value hedge) or in fair value
or cash flows (if a cash flow hedge) of the derivative
instrument or the hedged items. Generally, the process of
formulating an expectation regarding the effectiveness of a
proposed hedging relationship involves a probability-weighted
analysis of the possible changes in fair value (if a fair value
hedge) or in fair value or cash flows (if a cash flow hedge) of
the derivative instrument and the hedged items for the hedge
period. Therefore, a probable future change in fair value will
be more heavily weighted than a reasonably possible future
change.
2.5.2.1.1.3 Other Statistical Methods
Generally speaking, regression analysis is the most
common type of statistical analysis used by entities to determine
the level of effectiveness of a hedging relationship. The
dollar-offset method and regression analysis are both specifically
mentioned in ASC 815, but broader reference is also made to “other
statistical analysis.” Other analyses may involve simulations (e.g.,
Monte Carlo simulation), which may be necessary in scenarios in
which there is not enough historical information available to
provide a statistically valid regression analysis. For example, a
new market may develop for a product or a derivative market may
develop in connection with a specific underlying. In these cases,
entities should consider consulting with relevant experts to develop
the proper parameters for an analysis that would validate whether a
hedging relationship is expected to be or has been highly effective.
2.5.2.1.2 Data for Models
To perform a statistical analysis, an entity must select an appropriate
mathematical model and identify the relevant inputs for the model. These
are not necessarily distinct processes; in fact, they often go hand in
hand. For example, if an entity is going to perform a dollar-offset
analysis (see Section 2.5.2.1.1.1) to assess hedge
effectiveness, the relevant inputs are changes in the fair value of the
hedging instrument and changes in the fair value or cash flows of the
hedged item that are attributable to the hedged risk. While an entity
has limited options regarding the nature of the inputs (changes in fair
value or cash flows), the actual inputs it uses will vary depending on
whether it has chosen to perform the analysis on a period-by-period or
cumulative basis. The discussion below focuses on the various elections
an entity can make that would influence the data inputs for the
statistical model the entity uses to perform its quantitative hedge
effectiveness assessment.
2.5.2.1.2.1 Derivative — Excluded Components
ASC 815-20
25-82 In
defining how hedge effectiveness will be assessed,
an entity shall specify whether it will include in
that assessment all of the gain or loss on a
hedging instrument. An entity may exclude all or a
part of the hedging instrument’s time value from
the assessment of hedge effectiveness, as follows:
- If the effectiveness of a hedge with an option is assessed based on changes in the option’s intrinsic value, the change in the time value of the option would be excluded from the assessment of hedge effectiveness.
- If the effectiveness of a hedge with an option is assessed based on changes in the option’s minimum value, that is, its intrinsic value plus the effect of discounting, the change in the volatility value of the contract shall be excluded from the assessment of hedge effectiveness.
- An entity may exclude any of
the following components of the change in an
option’s time value from the assessment of hedge
effectiveness:
- The portion of the change in time value attributable to the passage of time (theta)
- The portion of the change in time value attributable to changes due to volatility (vega)
- The portion of the change in time value attributable to changes due to interest rates (rho).
- If the effectiveness of a hedge with a forward contract or futures contract is assessed based on changes in fair value attributable to changes in spot prices, the change in the fair value of the contract related to the changes in the difference between the spot price and the forward or futures price shall be excluded from the assessment of hedge effectiveness.
- An entity may exclude the portion of the change in fair value of a currency swap attributable to a cross-currency basis spread.
Time value is a
component of the fair value of derivative instruments, and it can be
a source of ineffectiveness in a hedging relationship if there is no
corresponding time value component in the hedged item’s fair value
or expected cash flows. ASC 815 gives entities the option to exclude
components of a derivative’s fair value (and the resulting changes
in the components’ fair value) from the assessment of hedge
effectiveness. Depending on the type of derivative used, different
components of a derivative’s fair value may be excluded. The
following table illustrates, by type of derivative, the alternatives
available for excluded components:
|
Type of Derivative
|
Excludable Component
|
|---|---|
|
Option
|
|
|
Forward/futures
|
Forward points — The change in fair
value related to the changes in the difference
between the spot price and the forward or futures
price
|
|
Currency swap
|
Cross-currency basis spread
|
An entity’s decision to exclude changes in the fair values of certain
components of a derivative is part of its overall method of
assessing hedge effectiveness. Since an entity should assess the
effectiveness of similar hedges in a consistent manner (see
Section 2.5.3), the entity should apply its
decision to exclude certain components (or no components) to all
similar hedging relationships.
ASC 815-20
25-83A For fair value and
cash flow hedges, the initial value of the
component excluded from the assessment of
effectiveness shall be recognized in earnings
using a systematic and rational method over the
life of the hedging instrument. Any difference
between the change in fair value of the excluded
component and amounts recognized in earnings under
that systematic and rational method shall be
recognized in other comprehensive income. Example
31 beginning in paragraph 815-20-55-235
illustrates this approach for a cash flow hedge in
which the hedging instrument is an option and the
entire time value is excluded from the assessment
of effectiveness.
25-83B For fair value and
cash flow hedges, an entity alternatively may
elect to record changes in the fair value of the
excluded component currently in earnings. This
election shall be applied consistently to similar
hedges in accordance with paragraph 815-20-25-81
and shall be disclosed in accordance with
paragraph 815-10-50-4EEEE.
When an entity excludes a component of the change in a derivative’s
fair value from its hedge effectiveness assessment, it has two
alternatives for accounting for the change in the fair value of that
excluded component:
- Recognize the initial value of the excluded component in earnings by using a systematic and rational method over the life of the hedging instrument. Any differences between the actual change in the fair value of the excluded component and the amount recognized in earnings would be recognized in OCI.
- Recognize the change in the fair value of the excluded component in earnings.
As indicated in ASC 815-20-25-83A, the default method of accounting
for an excluded component is the “systematic and rational
amortization method.” An entity that prefers to recognize changes in
the fair value of the excluded component in earnings as they occur
should document that election. Similar hedges should be accounted
for similarly.
Note that if an entity uses a purchased option that meets the
definition of a derivative under ASC 815 in a hedge, it can amortize
the time value of the option over its life by (1) designating the
option as the hedging instrument in a qualifying hedging
relationship and (2) electing to exclude the time value from the
hedge effectiveness assessment.
The fair value of an option has two components: intrinsic value and
time value. Intrinsic value is calculated by comparing the strike
price (or strike rate) of the option with the market price (or
market rate) of the underlying exposure. An option will have
intrinsic value only if its strike price is favorable compared with
the current market price. Time value is equal to the option’s fair
value minus its intrinsic value. The premium paid to enter into an
option generally represents the option’s time value since most
options are issued at-the-money or out-of-the-money.
ASC 815 requires all derivatives to be recorded at fair value. Under
ASC 815-20-25-82, when designating an option as a hedging instrument
in a qualifying hedging relationship, an entity can exclude the
option’s time value from the assessment of the hedging
relationship’s effectiveness if the entity documents that it is
using the change in the option’s intrinsic value to hedge the
exposure. In such a case, the entity recognizes the initial value of
the excluded time value component as an adjustment to earnings over
the life of the hedging instrument (i.e., the option) by using a
systematic and rational method. Any difference between the change in
the fair value of the excluded component (i.e., the time value) and
the amount recognized currently in earnings under the amortization
approach is recorded in OCI (for net investment hedges, this amount
should be in the CTA within OCI).
Alternatively, an entity may elect to record the changes in the fair
value of the excluded time value component currently in earnings
(albeit this election must be consistently applied to similar
hedges). In accordance with ASC 815-20-25-129, the time value of an
option can be an effective portion of the hedging relationship if
the “terminal value” method is applied and certain criteria are met
(see Sections 2.5.2.1.2.2 and
2.5.2.2.3).
Example 2-20
Golden Age is a premium gold watch
manufacturer. As of July 1, 20X9, Golden Age
expects to purchase 1,000 ounces of gold on
December 31, 20X9. The current price of gold is
$1,320 per ounce. To protect itself from increases
in the gold price, Golden Age purchases a call
option with the following terms:
- Notional: 1,000 ounces.
- Strike price: $1,320 per ounce.
- Expiration: December 31, 20X9.
- Premium: $60,000.
Golden Age designates the option as a hedge of
its forecasted purchase of 1,000 ounces of gold at
prices above $1,320 per ounce. The company elects
to exclude the time value of the option from the
hedge effectiveness assessment and will account
for the excluded component by using the
amortization method.
Since the term of the option is six months and
the initial time value is $60,000, the application
of a systematic and rational method of recognizing
the option’s initial time value in earnings
results in the recognition of $10,000 per month in
the cost of sales during the option’s term,
provided that the hedging relationship remains
highly effective (from July to December).
The following table shows the changes in the
price of an ounce of gold and the fair value of
the option components over the life of the hedge:
Because Golden Age excludes the option’s time
value from its assessment of the hedging
relationship’s effectiveness, it assesses
effectiveness by comparing the changes in only the
option’s intrinsic value with the change in the
forecasted cash flows related to the purchase of
gold. If Golden Age were performing a monthly
hedge effectiveness assessment, the change in the
intrinsic value of the derivative for each of
month of the hedge would be as follows:
If the hedging relationship is highly effective
throughout its term, all of the intrinsic value
changes would be recorded in OCI. The following
table illustrates the treatment of the changes in
the excluded component (time value):
The accounting for hedging relationships that
involve excluded components is discussed in more
detail in Chapters 3, 4, and 5.
2.5.2.1.2.2 Options — Unique Considerations
Hedging with options is different from hedging with forwards or swaps
because the payoff profile of an option is asymmetrical. Regardless
of whether an entity hedges with a single option or a combination of
options (like a collar), there is an unhedged element in the hedged
transaction. If an entity is seeking to eliminate a risk exposure,
it can enter into a forward contract; however, when it enters into
an option, it is hedging only the underlying risk beyond a certain
desired threshold (or thresholds). Accordingly, the hedge
effectiveness assessment should not focus solely on the risk being
hedged but also on the level of that risk.
ASC 815-20
25-76 If the hedging
instrument (such as an at-the-money option
contract) provides only one-sided offset of the
hedged risk, either of the following conditions
shall be met:
- The increases (or decreases) in the fair value of the hedging instrument are expected to be highly effective in offsetting the decreases (or increases) in the fair value of the hedged item (if a fair value hedge).
- The cash inflows (outflows) from the hedging instrument are expected to be highly effective in offsetting the corresponding change in the cash outflows or inflows of the hedged transaction (if a cash flow hedge).
For instance, in Example 2-20, Golden Age was
only concerned about its exposure to rising gold prices, so it
purchased an at-the-money option with a strike price of $1,320 per
ounce of gold. If it performed an assessment of hedge effectiveness
for scenarios in which the price of gold declined, the forecasted
cash flows related to the purchase of gold would be decreasing
(lowering the ultimate cost of sales), with no offsetting change in
ultimate cash flows from the option (it would expire unexercised).
Therefore, the hedge effectiveness assessment should actually focus
on those scenarios in which the price of an ounce of gold increases
above the option’s strike price (i.e., $1,320). Golden Age should
document that it is hedging the risk of changes in its overall cash
flows related to its purchases that are attributable to an increase
in the price of gold above $1,320 per ounce. A hedging relationship
that is documented in this manner would qualify for hedge accounting
if the option is highly effective at offsetting the increased costs
of the forecasted purchase of gold at prices above that threshold.
The type of hedge may dictate which components of the change in the
option’s fair value the entity will designate as part of its hedge
effectiveness assessment. For options that hedge a net investment in
foreign operations, ASC 815-35-35-5 describes the “spot method” of
assessing hedge effectiveness in which the only excludable component
is the change in fair value that is attributable to changes in the
difference between the forward exchange rates and the spot exchange
rate. For options in a fair value hedging relationship, all of the
time value components discussed in Section
2.5.2.1.2.1 may be excluded (i.e., time value,
volatility value, theta, vega, and rho). However, for options in
cash flow hedging relationships, there is another alternative, as
described below.
ASC 815-20
Additional Considerations for Options in Cash
Flow Hedges
25-123 When an entity has
documented that the effectiveness of a cash flow
hedge will be assessed based on changes in the
hedging option’s intrinsic value pursuant to
paragraph 815-20-25-82(a), that assessment (and
the related cash flow hedge accounting) shall be
performed for all changes in intrinsic value —
that is, for all periods of time when the option
has an intrinsic value, such as when the
underlying is above the strike price of the call
option.
25-124 When a purchased
option is designated as a hedging instrument in a
cash flow hedge, an entity shall not define only
limited parameters for the risk exposure
designated as being hedged that would include the
time value component of that option. An entity
cannot arbitrarily exclude some portion of an
option’s intrinsic value from the hedge
effectiveness assessment simply through an
articulation of the risk exposure definition. It
is inappropriate to assert that only limited risk
exposures are being hedged (for example, exposures
related only to currency-exchange-rate changes
above $1.65 per pound sterling as illustrated in
Example 26 [see paragraph 815-20-55-205]).
25-125 If an option is
designated as the hedging instrument in a cash
flow hedge, an entity may assess hedge
effectiveness based on a measure of the
difference, as of the end of the period used for
assessing hedge effectiveness, between the strike
price and forward price of the underlying,
undiscounted. Although assessment of cash flow
hedge effectiveness with respect to an option
designated as the hedging instrument in a cash
flow hedge shall be performed by comparing the
changes in present value of the expected future
cash flows of the forecasted transaction to the
change in fair value of the derivative instrument
(aside from any excluded component under paragraph
815-20-25-82), that measure of changes in the
expected future cash flows of the forecasted
transaction based on forward rates, undiscounted,
is not prohibited. With respect to an option
designated as the hedging instrument in a cash
flow hedge, assessing hedge effectiveness based on
a similar measure with respect to the hedging
instrument eliminates any difference that the
effect of discounting may have on the hedging
instrument and the hedged transaction. Pursuant to
paragraph 815-20-25-3(b)(2)(iv), entities shall
document the measure of intrinsic value that will
be used in the assessment of hedge effectiveness.
As discussed in paragraph 815-20-25-80, that
measure must be used consistently for each period
following designation of the hedging
relationship.
If an option is designated as a hedging instrument in a cash flow
hedge, an entity may calculate the intrinsic value of the option in
three different ways. Since the time value of the option is the
difference between the option’s total fair value and intrinsic
value, the intrinsic value calculation alternative selected directly
affects how the excluded time value component is calculated. An
entity may calculate intrinsic value as one of the following:
- The difference between the strike price of the option and the spot rate.
- The present value of the difference between the strike price and the forward rate.
- The undiscounted difference between the strike price and the forward rate.
In summary, the following methods of
calculating intrinsic value are available for options in hedging
relationships:
In addition, DIG Issue G20 introduced an assessment method (and a
measurement method until ASU 2017-12 eliminated it) called the
“terminal value” method for cash flow hedging strategies that
involve certain options.
ASC 815-20
Assessing Hedge Effectiveness Based on an
Option’s Terminal Value
25-126 The guidance in
paragraph 815-20-25-129 addresses a cash flow
hedge that meets all of the following conditions:
- The hedging instrument is a purchased option or a combination of only options that comprise either a net purchased option or a zero-cost collar.
- The exposure being hedged is the variability in expected future cash flows attributed to a particular rate or price beyond (or within) a specified level (or levels).
- The assessment of effectiveness is documented as being based on total changes in the option’s cash flows (that is, the assessment will include the hedging instrument’s entire change in fair value, not just changes in intrinsic value).
25-127 This guidance has no
effect on the accounting for fair value hedging
relationships. In addition, in determining the
accounting for seemingly similar cash flow hedging
relationships, it would be inappropriate to
analogize to this guidance.
25-128 For a hedging
relationship that meets all of the conditions in
paragraph 815-20-25-126, an entity may focus on
the hedging instrument’s terminal value (that is,
its expected future pay-off amount at its maturity
date) in determining whether the hedging
relationship is expected to be highly effective in
achieving offsetting cash flows attributable to
the hedged risk during the term of the hedge. An
entity’s focus on the hedging instrument’s
terminal value is not an impediment to the
entity’s subsequently deciding to dedesignate that
cash flow hedge before the occurrence of the
hedged transaction. If the hedging instrument is a
purchased cap consisting of a series of purchased
caplets that are each hedging an individual hedged
transaction in a series of hedged transactions
(such as caplets hedging a series of hedged
interest payments at different monthly or
quarterly dates), the entity may focus on the
terminal value of each caplet (that is, the
expected future pay-off amount at the maturity
date of each caplet) in determining whether each
of those hedging relationships is expected to be
highly effective in achieving offsetting cash
flows. The guidance in this paragraph applies to a
purchased option regardless of whether at the
inception of the cash flow hedging relationship it
is at the money, in the money, or out of the
money.
Under the terminal value method of assessing hedge effectiveness, an
entity compares the ultimate settlement amount of the option with
the change in the cash flows of the hedged transaction that is
attributable to the hedged risk. This approach requires the entity
to apply the hypothetical-derivative method of hedge effectiveness
assessment (see Section 2.5.2.1.2.4) and even
specifies the criteria for making a qualitative assessment (see
Section 2.5.2.2.3). Understanding the
theoretical underpinnings of DIG Issue G20 requires a bit of
intellectual flexibility. An entity that applies the terminal value
method establishes the “perfect” hypothetical derivative as an
option whose terms match the hedged transaction, which allows the
entity to essentially exclude the erosion of the initial time value
from the hedge effectiveness assessment. Because the entity is able
to focus on the option’s terminal value when assessing hedge
effectiveness, it can “account” for this excluded component
differently from other excluded components in hedging relationships.
In fact, when the entity applies the terminal value method, it does
not even acknowledge that time value is an excluded component.
Accordingly, if the hedging relationship is highly effective, the
entire change in the option’s fair value is recognized in OCI
(including all of the initial time value) and reclassified into
earnings when the hedged item affects earnings. Section
4.1.3 provides more details on the accounting for
cash flow hedges that use the terminal value method.
2.5.2.1.2.3 Hedged Item — Fair Value Hedge
In a qualifying fair value hedging relationship, an
entity will remeasure the hedged item in each reporting period for
changes in its fair value that are attributable to changes in the
designated risk. There is substantial guidance on how to measure
such changes in the context of accounting for qualifying fair value
hedges (see the discussion of measurement principles for fair value
hedges in Chapter 3). That
guidance is equally relevant for determining the inputs for the
hedged item that are used in a quantitative hedge effectiveness
assessment model because the purpose of such an assessment for a
fair value hedge is to determine whether the changes in the hedging
instrument’s fair value are highly effective at offsetting the
changes in the hedged item’s fair value that are attributable to
changes in the designated risk. Accordingly, the method that an
entity uses to calculate the changes in the hedged item’s fair value
that are attributable to the changes in the designated risk in a
quantitative effectiveness assessment should be consistent with the
method that the entity uses to calculate such changes when
remeasuring the hedged item in a qualifying fair value hedge.
Furthermore, a change in the method of measuring such changes would
also be considered a change in the method of assessing hedge
effectiveness for those fair value hedges.
2.5.2.1.2.4 Hedged Item — Cash Flow Hedge
DIG Issue G7 introduced three general methods for determining the
change in the hedged item in a cash flow hedge effectiveness
assessment.
ASC 815-30
Assessing Hedge Effectiveness in
Certain Cash Flow Hedges Involving Interest Rate
Risk When Effectiveness Is Assessed on a
Quantitative Basis
35-10 This guidance addresses
the following three methods of assessing
effectiveness of certain cash flow hedges when
hedge effectiveness is assessed on a quantitative
basis in accordance with paragraphs
815-20-25-3(b)(2)(iv)(01) and 815-20-35-2 through
35-2F:
- Change-in-variable-cash-flows method
- Hypothetical-derivative method
- Change-in-fair-value method.
35-11 Those three methods
relate to assessing the effectiveness of a cash
flow hedge that involves any of the following:
- A receive-variable, pay-fixed interest rate swap designated as a hedge of the variable interest payments on an existing floating-rate liability
- A receive-fixed, pay-variable interest rate swap designated as a hedge of the variable interest receipts on an existing variable-rate asset
- Cash flow hedges of the variability of future interest payments on interest-bearing assets to be acquired or interest-bearing liabilities to be incurred (such as the rollover of an entity’s short-term debt as described in Example 9 [see paragraph 815-30-55-52]).
35-12 The hedging
relationships covered by this guidance encompass
either of the following:
- Hedges of interest rate risk (pursuant to paragraph 815-20-25-15(j)(2)) that do not qualify for the shortcut method
- Hedges of the risk of overall changes in the hedged cash flows related to the asset or liability (pursuant to paragraph 815-20-25-15(j)(1)).
DIG Issue G7 specifically addressed how to assess and measure
ineffectiveness in an interest rate swap that hedges a variable-rate
debt instrument (including forecasted issuances of debt) for a
hedging relationship that did not qualify for the shortcut method
because (1) the terms of the swap did not perfectly match the terms
of the debt, (2) the entity wanted to hedge the total change in cash
flows (not just interest rate risk), or (3) the entity was hedging
interest rate risk related to forecasted debt.
The three models in DIG Issue G7 were:
- The change-in-variable-cash-flows method.
- The hypothetical-derivative method.
- The change-in-fair-value method.
If, at the inception of a hedge, the fair value of the swap that was
designated as the hedging instrument is zero or near zero, an entity
may apply any of the three methods listed above. By contrast, if, at
the inception of the hedge, the fair value of the swap is not at or
near zero, an entity cannot apply the change-in-variable-cash-flows
method.
ASC 815-20-25-3 and ASC 815-20-25-80 and 25-81 require an entity, at
the time it designates a hedging relationship, to define and
document the method it will use to assess a hedge’s effectiveness in
achieving offsetting cash flows. The guidance also requires the
entity to use that defined method consistently when evaluating
effectiveness in subsequent periods. In addition, an entity should
assess the effectiveness of similar hedges in a similar manner. If
an entity uses different methods for similar hedges, it should
justify such differences.
The three models are discussed in more detail later in this section,
but the discussion below begins with the hypothetical-derivative
method because it is the most broadly used, even outside of interest
rate hedging. In fact, it is required in certain situations.
ASC 815-30
Hypothetical-Derivative Method
35-25 An entity shall assess
hedge effectiveness under the
hypothetical-derivative method by comparing the
following amounts:
- The change in fair value of the actual interest rate swap designated as the hedging instrument
- The change in fair value of a
hypothetical interest rate swap having terms that
identically match the critical terms of the
floating-rate asset or liability, including all of
the following:
- The same notional amount
- The same repricing dates
- The same index (that is, the index on which the hypothetical interest rate swap’s variable rate is based matches the index on which the asset or liability’s variable rate is based)
- Mirror image caps and floors
- A zero fair value at the inception of the hedging relationship.
35-26 Essentially, the
hypothetical derivative would need to satisfy all
of the applicable conditions in paragraphs
815-20-25-104 and 815-20-25-106 necessary to
qualify for use of the shortcut method except the
criterion in paragraph 815-20-25-104(e). Thus, the
hypothetical interest rate swap would be expected
to perfectly offset the hedged cash flows. Because
the requirements of paragraph 815-20-25-104(e)
were developed with an emphasis on fair value
hedging relationships, they do not fit the more
general principle that the hypothetical derivative
in a cash flow hedging relationship should be
expected to perfectly offset the hedged cash
flows.
35-27 The change in the fair
value of the perfect hypothetical interest rate
swap can be regarded as a proxy for the present
value of the cumulative change in expected future
cash flows on the hedged transaction.
35-28 Paragraph superseded by
Accounting Standards Update No. 2017-12.
35-29 The determination of
the fair value of both the perfect hypothetical
interest rate swap and the actual interest rate
swap shall use discount rates based on the
relevant interest rate swap curves.
DIG Issue G7 extended the hypothetical derivative concept that
previously existed in net investment hedging. Under that concept, an
entity could assess effectiveness (and, until ASU 2017-12 was
issued, measure ineffectiveness) by comparing the actual derivative
in the hedging relationship with a derivative that would be deemed
“perfectly effective.” Since the shortcut method requires the terms
of an interest rate swap to perfectly match the relevant features of
a debt instrument to qualify for an assumption of perfect
effectiveness (see Section 2.5.2.2.1), the DIG
believed that using those criteria as the yardstick for comparison
when the actual swap used did not mirror the terms of the debt was
an acceptable approach for assessing the effectiveness of a hedging
relationship.
Under the hypothetical-derivative method, an entity uses the same
discount rate to compare (1) the change in the fair value of the
actual interest rate swap designated as the hedging instrument with
(2) the change in the fair value of a hypothetical swap (one that
would have qualified for the shortcut method). The hypothetical
derivative should have the same critical terms as the floating rate
asset or liability (hedged item) — including notional amount,
repricing dates, index, caps, and floors — and have a fair value of
zero at the inception of the hedging relationship. Thus, the
hypothetical swap would be expected to perfectly offset the hedged
cash flows. Under this method, the actual swap is recorded at fair
value on the balance sheet, and an offsetting entry is recorded in
OCI, as long as the hedging relationship is deemed highly effective.
Amounts are reclassified out of AOCI when hedged transactions affect
earnings.
In addition, the shortcut method criterion in ASC 815-20-25-104(e),
under which an interest rate swap must mirror any prepayment
features in the related debt, is not a required term of the
hypothetical derivative under ASC 815-30-35-26 “[b]ecause the
requirements of paragraph 815-20-25-104(e) were developed with an
emphasis on fair value hedging relationships.” However, if the
hedged debt is prepayable or is related to a future forecasted
transaction, the entity still needs to assert that it is probable
that those payments will either occur or be replaced by a sufficient
amount of interest payments with the same key characteristics.
The hypothetical-derivative method may also be applied to hedges of
interest payments for debt instruments that cannot be hedged under
the shortcut method and could potentially achieve shortcut-like
results. For example, the shortcut method cannot be applied to
rollovers of fixed-rate debt or forecasted purchases or issuances of
variable-rate debt, but the hypothetical-derivative method would be
available.
Example 2-21
On July 1, 20X0, PiperPiper issues $100
million of noncallable 10-year variable-rate debt
that (1) is indexed to six-month LIBOR and (2)
resets semiannually. At the same time, the company
enters into a 10-year pay-fixed, receive-variable
interest rate swap with a notional amount of $100
million that resets quarterly on the basis of
three-month LIBOR. The only reason the cash flow
hedging relationship does not qualify for the
shortcut method is that the interest rate on the
debt resets semiannually on the basis of six-month
LIBOR while the swap resets quarterly on the basis
of three-month LIBOR.
Under the
hypothetical-derivative method, a hedge
effectiveness assessment can be based on a
comparison of (1) the change in the fair value of
the actual swap that is designated as the hedging
instrument and (2) the change in the fair value of
a hypothetical swap. The hypothetical swap should
have terms that match the critical terms of the
hedged item and satisfy all of the applicable
conditions to qualify for the use of the shortcut
method.11 Thus, the hypothetical swap would be a $100
million notional, 10-year pay-fixed,
receive-variable interest rate swap that resets
semiannually on the basis of six-month LIBOR
(unlike the actual swap, which resets quarterly on
the basis of three-month LIBOR). To qualify for
the shortcut method, the hypothetical swap must
also have a fair value of $0 at inception (unless
the nonzero fair value is attributable solely to
differing prices within the bid-ask spread; see
ASC 815-20-25-104(b)).
PiperPiper uses discount rates that are based
on the relevant swap curves to compute the fair
values of the actual swap and the hypothetical
swap. On September 30, 20X0, the fair value of the
actual swap used by PiperPiper is $100,000 and the
fair value of the hypothetical swap is $95,000,
resulting in a hedging relationship that is 105.3
percent effective ($100,000 ÷ $95,000). Because
the hedging relationship is deemed to be highly
effective (i.e., within the 80 to 125 percent
threshold), the swap is eligible for hedge
accounting. Accordingly, PiperPiper would record
the actual swap on the balance sheet at fair value
($100,000), with an offsetting balance recorded in
OCI ($100,000).
The hypothetical-derivative method has also been applied in practice
to many cash flow hedging relationships other than those involving
interest rate swaps that hedge interest rate risk in debt
instruments. Oftentimes, it is used as a proxy for determining the
change in the hedged item’s estimated cash flows in cash flow hedges
of forecasted transactions in commodities and foreign currencies. An
entity that applies the hypothetical-derivative method by analogy to
assess the effectiveness of non-interest-related hedges would
construct the hypothetical “perfectly effective” derivative so that
it satisfies all applicable conditions in ASC 815-20-25-84 and
25-84A for designation as the hedging derivative in a
“critical-terms-match” relationship (see Section
2.5.2.2.2). This is because the conditions in ASC
815-30-35-25 and 35-26 are specific to interest rate swaps that
hedge the interest payments of a recognized interest-bearing asset
or liability, while ASC 815-20-25-84 and 25-84A describe scenarios
in which a hedge of a forecasted transaction could be deemed
perfectly effective.
ASC 815-30
Change-in-Variable-Cash-Flows Method
35-16 An entity shall assess
hedge effectiveness under the
change-in-variable-cash-flows method by comparing
the following items:
- The variable leg of the interest rate swap
- The hedged variable-rate cash flows on the asset or liability.
35-17 As noted in paragraph
815-30-35-14, the change-in-variable-cash-flows
method shall not be used in certain circumstances.
35-18 The
change-in-variable-cash-flows method is consistent
with the cash flow hedge objective of effectively
offsetting the changes in the hedged cash flows
attributable to the hedged risk. The method is
based on the premise that only the floating-rate
component of the interest rate swap provides the
cash flow hedge, and any change in the interest
rate swap’s fair value attributable to the
fixed-rate leg is not relevant to the variability
of the hedged interest payments (receipts) on the
floating-rate liability (asset).
35-19 An entity shall assess
hedge effectiveness under this method by comparing
the following amounts:
- The present value of the cumulative change in the expected future cash flows on the variable leg of the interest rate swap
- The present value of the cumulative change in the expected future interest cash flows on the variable-rate asset or liability.
35-20 Because the focus of a
cash flow hedge is on whether the hedging
relationship achieves offsetting changes in cash
flows, if the variability of the hedged cash flows
of the variable-rate asset or liability is based
solely on changes in a variable-rate index, the
present value of the cumulative changes in
expected future cash flows on both the
variable-rate leg of the interest rate swap and
the variable-rate asset or liability shall be
calculated using the discount rates applicable to
determining the fair value of the interest rate
swap.
35-21 Paragraph superseded by
Accounting Standards Update No. 2017-12.
35-22 The
change-in-variable-cash-flows method will result
in a perfectly effective hedge if all of the
following conditions are met:
- The variable-rate leg of the interest rate swap and the hedged variable cash flows of the asset or liability are based on the same interest rate index (for example, three-month London Interbank Offered Rate (LIBOR) swap rate).
- The interest rate reset dates applicable to the variable-rate leg of the interest rate swap and to the hedged variable cash flows of the asset or liability are the same.
- The hedging relationship does not contain any other basis differences (for example, if the variable leg of the interest rate swap contains a cap and the variable-rate asset or liability does not).
- The likelihood of the obligor not defaulting is assessed as being probable.
35-23 However, a hedge would
not be perfectly effective if any basis
differences existed. For example, this would be
expected to result from either of the following
conditions, among others:
- A difference in the indexes used to determine cash flows on the variable leg of the interest rate swap (for example, the three-month U.S. Treasury rate) and the hedged variable cash flows of the asset or liability (for example, three-month LIBOR)
- A mismatch between the interest rate reset dates applicable to the variable leg of the interest rate swap and the hedged variable cash flows of the hedged asset or liability.
Under the change-in-variable-cash-flows method, an entity compares
the changes in the floating-rate leg of the swap that is designated
as the hedging instrument with the changes in the floating-rate cash
flows related to the hedged item. Both items would be discounted by
using the relevant discount rate for valuing the swap. If the
hedging relationship is deemed to be highly effective, the entire
change in the swap’s fair value is recorded in OCI and will not
affect the entity’s earnings until the hedged item affects earnings
(which will trigger the reclassification out of AOCI).
Although it may seem counterintuitive, it is possible for a hedge to
be deemed perfectly effective under the guidance in ASC 815-30-35-22
on the change-in-variable-cash-flows method even if the hedging
relationship did not qualify for the application of the shortcut
method. Before the issuance of ASU 2017-12, strategies that involved
debt that was repriced on the basis of a nonbenchmark interest rate
(e.g., prime rate) would not have qualified for application of the
shortcut method even if the swap terms matched the hedged debt’s
terms.
ASU 2017-12 eliminated the requirement that to be eligible for the
shortcut method, the interest rate index of variable-rate debt and a
hedging interest rate swap must be a benchmark interest rate;
instead the ASU introduced the notion of a “contractually specified
interest rate.” As a result, this hedging strategy may now qualify
for the shortcut method.
As noted above, the change-in-variable-cash-flows method
cannot be applied if, at the inception of the hedge, the
fair value of the swap is not at or near zero.
ASC 815-30
Change-in-Fair-Value Method
35-31 An entity shall assess
hedge effectiveness under the change-in-fair-value
method by comparing the following amounts:
- The present value of the cumulative change in expected variable future interest cash flows that are designated as the hedged transactions
- The cumulative change in the fair value of the interest rate swap designated as the hedging instrument.
35-32 The discount rates
applicable to determining the fair value of the
interest rate swap designated as the hedging
instrument shall also be applied to the
computation of present values of the cumulative
changes in the hedged cash flows.
The use of the change-in-fair-value method is fairly limited. As
discussed above, most entities that cannot apply the shortcut method
elect to apply the hypothetical-derivative method. Under the
change-in-fair-value method, the entity would use the same discount
rate to compare (1) the cumulative change in the fair value of the
interest rate swap that is designated as the hedging instrument with
(2) the present value of the cumulative change in expected variable
future interest cash flows that are designated as the hedged
transactions. The discount rate used to calculate the fair value of
the interest rate swap should also be used to calculate the present
value of the cumulative change in expected variable future interest
cash flows that are designated as the hedged transactions. If the
hedging relationship is deemed to be highly effective, the entire
change in the swap’s fair value is recorded in OCI and will not
affect the entity’s earnings until the hedged item affects earnings
(which will trigger the reclassification out of AOCI).
2.5.2.1.2.5 Hedged Item — Net Investment Hedge
ASC 815-35
35-4 If a derivative
instrument is used as the hedging instrument, an
entity may assess the effectiveness of a net
investment hedge using either a method based on
changes in spot exchange rates (as specified in
paragraphs 815-35-35-5 through 35-15) or a method
based on changes in forward exchange rates (as
specified in paragraphs 815-35-35-17 through
35-26). This guidance can also be applied to
purchased options used as hedging instruments in a
net investment hedge. However, an entity shall
consistently use the same method for all its net
investment hedges in which the hedging instrument
is a derivative instrument; use of the spot method
for some net investment hedges and the forward
method for other net investment hedges is not
permitted. An entity may change the method that it
chooses to assess the effectiveness of its net
investment hedges in accordance with paragraphs
815-20-55-55 through 55-56A.
35-4A Hedge effectiveness
shall be assessed on a quantitative basis at hedge
inception in accordance with paragraph
815-20-25-3(b)(2)(iv)(01) unless one of the
exceptions in that paragraph applies. Subsequent
assessments of hedge effectiveness may be
performed either on a quantitative basis or on a
qualitative basis in accordance with paragraphs
815-20-35-2 through 35-2F.
ASC 815 provides detailed guidance on assessing the effectiveness of
net investment hedges. If the hedging instrument is a
foreign-currency-denominated nonderivative instrument, the spot
method is the only method that can be used to assess the
effectiveness of the hedging relationship. By contrast, if the
hedging instrument is a derivative instrument, the entity may choose
between the “spot method” and the “forward method.” Generally
speaking, the entity’s choice is largely based on the financial
reporting differences between the methods, which we explain in
further detail in Section 5.4.2.1. However, an
entity must use the same method of assessing effectiveness for all
of its net investment hedges that involve derivative instruments. A
change in methods can only be made if the new method is considered
an improved method of assessing hedge effectiveness (see
Section 2.5.4).
Note that regardless of whether the hedging instruments is a derivate
or nonderivative, if an entity elects to assess and measure the
results of the net investment hedge on an after-tax basis (see
Section 5.1.3), the assessment should
reflect the after-tax notional amounts of the hedging instrument.
When assessing the effectiveness of a net investment hedge, an entity
may be able to assume that the hedge is perfectly effective if
certain conditions are satisfied (see Section
2.5.2.2.4); in such a case, the entity would make a
qualitative assessment. If the conditions for a qualitative
assessment are not met for the net investment hedging relationship,
the entity should refer to the detailed quantitative assessment
guidance in ASC 815-35. The mechanics of that quantitative
assessment will vary, depending on (1) whether the hedging
instrument is a derivative or a foreign-currency-denominated
nonderivative instrument and (2) for derivatives, whether the spot
method or the forward method is applied.
ASC 815-35
Method Based on Changes in Spot
Exchange Rates
Hedging Instrument Is a Derivative Instrument
35-9 The hedging relationship
would not be considered perfectly effective, and
the guidance in paragraph 815-35-35-10 shall be
applied if any of the following conditions exist:
- The notional amount of the derivative instrument does not match the portion of the net investment designated as being hedged.
- The derivative instrument’s underlying exchange rate is not the exchange rate between the functional currency of the hedged net investment and the investor’s functional currency.
- When the hedging derivative instrument is a cross-currency interest rate swap eligible for designation in a net investment hedge in accordance with paragraph 815-20-25-67, both legs are not based on comparable interest rate curves (for example, pay foreign currency based on the three-month London Interbank Offered Rate [LIBOR], receive functional currency based on three-month commercial paper rates).
35-10 If any of the
conditions in paragraph 815-35-35-9 exist, the
change in fair value of the hypothetical
derivative instrument that does not incorporate
those differences shall be compared with the
change in fair value of the actual derivative
instrument in assessing hedge effectiveness.
35-11 The hypothetical
derivative instrument used to assess hedge
effectiveness also shall have a maturity and
repricing and payment frequencies for any interim
payments that match the maturity and repricing and
payment frequencies for any interim payments of
the actual derivative instrument designated as the
hedging instrument in the net investment
hedge.
Hedging Instrument Is Not a Derivative
Instrument
35-13 The hedging
relationship would not be perfectly effective if
either of the following conditions is met:
- The notional amount of the nonderivative instrument does not match the portion of the net investment designated as being hedged.
- The nonderivative instrument is denominated in a currency other than the functional currency of the hedged net investment.
35-14 Effectiveness shall be
assessed by comparing the following two values:
- The foreign currency transaction gain or loss based on the spot rate change (after tax effects, if appropriate) of that nonderivative instrument
- The transaction gain or loss based on the spot rate change (after tax effects, if appropriate) that would result from the appropriate hypothetical nonderivative instrument that does not incorporate those differences. The hypothetical nonderivative instrument shall also have a maturity that matches the maturity of the actual nonderivative instrument designated as the net investment hedge.
In situations in which a net investment hedge does not qualify for an
assumption of perfect hedge effectiveness, if the hedging instrument
is a derivative and the entity elects to apply the spot method, the
quantitative effectiveness assessment would involve a comparison of
(1) the changes in the fair value of the actual derivative with (2)
the changes in the fair value of a hypothetical derivative that is
deemed to be “perfectly effective.” In other words, if the hedging
relationship did not qualify for the qualitative assessment outlined
in Section 2.5.2.2.4, the changes in the fair
value of the actual derivative would be compared with those of a
derivative that would have met those conditions. The sources of
ineffectiveness would result from:
- Differing notional amounts.
- Differing underlying currencies.
- For a derivative that is a float-for-float cross-currency interest rate swap, interest rate indexes that are not comparable.
If the hedging instrument is a foreign-currency-denominated
nonderivative instrument, the spot method must be applied. If the
net investment hedge does not qualify for an assumption of perfect
effectiveness, the entity would perform a quantitative assessment to
compare (1) the foreign currency transaction gain or loss on the
actual hedging instrument with (2) the foreign currency transaction
gain or loss on a hypothetical nonderivative that would have
qualified for a “perfectly effective” hedging relationship. The
potential sources of ineffectiveness are:
- Differing notional amounts.
- Differing underlying currencies.
ASC 815-35
35-18 However, the hedging
relationship would not be considered perfectly
effective if any of the following conditions
exist:
- The notional amount of the derivative instrument does not match the portion of the net investment designated as being hedged.
- The derivative instrument’s underlying exchange rate is not the exchange rate between the functional currency of the hedged net investment and the investor’s functional currency.
- When the hedging derivative instrument is a cross-currency interest rate swap eligible for designation in a net investment hedge in accordance with paragraph 815-20-25-67, both legs are not based on comparable interest rate curves (for example, pay foreign currency based on three-month LIBOR, receive functional currency based on three-month commercial paper rates).
35-19 The assessment of hedge
effectiveness due to such differences between the
hedging derivative instrument and the hedged net
investment considers the following:
- Different notional amounts.
If the notional amount of the derivative
instrument designated as a hedge of the net
investment does not match the portion of the net
investment designated as being hedged, hedge
effectiveness shall be assessed by comparing the
following two values:
- The change in fair value of the actual derivative instrument designated as the hedging instrument
- The change in fair value of a hypothetical derivative instrument that has a notional amount that matches the portion of the net investment being hedged and a maturity that matches the maturity of the actual derivative instrument designated as the net investment hedge. See paragraph 815-35-35-26 for situations in which the hedge of a net investment in a foreign operation is hedging foreign currency risk on an after-tax basis, as permitted by paragraph 815-20-25-3(b)(2)(vi).
- Different currencies. If the
derivative instrument designated as the hedging
instrument has an underlying foreign exchange rate
that is not the exchange rate between the
functional currency of the hedged net investment
and the investor’s functional currency (a tandem
currency hedge), hedge effectiveness shall be
assessed by comparing the following two values:
- The change in fair value of the actual cross-currency hedging instrument
- The change in fair value of a hypothetical derivative instrument that has as its underlying the foreign exchange rate between the functional currency of the hedged net investment and the investor’s functional currency and a maturity and repricing and payment frequencies for any interim payments that match the maturity and repricing and payment frequencies for any interim payments of the actual derivative instrument designated as the net investment hedge.
- Multiple underlyings. In accordance with paragraph 815-20-25-67(a), the only derivative instruments with multiple underlyings permitted to be designated as a hedge of a net investment are receive-variable-rate, pay-variable-rate cross-currency interest rate swaps that meet certain criteria. Paragraph 815-20-25-67(b) also permits receive-fixed-rate, pay-fixed-rate cross-currency interest rate swaps to be designated as a hedge of a net investment.
35-20 If a
receive-variable-rate, pay-variable-rate
cross-currency interest rate swap is designated as
the hedging instrument in a net investment hedge,
hedge effectiveness shall be assessed by comparing
the following two values:
- The change in fair value of the actual cross-currency interest rate swap designated as the hedging instrument
- The change in fair value of a hypothetical receive-variable-rate, pay-variable-rate cross-currency interest rate swap in which the interest rates are based on the same currencies contained in the hypothetical swap and both legs of the hypothetical swap have the same repricing intervals and dates. The hypothetical derivative instrument also shall have a maturity that matches the maturity of the actual cross-currency interest rate swap designated as the net investment hedge.
Assessing hedge effectiveness under the forward
method is not substantially different from doing so under the spot
method. Although the entity is potentially able to perform a
qualitative assessment for a perfectly effective hedge under the
forward method (see Section
2.5.2.2.4), a quantitative assessment, if required,
would involve comparing the actual hedging instrument with a
hypothetical perfectly effective derivative. As with the spot
method, the sources of ineffectiveness that would require an entity
to perform a quantitative assessment are:
- Differing notional amounts.
- Differing underlying currencies.
- If the derivative is a float-for-float cross-currency interest rate swap, interest rate indexes that are not comparable rates.
2.5.2.1.2.6 Impact of Derivative Credit Risk
The fair value of a derivative is affected by the credit risk of both
parties to the derivative contract (i.e., the entity and the
counterparty to the derivative). The impact on fair value can be
somewhat mitigated by collateral arrangements or master netting
arrangements (for multiple derivatives between the same
counterparties), but changes in credit risk are not typically
eliminated by such arrangements. Changes in a hedging derivative’s
fair value that are attributable to changes in credit risk are not
generally offset by changes in the fair value (or cash flows) of the
hedged item, since the hedged item may not have any credit risk
(e.g., a nonfinancial asset) or it may have a different credit risk
(e.g., debt only has credit risk related to the issuer).
The impact of changes in credit risk on the hedge effectiveness
assessment depends on the type of hedging relationship and the
method of assessment chosen by the entity. The table below briefly
summarizes the impacts of credit risk changes. We divide the
discussion between default risk (i.e., whether it is no longer
probable that both parties will perform under the derivative) and
general credit risk (changes in the credit spreads of either party
to the arrangement that do not rise to the level of default risk). A
more detailed discussion follows the table.
|
Impact of Changes in the Credit Risk of
Derivatives on the Hedge Effectiveness
Assessment
| |
|---|---|
|
All hedges
|
If an entity can no longer
assert that performance by both parties to the
derivative is probable (i.e., default risk), hedge
accounting must cease.
|
|
Fair value hedge
|
Shortcut method — No
impact. The shortcut method allows an entity to
assume that the change in the hedged item’s fair
value that is attributable to changes in the
interest rate risk is equal to the change in the
derivative’s fair value.
All other methods — Creates
ineffectiveness. Changes in credit risk that
affect the derivative’s fair value will not affect
the change in the hedged item’s fair value that is
attributable to the hedged risk in the same
manner. This mismatch will affect both the
assessment of hedge effectiveness and the hedging
relationship’s effect on earnings.
|
|
Cash flow hedge
|
Shortcut method — No
impact. All changes in the swap’s fair value are
recorded in OCI.
All other methods — Mostly no impact.
Under the following methods of hedge effectiveness
assessment, the same discount rate is used to
measure both the derivative and the hedged item:
Because of the mechanics of the calculation
under the change-in-fair-value method, hedging
relationships whose effectiveness is assessed by
applying this method may show some
ineffectiveness, even though the same discount
rate is used to measure both the hedging
instrument and the hedged item. Ineffectiveness
does not affect the amount recognized in OCI for a
highly effective hedging relationship.
|
|
Net investment hedge
|
Assessment — No impact. Under both the
spot method and the forward method, the
effectiveness assessment is based on the
application of a hypothetical-derivative
method.
Measurement — Results in imperfect
offset. The amount recognized in the CTA section
of OCI is limited to the actual changes in the
derivative’s fair value. This impact is not
mirrored in the translation of the net investment
in foreign operations.
|
2.5.2.1.2.6.1 Risk of Default
DIG Issue G10 dealt with the need to consider default risk
related to a derivative in a cash flow hedging relationship. The
guidance in DIG Issue G10 was codified in ASC 815-20-35-14
through 35-18.
ASC 815-20
Possibility of Default by the
Counterparty to Hedging Derivative
35-14 For an entity to
conclude on an ongoing basis that the hedging
relationship is expected to be highly effective in
achieving offsetting changes in cash flows, the
entity shall not ignore whether it will collect
the payments it would be owed under the
contractual provisions of the derivative
instrument. In complying with the requirements of
paragraph 815-20-25-75(b), the entity shall assess
the possibility of whether the counterparty to the
derivative instrument will default by failing to
make any contractually required payments to the
entity as scheduled in the derivative instrument.
In making that assessment, the entity shall also
consider the effect of any related
collateralization or financial guarantees. The
entity shall be aware of the counterparty’s
creditworthiness (and changes therein) in
determining the fair value of the derivative
instrument. Although a change in the
counterparty’s creditworthiness would not
necessarily indicate that the counterparty would
default on its obligations, such a change shall
warrant further evaluation.
35-15 If the likelihood that
the counterparty will not default ceases to be
probable, an entity would be unable to conclude
that the hedging relationship in a cash flow hedge
is expected to be highly effective in achieving
offsetting cash flows.
35-16 In contrast, a change
in the creditworthiness of the derivative
instrument’s counterparty in a fair value hedge
would have an immediate effect because that change
in creditworthiness would affect the change in the
derivative instrument’s fair value, which would
immediately affect both of the following:
- The assessment of whether the relationship qualifies for hedge accounting
- The amount of mismatch between the change in the fair value of the hedging instrument and the hedged item attributable to the hedged risk recognized in earnings under fair value hedge accounting.
35-17 Paragraph superseded by
Accounting Standards Update No. 2017-12.
35-18 Paragraph 815-20-25-103
states that, in applying the shortcut method, an
entity shall consider the likelihood of the
counterparty’s compliance with the contractual
terms of the hedging derivative that require the
counterparty to make payments to the entity. That
paragraph explains that implicit in the criteria
for the shortcut method is the requirement that a
basis exist for concluding on an ongoing basis
that the hedging relationship is expected to be
highly effective in achieving offsetting changes
in fair values or cash flows.
DIG Issue G10 addressed the lack of guidance on the consideration
of counterparty default risk related to derivatives in cash flow
hedging relationships as a result of the failure of many hedge
effectiveness assessment methods to pick up changes in credit
risk as a source of ineffectiveness (see Section
2.5.2.1.2.6.2). Under DIG Issue G10, if an entity
could not assert that it was probable that the counterparty
would perform under the derivative contract, it would not be
appropriate to (1) conclude that the hedging relationship is
highly effective and (2) apply hedge accounting. In other words,
even if a quantitative assessment of hedge effectiveness
indicates that a hedging relationship is highly effective, if it
is no longer probable that the counterparty to the derivative
will perform under the contract (i.e., it is no longer probable
that the counterparty will not default), the qualitative
nonperformance risk will override any quantitative analysis, and
the application of hedge accounting is inappropriate.
Example 2-22
Effect of Entity’s Own Nonperformance
Risk
Entity B designates a derivate as the hedging
instrument in a cash flow hedging relationship.
When assessing hedge effectiveness, B is required
to consider its own creditworthiness and ability
to comply with the contractual terms of the
hedging derivative. Although ASC 815-20-25-122 and
ASC 815-20-35-14 through 35-18 do not explicitly
address assessment of the possible impact of an
entity’s own default in a cash flow hedging
relationship, there is still a requirement in ASC
815 that any hedging instrument must be expected
to be highly effective at offsetting cash flows
attributable to the hedged risk. This requirement
is further clarified in ASC 815-20-35-2. Thus, if
B is unable to conclude (on the basis of a
qualitative analysis) that it is probable that it
will not default on the contractual terms of the
hedging derivative, it cannot continue to assert
that it expects the cash flow hedging relationship
to be highly effective. That is, before B can
conclude that it expects a cash flow hedging
relationship to be highly effective at achieving
offsetting changes in cash flows, it must first
conclude that it is probable that both parties to
the derivative contract (i.e., both the entity
itself and the derivative counterparty) will not
default and will perform in accordance with the
provisions of the derivative contract.
Although deterioration in B’s own
creditworthiness would not necessarily be the sole
basis for a conclusion that it would default on
its obligations, B would generally need to further
evaluate whether the likelihood remains probable
that it will not default as the result of such a
change.
The guidance in ASC 815-20-35-16 does not specifically indicate
that the likelihood of a default related to the hedging
derivative would automatically render a fair value hedging
relationship not highly effective. The reason for the lack of
specific guidance on such hedges is that an entity is unlikely
to conclude that a fair value hedging relationship that involves
a derivative with significant nonperformance risk would be
highly effective since the derivative’s nonperformance risk
would not be mirrored in the hedged item. However, ASC
815-20-35-16 does indicate that any changes in credit risk will
directly affect the hedge effectiveness assessment. Thus, we
believe that an entity should not rely on a quantitative hedge
effectiveness assessment under which a hedging relationship is
determined to be highly effective if it is no longer probable
that the parties to the derivative contract will not
default.
Similarly, there is no explicit guidance addressing
nonperformance risk for a net investment hedge. Generally
speaking, we believe that when there is no specific guidance
related to net investment hedges, it is appropriate to consider
the overall hedge qualification requirements that apply to both
fair value and cash flow hedges. In addition, since the hedge
effectiveness quantitative assessment guidance for net
investment hedges involves a hypothetical-derivative analysis,
which is similar to the guidance for cash flow hedges, we
believe that if it is no longer probable that both parties to a
derivative contract will continue to perform, any related net
investment hedging relationship should be discontinued.
2.5.2.1.2.6.2 Other Changes in Credit Risk
Even before it becomes no longer probable that both parties will
perform under a derivative, changes in credit risk can affect
the effectiveness of a hedging relationship. However, any
assessment method that uses the changes in the derivative’s fair
value as a proxy for changes in the fair value or cash flows of
the hedged item (e.g., the shortcut method or the
critical-terms-match method) will not be affected by changes in
credit risk, other than the default risk discussed above.
In addition, any assessment method that uses a hypothetical
derivative requires the derivative to be valued by using the
same discount rate as the actual derivative. Therefore, the
impact of changes in credit risk are also negated when the
hypothetical-derivative method is used. As discussed previously,
the hypothetical-derivative method is required for “imperfect”
net investment hedges and is the most widely used assessment
method for cash flow hedges. The change-in-variable-cash-flows
method also requires an entity to use the same discount rate to
determine the present value of the cumulative changes in
expected future cash flows for both the variable leg of the swap
and the variable-rate asset or liability. Accordingly, changes
in credit risk, in and of themselves, do not cause
ineffectiveness to be reflected in the assessment.
The two remaining scenarios in which changes in credit risk have
a direct impact on hedge effectiveness assessments are (1)
non-shortcut-method fair value hedges and (2) cash flow hedges
that use the change-in-fair-value method.
As noted in ASC 815-20-35-16, a change in the credit risk of the
hedging derivative in a fair value hedge would have an immediate
impact on the effectiveness of the hedging relationship because
it would affect the change in the fair value of the derivative
but not that of the hedged item. This mismatch would directly
affect the results of a quantitative assessment of hedge
effectiveness, and entities should also consider its potential
effect in any qualitative effectiveness assessment (see
Section 2.5.2.2.6 for further
discussion of the impact of credit risk on qualitative
assessments).
Because of its mechanics, the change-in-fair-value method for
cash flow hedges could generate some ineffectiveness that needs
to be evaluated in the assessment of hedge effectiveness. Under
that method, an entity must (1) calculate the change in expected
cash flows that is attributable to the change in the hedged risk
and then (2) discount those cash flows by using the
end-of-period discount rate (which incorporates the
end-of-period credit spread) that is used to measure the change
in the derivative’s fair value (which incorporates the change in
the credit spread over the period). In other words, in the
calculation of the change in the derivative’s fair value, the
starting fair value is based on the relevant discount rate (and
credit risk) as of the beginning of the measurement period,
while the ending fair value incorporates changes in the
derivative’s underlying and is then discounted by using the
relevant discount rate (and credit risk) as of the end of the
measurement period. However, the entity separately calculates
the change in expected cash flows related to the hedged item
from period to period and then determines the derivative’s
present value by applying the ending-period discount rate (and
credit risk) to that change.
2.5.2.1.2.6.3 Allocation of Portfolio-Level Credit Risk Adjustments
If an entity enters into multiple derivatives with a single
counterparty that are subject to a master netting arrangement,
the impact of credit risk on the valuation of those derivatives
is typically assessed on the basis of the entity’s net exposure;
however, hedge accounting (and the related hedge effectiveness
assessments) is applied on a hedge-by-hedge basis. To calculate
the fair value of its derivative holdings, an entity generally
determines the fair value of multiple derivatives with a single
counterparty that are subject to a master netting arrangement by
viewing those contracts as a single portfolio. In doing so, the
entity may adjust its portfolio valuation to reflect credit risk
(i.e., the entity may consider credit risk at the portfolio
level), but such valuation adjustments might not be allocated to
individual derivative contracts within the group.
For a hedging relationship to qualify for fair value hedge
accounting, the change in the hedging derivative’s fair value
must be highly effective at offsetting the changes in the hedged
item’s fair value that are attributable to the hedged risk, as
indicated by periodic assessments of hedge effectiveness. In
these assessments, each individual derivative contract covered
by a master netting arrangement is considered a separate unit of
account (i.e., the effectiveness assessment is performed at the
level of the hedging relationship). Many preparers have
questioned whether an entity that uses a “long-haul” method to
assess hedge effectiveness needs to consider valuation
adjustments for credit risk made at the master netting
arrangement/portfolio level in its determination of the fair
value of individual hedging derivatives within such a
portfolio.
The short answer to the question is yes — an entity needs to
consider such portfolio-level valuation adjustments in the hedge
effectiveness assessments of individual hedging relationships.
Discussions with the SEC staff have confirmed the view that a
reporting entity must consider the impact of credit risk on the
fair value of a designated hedging derivative when assessing the
effectiveness of a fair value hedge. However, the reporting
entity may separately determine the credit-risk effect of the
designated derivative on the effectiveness of the hedging
relationship by performing a qualitative analysis that shows
that the changes in fair value attributable to the credit risk
would not affect the highly effective nature of the fair value
hedge. This qualitative determination should take into account
(1) the magnitude of the credit valuation adjustment in relation
to the portfolio size and (2) the level of effectiveness of each
individual hedging relationship before consideration of credit
risk. For example, the qualitative assessment may include a
determination, made at both the portfolio level and the
individual-counterparty level, that the credit-risk adjustment
is insignificant.
Even if a reporting entity’s qualitative analysis supports a
conclusion that the effect of credit risk on hedge effectiveness
is not significant, the entity still must perform a separate
assessment of hedge effectiveness that excludes the effect of
the derivative’s credit risk. In other words, the reporting
entity may exclude credit risk from its periodic quantitative
fair value hedge effectiveness assessments when it determines
qualitatively that credit risk would not cause the hedging
relationship to fail that assessment. If an entity is performing
its periodic hedge effectiveness assessments qualitatively, its
analysis should also factor in the effect of credit risk (see
Section 2.5.2.2.6).
If a reporting entity cannot or does not determine qualitatively
that credit risk would not cause the hedging relationship to
fail the reporting entity’s periodic effectiveness assessment,
it must include credit risk in its periodic quantitative
assessment of the effectiveness of the fair value hedging
relationship. As noted above, ASC 815 requires reporting
entities to perform hedge effectiveness assessments at the
individual hedging relationship level (i.e., the individual
derivative level). If, in determining the fair value of its
derivatives, the reporting entity estimates the credit
adjustment at the portfolio level, the following four methods
are acceptable alternatives for allocating the portfolio-level
credit adjustment to the individual derivative contract:
- Relative fair value approach — An entity may allocate to the portfolio a portion of the portfolio-level credit adjustment made to each derivative asset and liability on the basis of the relative fair value of each derivative instrument.
- In-exchange or “full credit” approach — An entity may use the derivative’s stand-alone fair value (in-exchange premise), which would take into account the parties’ credit standing and ignore the effect of the master netting arrangement.
- Relative credit adjustment approach — An entity may allocate to the portfolio a portion of the portfolio-level credit adjustment made to each derivative asset and liability on the basis of the relative credit adjustment of each derivative instrument. This approach would require the entity to use an in-exchange premise to calculate a credit adjustment for each instrument.
- Marginal contribution approach — An entity may allocate a portion of the portfolio-level credit adjustment to each derivative asset and liability on the basis of the marginal amount that each derivative asset or liability contributes to the portfolio-level credit adjustment.
The SEC staff has indicated that it would not object to any of
these methods. Other rational methods may also be appropriate. A
reporting entity should always consistently apply the selected
method and consider whether the method is a significant
accounting policy that should be disclosed in its financial
statements.
The above guidance addresses considerations related to
creditworthiness in the context of hedge effectiveness. It does
not change the overall guidance on measuring the fair value of
hedging derivatives, which specifies that the change in a
hedging instrument’s fair value must include an adjustment for
nonperformance risk (as that term is defined in ASC 820).
2.5.2.1.3 Period of Assessment
ASC 815-20
Hedge Effectiveness During Designated Hedge
Period
25-101 It is inappropriate
under this Subtopic for an entity to designate a
derivative instrument as the hedging instrument if
the entity expects that the derivative instrument
will not be highly effective in achieving
offsetting changes in fair value or cash flows
attributable to the hedged risk during the period
that the hedge is designated, unless the entity
has documented undertaking a dynamic hedging
strategy in which it has committed itself to an
ongoing repositioning strategy for its hedging
relationship.
Hedge Effectiveness Criterion Applicable to
Fair Value Hedges Only
25-118 In documenting its
risk management strategy for a fair value hedge,
an entity may specify an intent to consider the
possible changes (that is, not limited to the
likely or expected changes) in value of the
hedging derivative instrument and the hedged item
only over a shorter period than the derivative
instrument’s remaining life in formulating its
expectation that the hedging relationship will be
highly effective in achieving offsetting changes
in fair value for the risk being hedged. The
entity does not need to contemplate the offsetting
effect for the entire term of the hedging
instrument.
ASC 815-20-25-79 requires an entity to perform assessments of hedge
effectiveness (both prospective and retrospective) “whenever financial
statements or earnings are reported, and at least every three months.”
In addition, ASC 815-20-25-101 notes that the purpose of the prospective
hedge effectiveness assessment is to determine whether the entity can
support an expectation that the hedge will be highly effective during
the period in which the hedge is designated. Finally, ASC 815-20-25-118
addresses the possibility that an entity may not intend to use a hedging
instrument in an individual fair value hedging relationship for the
entire term of the instrument.
When determining how often to perform a hedge effectiveness assessment,
an entity should consider the nature and term of the hedging
relationship. ASC 815-20-25-79 requires an entity to perform its hedge
effectiveness assessment at least every three months, or sooner if the
entity reports earnings before then. The initial prospective assessment
must be performed at the inception of the hedging relationship (see
Section 2.6 for a discussion of timing relief).
The timing of the next subsequent assessment depends on the following:
- When the reporting period ends.
- When the hedging instrument matures or expires.
- The intended term of the hedging relationship.
- How often the entity intends to reassess whether the hedge remains highly effective.
In many cases, an entity will default to performing its hedge
effectiveness assessments at the end of each quarter. For example, if an
entity is hedging interest payments on 10-year debt with an interest
rate swap that has a 10-year term, the entity is likely to perform its
hedge effectiveness assessments every quarter. However, if the entity is
only hedging a risk for one month, the hedge effectiveness assessments
need to be performed both at inception of the hedge and at the end of
the hedging relationship, which would be a period that is shorter than a
quarter. Of course, if that one-month period includes a reporting date,
the entity needs to perform an additional assessment (e.g., if a
calendar-quarter company enters into a one-month hedge on June 15, the
hedge effectiveness assessments must be performed as of June 15, June
30, and July 15).
If a hedging relationship does not have significant potential sources of
ineffectiveness, it is typically not necessary for an entity to consider
assessing the effectiveness of the hedge more frequently than it must
under the minimum requirements discussed above (i.e., before the end of
the quarterly reporting period or the maturity of the hedging
instrument, if sooner). However, for some hedging relationships, an
entity may choose to assess effectiveness more frequently, or it may
even assert that the hedging relationship is only expected to be
effective until the next assessment date but not necessarily over the
life of the hedging instrument.
For example, an entity may designate a 10-year interest rate swap as a
hedge of a 30-year mortgage-backed security because it expects that
security to have a weighted-average life of approximately 10 years as a
result of prepayments. However, the entity may indicate in its
documentation that it intends to assess hedge effectiveness on the basis
of three-month periods and thus designate the hedge for three months. To
determine whether that hedging relationship is and will continue to be
highly effective, the entity would compare the changes in the swap’s
fair value with the change in the fair value of the hedged
mortgage-backed security (MBS). The entity would need to perform this
assessment frequently enough to take into account small movements in the
yield curve.
In addition, an entity may use a dynamic hedging strategy under which it
continually adjusts the hedging instrument or the amount of the hedged
item in a hedging relationship (e.g., by making daily or weekly
adjustments). If so, the retrospective and prospective hedge
effectiveness assessments would only need to support the entity’s
expectation that the hedging relationship was or will be highly
effective over the minimum period in which the entity intends to keep
the current hedging relationship in place.
2.5.2.1.4 Off-Market Derivatives
If a nonoption derivative has off-market terms (i.e., its fair value is
other than zero) at the inception of the hedging relationship, such
terms will affect the assessment of hedge effectiveness. In fact, an
entity is not permitted to use the following methods to assess the
effectiveness of hedging relationships that involve off-market nonoption
derivatives:
- Shortcut method (see Section 2.5.2.2.1).
- Critical-terms-match method (see Section 2.5.2.2.2).
- Change-in-variable-cash-flows method for cash flow hedges (see Section 2.5.2.1.2.4).
A forward-based derivative with off-market terms has an embedded
financing component that is equal to the fair value of the derivative
asset or liability. When assessing hedge effectiveness, an entity should
take into account changes in the embedded component’s fair value, which
are a source of ineffectiveness in a hedging relationship. In addition,
the entity should consider the “principal” element of that financing
component in the financial reporting for the hedging relationship.
Before we discuss the mechanics of hedging with off-market derivatives,
it is important to highlight some common scenarios in which an entity
would designate such a derivative as the hedging instrument in a hedging
relationship:
- The derivative is initially structured as an off-market derivative — An entity may decide to enter into an off-market derivative to either (1) pay or receive cash at the inception of the derivative in exchange for changing the forward price or swap rate or (2) compensate one of the parties to the derivative for a separate transaction that occurs simultaneously with the entity’s entering into the derivative (e.g., fees for an associated debt issuance). Payment of a “normal” fee for entering into the derivative does not itself establish an off-market derivative. For example, interest rate swaps typically include the dealer fee as an adjustment to the fixed leg of the swap. However, if the entity has other transactions with the dealer, incorporating the fees and payments related to those transactions into the fixed leg of the swap would create an off-market swap (see Example 2-25).
- The existing derivative is modified or replaced — An entity may have an existing derivative whose terms become off-market. Sometimes, the terms of the derivative are renegotiated and the life of the derivative is extended (i.e., a “blend-and-extend” strategy). For example, assume that an entity has an existing receive-variable, pay-fixed interest rate swap with three years remaining and a negative fair value. In such a case, the entity may be willing to replace that derivative with one that has a lower fixed rate in exchange for a three-year extension of the term. The new fixed rate would still be considered “above market” but would be lower than the fixed rate of the existing swap. After the modification, the overall fair value of the new swap would be the same as that of the old swap (i.e., no consideration would be exchanged).
- The entity is an acquirer in a business combination — An acquirer in a business combination recognizes the assets and liabilities acquired at fair value on the acquisition date. If the acquirer wants to designate those derivatives in the same hedging relationships that the acquiree had before the combination (or even in new hedging relationships), the derivatives are likely to be off-market at the inception of the new hedging relationships.
- The entity emerges from bankruptcy — ASC 852-10-45-21 indicates that after a bankruptcy, a new reporting entity is created at the time fresh-start accounting is applied. Therefore, because the post-bankruptcy entity is considered a new entity, any hedging relationships are new to that entity and must be designated and documented anew.
- A derivative is redesignated in a new hedging relationship — An entity may have derivatives that are dedesignated from previous hedging relationships and designated in new hedging relationships. This could occur for several reasons, including (1) the hedging relationship is no longer highly effective, (2) the hedging relationship was voluntarily dedesignated, or (3) the documentation of a prior hedging relationship was insufficient.
- Hedge designation documentation is not completed on time — If an entity does not complete the hedge designation documentation in a timely manner when entering into an at-market derivative, it is likely that the terms of the derivative will no longer be at-market when the hedge designation documentation is completed (see Section 2.6 for further discussion of the hedge designation requirements).
- There is a change in the method of assessing hedge effectiveness — An entity may decide to change its method of assessing the effectiveness of a hedging relationship. As discussed in Section 2.5.4, such a change requires a hedging relationship to be dedesignated and redesignated. Common reasons for changing the method of assessing the effectiveness of a hedging relationship include (1) a change in the components (if any) that are excluded from the derivative’s fair value in the assessment of hedge effectiveness (including changing between the forward and spot methods for net investment hedges) and (2) a change from the dollar-offset method to the regression method and vice versa.
The examples below
illustrate the nature of an off-market derivative and its impact on
hedge effectiveness.
Example 2-23
Off-Market Forward
Reprise wants to hedge the cost of aluminum sales
with a forward contract to sell aluminum that
settles in one year. The market forward price is
$2,070 per metric ton (the current spot price is
$1,896 per metric ton). Reprise would prefer to
lock in a price of $2,270 per metric ton on the
forward. To “buy up” the forward price by $200 per
metric ton, Reprise must pay $192.31 at the
inception of the forward. The up-front payment of
$192.31 represents the present value of $200 one
year from now.
The off-market forward consists of the following:
The change in the fair value of the “loan” over
the life of the forward is a source of
ineffectiveness. Although the cumulative amount of
ineffectiveness that will be recognized over the
life of the hedging relationship is $7.69 (the
“interest” on the loan), the periodic changes in
the loan’s fair value will not necessarily act in
the same manner as accrued interest. By the
settlement date, the fair value of the actual
forward (off-market derivative) will be $200
greater than that of the hypothetical forward (one
that was at-market on the date the forward was
entered into). The hypothetical-derivative method
will reflect this ineffectiveness.
Assume that prices and fair values throughout the
life of the hedging relationship are as follows:
At the end of the third month of the hedging
relationship, the spot price of aluminum remains
at $1,896 per metric ton, and the nine-month
forward rate is $2,033.61 per metric ton. The
market forward points have shrunk from $174 per
metric ton to $137.61 per metric ton because of
the decrease in remaining time, which is partially
offset by a slight increase in risk-free interest
rates (which are a component of the forward points
related to aluminum). The increase in risk-free
interest rates and the decrease in remaining time
affect the fair value of the loan component of the
actual derivative in opposite ways, but the impact
of the passage of time is stronger.
Note that even the hypothetical derivative has
forward points that would erode over time. Because
Reprise is using the hypothetical-derivative
method to assess the hedge’s effectiveness, the
portion of the change in fair value that is based
on the market erosion of the forward points is no
longer a source of ineffectiveness. All that is
left is the change in the fair value of the loan
component, and that fair value is actually exposed
only to the changes in interest rates and the
passage of time.
If the entity was performing a dollar-offset
analysis, the hedge would be 103.3 percent
effective ($36.36 ÷ $35.20), which would indicate
that the hedging relationship is highly effective.
Now, assume that three more months have passed.
The spot price of aluminum has dropped to $1,700
per metric ton, and the six-month forward rate is
$1,782.26 per metric ton. The market forward
points have fallen from $137.61per metric ton to
$82.26 per metric ton solely because of the
decrease in remaining time, which affects the fair
value of the loan component of the actual
derivative. The decreases in the spot price have
resulted in even larger changes in the fair values
of both the actual and hypothetical forwards.
Under the period-by-period dollar-offset method,
the hedge is calculated to be 100.9 percent
effective ($248.34 ÷ $246.21) during the period.
Under the cumulative dollar-offset method, the
hedge is calculated to be 101.2 percent effective
($284.70 ÷ $281.41). Therefore, both methods
demonstrate that the hedging relationship is
highly effective.
After three more months pass,
the spot price of aluminum partially recovers to
$1,800 per metric ton, and the three-month forward
rate is $1,841.85 per metric ton. The market
forward points have shrunk from $82.26 to $41.85
per metric ton because of the decreases in
remaining time, risk-free interest rates, and
other costs to carry aluminum. The decreases in
both the remaining time and the risk-free interest
rates increase the fair value of the loan
component of the actual derivative. The increase
in the spot price had a slightly greater impact on
the fair values of both the actual and
hypothetical forwards than did the decrease in
forward points.
Under the period-by-period dollar-offset method,
the hedge is calculated to be 95.9 percent
effective ($53.36 ÷ $55.66) during the period.
Under the cumulative dollar-offset method, the
hedge is calculated to be 102.5 percent effective
($231.34 ÷ $225.75). Therefore, both methods
indicate that the relationship is highly
effective.
During the last three months, the spot price of
aluminum recovers more to finish at $1,850 per
metric ton. The loan component of the actual
derivative is then due (Reprise will collect $200
more per ton than it would have on an at-market
forward). The increase in the loan’s fair value is
the interest accrual in the final period of the
forward.
Under the period-by-period dollar-offset method,
the hedge is calculated to be only 63.4 percent
effective ($3.65 ÷ $5.75) during the period, which
would not be indicative of a highly effective
hedging relationship. However, under a cumulative
dollar-offset method, the hedge is calculated to
be 103.5 percent effective ($227.69 ÷ $220), which
would support a conclusion that the hedging
relationship is highly effective. This also
illustrates why most entities that employ the
dollar-offset method choose to perform that
analysis by using cumulative changes in fair value
over the hedging relationship.
Note that the example above describes a
single-settlement forward in which the loan component of an off-market
forward had no interim payments. However, if an entity uses a
multiple-delivery forward or a swap at off-market terms as the hedging
instrument, the loan component would also have a series of payments that
warrant unique consideration in the hedge effectiveness assessment and
in the determination of the gain or loss on the derivative that should
be recorded in OCI for a qualifying cash flow hedging relationship or
net investment hedging relationship (see Section 5.4.2.1.1.1.1).
Example 2-24
Off-Market Swap
Fish’s Donuts has an existing receive-variable,
pay-fixed interest-rate swap with two years
remaining that it is using to hedge $100 million
of three-month LIBOR-based debt. Interest rates
have decreased since it entered into the swap, so
the swap is currently a derivative liability with
a fair value of $2,437,887. Fish’s Donuts agrees
with the counterparty to enter into a
“blend-and-extend” modification that would reduce
the fixed rate on the pay leg of the swap but
extend the swap’s term to five years. Under the
modification, the interest rate on the fixed leg
on the swap is reduced from 3.5 to 3.126 percent,
while the market rate for the fixed leg of the
five-year swap is 2.5 percent. The terms of the
new swap and the hypothetical swap at the
inception of the hedging relationship are as
follows:
To illustrate our earlier point about the need to
consider the settlements in a hedge effectiveness
assessment, we can look at the effectiveness
assessment for this hedging relationship through
the first quarter. Assume that at the end of three
months, the relevant swap curve shows that
interest rates have decreased further, resulting
in the following fair values:
In calculating the changes in the fair values of
the actual derivative and the hypothetical
derivative, an entity should note that because the
actual derivative has off-market terms, there is a
difference between (1) the net settlements that
occur on the actual swap and (2) the net
settlements that would have occurred on the
hypothetical swap. To properly assess the
effectiveness of the hedging relationship, the
entity must measure the changes in fair value
before any settlements that occur during the
period; this is because after settlements occur,
some of the change in fair value will be
attributable to payments that were made on the
actual swap (and theoretically made on the
hypothetical swap).
In the case of the embedded loan, which can be
represented by the difference between the fixed
legs of the two swaps, a payment was made on the
loan that was not recognized in the income
statement. That payment represented a partial
settlement of the initial liability. The hedge
effectiveness assessment should actually compare
the changes in the fair values of the swaps after
the settlements are added back. The appropriate
dollar-offset ratio for the period would be 101.1
percent ($382,050 ÷ $377,847). If the entity did
not add back the net settlements during the
period, it would inappropriately calculate a
dollar-offset ratio for the period of 49.2
percent, or ($2,585,429 – $2,437,887) ÷
$299,722.
Connecting the Dots
Recent changes in U.S. interest rates (i.e., a
steep drop before 2022 and a sharp increase during 2023) have
posed challenges for some entities using interest rate swaps to
hedge variable-rate debt obligations. When interest rates
decrease significantly, many entities are interested to exit
pay-fixed interest rate swaps as they become significant balance
sheet liabilities; alternately, when interest rates increase,
many entities wish to settle pay-fixed swaps as they become
significant balance sheet assets in order to accelerate receipt
of cash payments on the contracts. In either case, early
settlement will require the party in a net-loss position to make
significant cash payments to terminate the instrument, which may
not be desirable or possible. Therefore, some lenders and
borrowers may agree to restructure borrowers’ existing
pay-fixed, receive-variable interest rate swaps by changing the
fixed leg and changing the term of the swap.
For example, for a swap in a deep liability position, a “blend
and extend” strategy may be used — under this strategy, the
lender agrees to (1) extend the maturity date of the existing
interest rate swap and (2) revise the fixed interest rate. The
new fixed interest rate is determined such that the fair value
of the new swap (with the extended maturity date) approximates
the current fair value of the existing swap. The new swap’s
fixed rate would be higher than the rate of a new at-the-market
swap but lower than the existing swap’s rate.
Similarly, we have seen entities engage in a “blend and shorten”
strategy when swaps are in a significant asset position as a
result of increasing interest rates. In this strategy, the
lender agrees to (1) shorten the maturity date of the existing
interest rate swap and (2) revise the fixed interest rate. Just
as in the blend and extend strategy, the new fixed interest rate
and shortened maturity date is determined such that the fair
value of the new swap approximates the current fair value of the
existing swap.
Practitioners have questioned whether the modified derivative
contracts should continue to be accounted for as derivatives in
their entirety or, instead, as hybrid debt instruments. We
believe that the fair value of the existing derivative contract
should be considered the entity’s initial net investment in the
new contract under ASC 815-10-15-83(b). If the fair value of the
existing swap is large enough (i.e., greater than 90 percent of
the effective notional amount of the new derivative contract),
the new derivative contract would not meet the definition of a
derivative under ASC 815-10-15-83 and should be considered a
hybrid instrument with an embedded derivative. See Section 1.4.2 of Deloitte’s
Roadmap Derivatives
for further discussion of the initial net investment
characteristic of a derivative and the concept of the effective
notional amount of an interest rate swap.
If a reporting entity determines on the basis of its specific
facts and circumstances that its off-market contract does
not meet the definition of a derivative instrument in
its entirety, the financial instrument will be accounted for as
a debt host with an embedded interest rate swap derivative. The
entity can thereafter either (1) elect the fair value option to
measure the entire hybrid instrument at fair value under either
ASC 825 or ASC 815-15-25-4 or (2) measure the debt portion of
the hybrid instrument at amortized cost while bifurcating the
embedded “at-market” swap at fair value.
If the entity elects to mark the entire hybrid instrument to
market under the fair value option, it may not designate that
hybrid instrument as a hedging instrument under ASC 815-15-35-1.
However, if the entity bifurcates the at-market swap from the
debt host contract, the swap may qualify to be designated in a
hedging relationship. Initial and subsequent measurement of the
debt and bifurcated at-market swap are as follows:
- The initial principal amount of the debt will equal the day-one fair value of the instrument. The initial day-one fair value of the bifurcated at-market interest rate swap is zero.
- Each settlement under the swap will comprise two parts: (1) settlement of the bifurcated at-market swap and (2) a principal and interest payment under the debt host.
- The interest on the debt will equal the difference between (1) the day-one fair value amount and (2) the undiscounted difference between the fixed leg payments on the derivative contract and the fixed leg payments on the bifurcated hypothetical at-market derivative with all other terms corresponding exactly to the actual derivative contract.
- If the bifurcated at-market swap is designated in a qualifying cash flow hedging relationship, changes in its fair value will be recorded in OCI.
2.5.2.2 Qualitative Methods of Assessment
Sometimes, a hedge
effectiveness assessment can be qualitative rather than quantitative. While
a quantitative assessment typically must be performed at the inception of a
hedging relationship, there are some exceptions listed in ASC
815-20-25-3(b)(2)(iv)(01) that permit an assumption of perfect
effectiveness. If an entity elects to apply these exceptions to a hedging
relationship, the entity is not required to perform an initial prospective
assessment of hedge effectiveness on a quantitative basis. The table below
summarizes the circumstances in which qualitative assessments may be used
and the timing of those assessments. Each scenario is discussed in more
detail throughout this section.
|
Qualitative Method
|
Timing of Method
|
Roadmap Discussion
|
|---|---|---|
|
Shortcut method
|
At inception and subsequently
| |
|
Critical-terms-match method
|
At inception and subsequently
| |
|
Critical-terms-match method — options: terminal value
(DIG Issue G20)
|
At inception and subsequently
| |
|
Perfect net investment hedge
|
At inception and subsequently
| |
|
Simplified hedge accounting approach for private
companies
|
At inception and subsequently
| |
|
Certain highly effective hedges
|
Only after inception of hedge
|
2.5.2.2.1 The Shortcut Method
ASC 815-20
25-102
The conditions for the shortcut method do not
determine which hedging relationships qualify for
hedge accounting; rather, those conditions
determine which hedging relationships qualify for
a shortcut version of hedge accounting that
assumes perfect hedge effectiveness. If all of the
applicable conditions in the list in paragraph
815-20-25-104 are met, an entity may assume
perfect effectiveness in a hedging relationship of
interest rate risk involving a recognized
interest-bearing asset or liability (or a firm
commitment arising on the trade [pricing] date to
purchase or issue an interest-bearing asset or
liability) and an interest rate swap (or a
compound hedging instrument composed of an
interest rate swap and a mirror-image call or put
option as discussed in paragraph 815-20-25-104[e])
provided that, in the case of a firm commitment,
the trade date of the asset or liability differs
from its settlement date due to generally
established conventions in the marketplace in
which the transaction is executed. The shortcut
method’s application shall be limited to hedging
relationships that meet each and every applicable
condition. That is, all the conditions applicable
to fair value hedges shall be met to apply the
shortcut method to a fair value hedge, and all the
conditions applicable to cash flow hedges shall be
met to apply the shortcut method to a cash flow
hedge. A hedging relationship cannot qualify for
application of the shortcut method based on an
assumption of perfect effectiveness justified by
applying other criteria. The verb match is
used in the specified conditions in the list to
mean be exactly the same or correspond
exactly.
The shortcut method is used to account for certain hedging relationships
in which interest rate swaps hedge interest rate risk in existing debt
instruments. If a hedging relationship qualifies for the shortcut
method, it is assumed to be a “perfect” relationship, so an entity does
not need to perform any quantitative assessments during the relationship
(see discussion of credit risk in Section
2.5.2.2.1.8). Under the shortcut method, synthetic
instrument accounting is combined with the requirement to recognize
derivatives on the balance sheet at fair value in each reporting period.
The periodic net settlements on the swap are recognized in the same
income statement line item as the coupon payments on the debt (interest
income or expense), while the derivative is recorded at fair value in
each period.
Note that the shortcut method applies to both fair value
hedges and cash flow hedges. For a fair value hedge, an entity should
adjust the carrying amount of the debt in an amount that equals and,
therefore, offsets the change in the derivative’s fair value. For a cash
flow hedge, the change in the fair value of the derivative is recorded
in OCI. The accounting is discussed in more detail in Examples 3-6 and
3-8 in Section 3.2.7
(fair value hedges) and Examples 4-18 and 4-19 in Section 4.2.6
(cash flow hedges). The discussion below focuses on the criteria that
need to be met for a hedging relationship to qualify for the application
of the shortcut method.
The shortcut method may
be applied to the following hedging relationships:
|
Debt Instrument
|
Swap — Debt Is Asset
|
Swap — Debt Is Liability
|
|---|---|---|
|
Fixed-rate debt
|
Receive-variable, pay-fixed
|
Receive-fixed, pay-variable
|
|
Variable-rate debt
|
Receive-fixed, pay-variable
|
Receive-variable, pay-fixed
|
Application of the shortcut method allows an entity to assume that it has
a perfectly effective hedging relationship; therefore, there is no need
for the entity to perform any quantitative assessments of whether the
hedge is highly effective. Accordingly, an entity’s ability to use the
shortcut method is fairly restricted. Note that all further references
to debt in this section on the shortcut method refer to a debt
instrument that could be either an asset (to the investor/lender) or a
liability (to the issuer/borrower).
Also, the guidance in ASC 815 acknowledges that although
entities are exposed to interest rate risk at the time they firmly
commit to the terms of a debt instrument (i.e., on the trade date), many
entities do not recognize the debt in their financial statements until
the settlement date. To ensure prudent risk management, those entities
may want to enter into an interest rate swap on the trade date before
the debt is recognized on the balance sheet. Under ASC 815-20-25-102, a
shortcut hedging relationship can begin when there is a “firm commitment
arising on the trade [pricing] date to purchase or issue an
interest-bearing asset or liability [if] the trade date of the asset or
liability differs from its settlement date due to generally established
conventions in the marketplace in which the transaction is
executed.”
An entity may apply the
shortcut method to hedging relationships that meet all of the conditions
in the table below. If any one condition is not met, application of the
shortcut method is not appropriate. However, failure to qualify for the
shortcut method does not mean that a hedging relationship is not highly
effective; therefore, the hedging relationship may still be eligible for
hedge accounting.
These conditions are discussed in greater detail in the next sections.
2.5.2.2.1.1 Notional Matches — Hedged Item
ASC 815-20
25-104 All of the following
conditions apply to both fair value hedges and
cash flow hedges:
- The notional amount of the interest rate swap matches the principal amount of the interest-bearing asset or liability being hedged. . . .
25-105 All of the following
incremental conditions apply to fair value hedges
only: . . .
d. For fair value hedges
of a proportion of the principal amount of the
interest-bearing asset or liability, the notional
amount of the interest rate swap designated as the
hedging instrument (see (a) in paragraph
815-20-25-104) matches the portion of the asset or
liability being hedged.
e. For fair value hedges
of portfolios (or proportions thereof) of similar
interest-bearing assets or liabilities, both of
the following criteria are met:
1. The notional amount of the interest rate
swap designated as the hedging instrument matches
the aggregate notional amount of the hedged item
(whether it is all or a proportion of the total
portfolio).
2. The remaining criteria for the shortcut
method are met with respect to the interest rate
swap and the individual assets or liabilities in
the portfolio. . . .
25-106 All of the following
incremental conditions apply to cash flow hedges
only: . . .
e. For cash flow hedges of
the interest payments on only a portion of the
principal amount of the interest-bearing asset or
liability, the notional amount of the interest
rate swap designated as the hedging instrument
(see paragraph 815-20-25-104(a)) matches the
principal amount of the portion of the asset or
liability on which the hedged interest payments
are based.
f. For a cash flow hedge
in which the hedged forecasted transaction is a
group of individual transactions (as permitted by
paragraph 815-20-25-15(a)), if both of the
following criteria are met:
1. The notional amount of the interest rate
swap designated as the hedging instrument (see
paragraph 815-20-25-104(a)) matches the notional
amount of the aggregate group of hedged
transactions.
2. The remaining criteria for the shortcut
method are met with respect to the interest rate
swap and the individual transactions that make up
the group. For example, the interest rate
repricing dates for the variable-rate assets or
liabilities whose interest payments are included
in the group of forecasted transactions shall
match (that is, be exactly the same as) the reset
dates for the interest rate swap. . . .
The first criterion that must be met for an entity to apply the
shortcut method is that the notional amount of an interest rate swap
designated as the hedging instrument must match the amount of the
debt being hedged. If a proportion of a swap is designated as the
hedging instrument in a hedging relationship, the designated
notional amount of that swap needs to match the portion of the
hedged asset or liability. If multiple swaps are designated as the
hedging instrument in a single hedging relationship, the combined
notional amount of the swaps needs to match the hedged item. Also,
if multiple swaps are used in one hedging relationship, all of the
swaps must have the same terms so that they all meet the other
conditions for application of the shortcut method (e.g., the net
settlements are calculated in the same manner and the maturity dates
match).
If the hedged item is (1) only a proportion of fixed-rate debt or (2)
interest payments related to a proportion of variable-rate debt, the
notional amount of the swap must match the amount of the hedged
debt. Also, if the hedged item is a portfolio of fixed-rate debt or
interest payments on a portfolio of variable-rate debt, the notional
amount of the swap must match the principal amount of the debt
portfolio. When such a portfolio is designated in a hedging
relationship that is eligible for the shortcut method, each of the
debt instruments in the portfolio must individually qualify to be
the hedged item. Consequently, all of the other criteria for
application of the shortcut method must be evaluated against each
individual item in the portfolio (see ASC 815-20-25-116 and 25-117
for further discussion).
2.5.2.2.1.2 Fair Value of Swap at Hedge Inception
ASC 815-20
25-104
All of the following conditions apply to both fair
value hedges and cash flow hedges: . . .
b. If the hedging instrument is solely an
interest rate swap, the fair value of that
interest rate swap at the inception of the hedging
relationship must be zero, with one exception. The
fair value of the swap may be other than zero at
the inception of the hedging relationship only if
the swap was entered into at the relationship’s
inception, the transaction price of the swap was
zero in the entity’s principal market (or most
advantageous market), and the difference between
transaction price and fair value is attributable
solely to differing prices within the bid-ask
spread between the entry transaction and a
hypothetical exit transaction. The guidance in the
preceding sentence is applicable only to
transactions considered at market (that is,
transaction price is zero exclusive of commissions
and other transaction costs, as discussed in
paragraph 820-10-35-9B). If the hedging instrument
is solely an interest rate swap that at the
inception of the hedging relationship has a
positive or negative fair value, but does not meet
the one exception specified in this paragraph, the
shortcut method shall not be used even if all the
other conditions are met.
c. If the hedging instrument is a compound
derivative composed of an interest rate swap and
mirror-image call or put option as discussed in
(e), the premium for the mirror-image call or put
option shall be paid or received in the same
manner as the premium on the call or put option
embedded in the hedged item based on the
following:
1. If the implicit
premium for the call or put option embedded in the
hedged item is being paid principally over the
life of the hedged item (through an adjustment of
the interest rate), the fair value of the hedging
instrument at the inception of the hedging
relationship shall be zero (except as discussed
previously in (b) regarding differing prices due
to the existence of a bid-ask spread).
2. If the implicit
premium for the call or put option embedded in the
hedged item was principally paid at
inception-acquisition (through an original issue
discount or premium), the fair value of the
hedging instrument at the inception of the hedging
relationship shall be equal to the fair value of
the mirror-image call or put option. . . .
As discussed in Section 2.5.2.1.4, the
designation of an off-market derivative in a hedging relationship
results in a source of ineffectiveness related to the embedded
financing component of that derivative. Thus, since the shortcut
method is based on an assumption of perfect hedge effectiveness, it
is only available for at-market swaps, with one exception for
prepayable debt in certain circumstances. That is, if the hedged
item is prepayable debt that was issued at a premium or discount on
the basis of the value of the prepayment option, the swap’s fair
value upon the inception of the hedge must be equal to and offset
the fair value of the premium or discount on the debt related to
that prepayment option. The prepayment option in most debt
instruments is paid for by adjusting the coupons on the debt. For
example, debt that may be called by the issuer carries a higher
interest rate than debt that is not prepayable. Conversely, debt
that is puttable by the investor carries a lower interest rate than
debt that is not puttable. However, if an entity issued callable
debt at a discount instead of structuring it to have a higher coupon
rate, the fair value of the hedged interest rate swap should match
that of the debt discount and that swap should be a liability for
the issuer. In other words, the combination of the fair value of the
swap and the proceeds from the debt (ignoring debt issuance costs
with third parties) should equal the par amount of the debt if the
discount or premium is solely attributable to the fair value of the
prepayment option.
A swap is considered to be at-market as long as it is entered into
for no consideration, exclusive of commissions and other transaction
costs (see ASC 820-10-35-9B). If there is an initial fair value
because there are differences in the bid-ask spread or the
transactions occurred in markets that are not the entity’s primary
market, the swap is not automatically ineligible for application of
the shortcut method.
Example 2-25
Bank B enters into a brokered certificate of
deposit (CD) arrangement and an interest rate swap
whose terms are similar to those of the CD but
offset them. Under these arrangements, the broker
introduced B to (1) the investor in the CD and (2)
an unrelated interest rate swap counterparty. Bank
B does not pay the broker’s commission; instead,
it is paid by the interest rate swap counterparty.
To reimburse the counterparty for this payment, B
increases the “pay leg” of the swap (from B’s
perspective) and then designates the swap as a
hedge of the interest rate risk in the CD.
The interest rate swap does not qualify for the
shortcut method since its fair value at inception
is not zero and the brokered CD is not prepayable;
the swap’s fair value is equal to the amount of
the broker’s commission that was effectively
financed by the swap counterparty. Note that while
brokered CDs can be liquidated by the investor
before their maturity, the method of liquidation
actually represents a sale to another investor
through the brokered CD market. The CD itself is
not prepaid.
An interest rate swap will qualify for the
shortcut method only if it meets all of the
conditions in ASC 815-20-25-102 through 25-111.
ASC 815-20-25-104 requires the fair value of a
designated interest swap to be zero at the
inception of the hedging relationship unless (1)
the nonzero fair value is attributable solely to
differing prices within the bid-ask spread or (2)
the swap’s initial fair value offsets the fair
value of a prepayment option in the debt that was
not paid principally over the life of the debt
through the coupons.
In the case of B, even though no cash
consideration was exchanged between the
counterparties at the swap’s inception, the swap’s
fair value is other than zero because of the
financing element embedded in the pay leg of the
swap (i.e., the pay leg is not at market terms as
of the swap’s inception date). Therefore, use of
the shortcut method is not permitted.
The interest rate swap could still qualify for
hedge accounting if it is a highly effective
hedging instrument; however, the financing element
creates some level of mismatch between the change
in the fair value or cash flows of the interest
rate swap and the change in the fair value or cash
flows of the CD, which results in a hedging
relationship that is not perfect. If the financing
element is too significant, the hedging
relationship may not be highly effective. In
addition, if there is an other-than-insignificant
financing component at hedge inception, all cash
inflows and outflows associated with the interest
rate swap should be reported as financing cash
flows in the statement of cash flows in accordance
with ASC 815-10-45-11 through 45-15. See further
discussion of the classification of derivative
activity on the cash flow statement in
Section 6.5.
2.5.2.2.1.3 If Debt Is Prepayable, Swap Has Mirror Terms
ASC 815-20
25-104 All of the following
conditions apply to both fair value hedges and
cash flow hedges: . . .
e. The interest-bearing
asset or liability is not prepayable, that is,
able to be settled by either party before its
scheduled maturity, or the assumed maturity date
if the hedged item is measured in accordance with
paragraph 815-25-35-13B, with the following
qualifications:
- This criterion does not apply to an interest-bearing asset or liability that is prepayable solely due to an embedded call option (put option) if the hedging instrument is a compound derivative composed of an interest rate swap and a mirror-image call option (put option).
- The call option embedded in the interest rate
swap is considered a mirror image of the call
option embedded in the hedged item if all of the
following conditions are met:
- The terms of the two call options match
exactly, including all of the following: 01. Maturities02. Strike price (that is, the actual amount for which the debt instrument could be called) and there is no termination payment equal to the deferred debt issuance costs that remain unamortized on the date the debt is called03. Related notional amounts04. Timing and frequency of payments05. Dates on which the instruments may be called.
- The entity is the writer of one call option and the holder (purchaser) of the other call option.
- Subparagraph not used. . . .
- The terms of the two call options match
exactly, including all of the following:
If the debt is prepayable during the term of the hedging
relationship, the swap must have mirrored prepayment terms, as
defined in ASC 815-20-25-104(e)(2), to qualify for application of
the shortcut method. Because this criterion is applicable to debt
that is prepayable during the hedging relationship, questions have
arisen about the types of terms that would cause a debt instrument
to be considered prepayable in the application of the shortcut
method. Consequently, that subject was addressed in DIG Issue E6,
which is codified in ASC 815-20-25-112 through 25-115 and the
examples in ASC 815-20-55-75 through 55-78.
ASC 815-20
25-112 An interest-bearing
asset or liability shall be considered prepayable
under the provisions of paragraph 815-20-25-104(e)
if one party to the contract has the right to
cause the payment of principal before the
scheduled payment dates unless either of the
following conditions is met:
- The debtor has the right to cause settlement of the entire contract before its stated maturity at an amount that is always greater than the then fair value of the contract absent that right.
- The creditor has the right to cause settlement of the entire contract before its stated maturity at an amount that is always less than the then fair value of the contract absent that right.
25-113 However, none of the
following shall be considered a prepayment
provision:
- Any term, clause, or other
provision in a debt instrument that gives the
debtor or creditor the right to cause prepayment
of the debt contingent upon the occurrence of a
specific event related to the debtor’s credit
deterioration or other change in the debtor’s
credit risk, such as any of the following:
- The debtor’s failure to make timely payment, thus making it delinquent
- The debtor’s failure to meet specific covenant ratios
- The debtor’s disposition of specific significant assets (such as a factory)
- A declaration of cross-default
- A restructuring by the debtor.
- Any term, clause, or other
provision in a debt instrument that gives the
debtor or creditor the right to cause prepayment
of the debt contingent upon the occurrence of a
specific event that meets all of the following
conditions:
- It is not probable at the time of debt issuance.
- It is unrelated to changes in benchmark interest rates, contractually specified interest rates, or any other market variable.
- It is related either to the debtor’s or creditor’s death or to regulatory actions, legislative actions, or other similar events that are beyond the control of the debtor or creditor.
- Contingent acceleration
clauses that permit the debtor to accelerate the
maturity of an outstanding note only upon the
occurrence of a specified event that meets all of
the following conditions:
- It is not probable at the time of debt issuance.
- It is unrelated to changes in benchmark interest rates, contractually specified interest rates, or any other market variable.
- It is related to regulatory actions, legislative actions, or other similar events that are beyond the control of the debtor or creditor.
25-114 Furthermore, a right
to cause a contract to be prepaid at its then fair
value would not cause the interest-bearing asset
or liability to be considered prepayable because
that right would have a fair value of zero at all
times and essentially would provide only liquidity
to the holder.
Note that in the determination of whether terms need to be mirrored
in a swap in a qualifying shortcut method hedge, the term
“prepayable” is a subset of what is considered prepayable in the
following contexts:
- The identification and evaluation of embedded derivatives.
- The application of portfolio layer method (see Section 3.2.1.4).
- The measurement of basis adjustments to the hedged item in fair value hedges (see Section 3.2.1.2).
In addition, the definition of “prepayable” in the context of the
shortcut method differs from the guidance in the ASC master
glossary, which defines prepayable as “[a]ble to be settled by
either party before its scheduled maturity.”
Changing Lanes
In November 2019, the FASB issued a
proposed ASU of Codification
improvements to hedge accounting. One of the proposed
improvements was to replace the phrase “prepayable” with
“early settlement feature” in the guidance on the
application of the shortcut method; however, at the October
11, 2023, FASB meeting, the Board decided not to affirm the
proposed amendment.
DIG Issue E6 stated that the
definition of prepayable that is used in other areas of derivative
and hedge accounting was too broad to incorporate into the criteria
for the shortcut method. This is because a requirement that interest
rate swaps mirror many typical prepayment options that may have
little to no economic substance or would only be triggered in remote
scenarios would be impractical to apply in practice. Accordingly,
DIG Issue E6 carved out prepayment options that would have no
theoretical economic value, which resulted in the guidance in ASC
815-20-25-112 and ASC 815-20-25-114. The following types of
prepayment options are excluded from the definition of prepayable:
|
Prepayable by Debtor (Callable)
|
Prepayable by Creditor (Puttable)
|
|---|---|
|
At fair value
|
At fair value
|
|
At an amount always greater than fair value
|
At an amount always less than fair value
|
Further, since the shortcut method applies only to hedges of interest
rate risk and not to credit risk, prepayment options related to the
borrower’s credit are also carved out of the definition and are
addressed in ASC 815-20-25-113(a). That guidance establishes that a
prepayment provision in debt does not need to be mirrored in the
interest rate swap if the debt would be prepaid at either the
debtor’s or creditor’s option upon the occurrence of a specific
event related to either (1) the debtor’s credit deterioration or (2)
other changes in the debtor’s credit risk. ASC 815-20-25-113(a)
provides the following examples of events that could trigger
prepayment but would not be considered prepayment provisions:
- The debtor’s failure to make timely payment, thus making it delinquent
- The debtor’s failure to meet specific covenant ratios
- The debtor’s disposition of specific significant assets (such as a factory)
- A declaration of cross-default
- A restructuring by the debtor.
Finally, DIG Issue E6 established
that contingent acceleration clauses that could be exercised by
either the debtor or the creditor do not need to be mirrored in the
interest rate swap if those prepayment options were triggered by
events whose occurrence was not probable, depending on the nature of
the triggering event. The following table highlights different types
of triggering events that do and do not need to be mirrored in the
interest rate swap:
|
Prepayment Trigger Needs to Be
Mirrored
|
Prepayment Trigger May Be
Ignored
|
|---|---|
|
Any of the following events whose occurrence is
not probable:
|
Example 2-26
Debt Prepayable Upon Tax Law
Change
PiperPiper issues debt that is prepayable if
there is a tax law change that causes interest on
the debt to be disqualified from being tax
deductible. To hedge the debt, PiperPiper enters
into an interest rate swap. If, at the time of
hedge designation, it is not probable that such a
tax law change will occur during the term of the
hedge, the prepayment option does not need to be
mirrored in the swap for the hedging relationship
to qualify for the shortcut method. ASC
815-20-25-113(b) states, in part, that in the
application of the shortcut method, debt is not
considered prepayable if that prepayment provision
is triggered by “the occurrence of a specific
event that meets all of the following conditions:
- It is not probable at the time of debt issuance.
- It is unrelated to changes in benchmark interest rates, contractually specified interest rates, or any other market variable.
- It is related either to the debtor’s or creditor’s death or to regulatory actions, legislative actions, or other similar events that are beyond the control of the debtor or creditor.”
This exclusion from the definition of
prepayable also would apply to prepayment clauses
triggered by “regulatory capital events” and
“investment company events,” which are common in
trust-issued preferred securities.
Note that the guidance in ASC 815-20-25-112
through 25-115 relates to when debt instruments
would be considered prepayable is only for use in
the application of the shortcut method. If a debt
instrument is considered prepayable under this
guidance, the hedging instrument (i.e., the
interest rate swap) must contain a mirror-image
prepayment option. Note that this example
addresses only one aspect of that guidance. ASC
815-20-25-113 discusses other situations in which
the debt would not be considered prepayable in the
application of the shortcut method.
DIG Issue E6
provided examples that illustrate whether certain terms in a debt
instrument make the instrument prepayable in the assessment of
eligibility for the shortcut method. These examples are codified in
ASC 815-20-55-75 through 55-78. The table below summarizes the
examples and conclusions in ASC 815-20-55-75.
|
Illustrative Debt
Instrument
|
Prepayable?
|
|---|---|
|
Debt instrument 1 — “Some fixed-rate
debt instruments include a typical call option
that permits the debt instrument to be called for
prepayment by the debtor at a fixed amount, for
example, at par or at a specified premium over
par. In some instruments, the prepayment amount
varies based on when the call option is
exercised.”
|
Yes. “Fixed-rate debt instruments that provide
the borrower with the option to prepay at a fixed
amount . . . permit settlement at an amount that
is potentially below the contract’s fair value [if
the designated benchmark interest rate
decreases].”
|
|
Debt instrument 2 — “Some debt
instruments include contingent acceleration
clauses that permit the lender to accelerate the
maturity of an outstanding note only if a
specified event related to the debtor’s credit
deterioration or other change in the debtor’s
credit risk occurs (for example, the debtor’s
failure to make timely payment, thus making it
delinquent; its failure to meet specific covenant
ratios; its disposition of specific significant
assets, such as a factory; a declaration of
cross-default; or a restructuring by the debtor).
A common example is a clause in a mortgage note
secured by certain property that permits the
lender to accelerate the maturity of the note if
the borrower sells the property.”
|
No. “Debt instruments that include contingent
acceleration clauses that permit the lender to
accelerate the maturity of an outstanding note
only upon the occurrence of a specified event
related to the debtor’s credit deterioration or
other changes in the debtor’s credit risk are not
considered prepayable.”
|
|
Debt instrument 3 — “Some fixed-rate
debt instruments include a call option that
permits the debtor to repurchase the debt
instrument from the creditor at an amount equal to
its then fair value.”
|
No. “[D]ebt instruments that provide the debtor
with the option to repurchase from the creditor
the debt at an amount equal to the then fair value
of the [debt] are not considered prepayable . . .
because that right would have a fair value of zero
at all times.”
|
|
Debt instrument 4 — “Some fixed-rate
debt instruments, typically issued in private
markets, include a make-whole provision. A
make-whole provision differs from a typical call
option, which enables the issuer to benefit by
prepaying the debt if market interest rates
decline. In a declining interest rate market, the
settlement amount of a typical call option is less
than what the fair value of the debt would have
been absent the call option. In contrast, a
make-whole provision involves settlement at a
variable amount typically determined by
discounting the debt’s remaining contractual cash
flows at a specified small spread over the current
Treasury rate. That calculation results in a
settlement amount significantly above the debt’s
current fair value based on the issuer’s current
spread over the current Treasury rate. The
make-whole provision contains a premium settlement
amount to penalize the debtor for prepaying the
debt and to compensate the investor (that is, to
approximately make the investor whole) for its
being forced to recognize a taxable gain on the
settlement of the debt investment. In some debt
instruments, the prepayment option under a
make-whole provision will not be exercisable
during an initial lock-out period. (For example,
Private Entity A borrows from Insurance Entity B
under a 10-year loan with fixed periodic coupon
payments. The spread over the Treasury rate for
Entity A at issuance of the debt is 275 basis
points. The loan agreement contains a make-whole
provision that if Entity A prepays the debt, it
will pay Insurance Entity B an amount equal to all
the future contractual cash flows discounted at
the current Treasury rate plus 50 basis
points.)”
|
No. “Fixed-rate debt instruments that include
this type of make-whole provision . . . are not
considered prepayable . . . because [the
provision] involves settlement of the entire
contract by the debtor before its stated maturity
at an amount greater than (rather than an amount
less than) the then fair value of the contract.”
See the Connecting the Dots discussion
below.
|
|
Debt instrument 5 — “Some variable-rate
debt instruments include a call option that
permits the debtor to repurchase the debt
instrument from the creditor at each interest
reset date at an amount equal to par.”
|
Yes. Generally speaking, the terms of
variable-rate debt instruments refer to a
contractually specified interest rate but have a
fixed spread to that rate that represents the
issuance-date credit spread. “Because the reset
provisions typically do not adjust the variable
interest rate for changes in credit sector spreads
and changes in the debtor’s creditworthiness, the
variable-rate debt instrument’s par amount could
seldom be expected to be equal to its fair value
at each reset date.”
|
|
Debt instrument 6 — “Some fixed-rate
debt instruments include both a call option as
described in . . . debt instrument 1 and a
contingent acceleration clause as described in . .
. debt instrument 2.”
|
Yes. Even though the contingent acceleration
clause described in debt instrument 2 does not
cause the instrument to be considered prepayable,
the call option described in debt instrument 1
does.
|
|
Debt instrument 7 — “Some debt
instruments contain an investor protection clause
(which is standard in substantially all debt
issued in Europe) that provides that, in the event
of a change in tax law that would subject the
investor to additional incremental taxation by tax
jurisdictions other than those entitled to tax the
investor at the time of debt issuance, the coupon
interest rate of the debt increases so that the
investor’s yield, net of the incremental taxation
effect, is equal to the investor’s yield before
the tax law change. The debt issuance also
contains an issuer protection clause (which is
standard in substantially all debt issued in
Europe) that provides that, in the event of a tax
law change that triggers an increase in the coupon
interest rate, the issuer has the right to call
the debt obligation at par. There would be no
market for the debt were it not for the prepayment
and interest rate adjustment clauses that protect
the issuer and investors.”
|
No, provided that, at the inception of the
debt, it is not probable that the prepayment
option will be triggered. As indicated in ASC
815-20-25-113(c), the prepayment feature in debt
instrument 7 does not make the debt prepayable
under the shortcut method criteria because:
Note that the example in DIG Issue E6 did not
include the fact that it is not probable at the
time of issuance that the prepayment option will
be triggered, but we believe it is implicit in the
example.
|
Connecting the Dots
Many corporate debt agreements contain
make-whole provisions such as those outlined in debt
instrument 4 above. The description of debt instrument 4
includes an example in which (1) upon a prepayment, the
debtor must repay an amount of cash flows equal to all the
future contractual cash flows discounted at the current
Treasury rate plus 50 basis points and (2) the entity’s
credit spread to the Treasury rate at issuance was 275 basis
points. In Issue E6, the DIG concluded that this prepayment
clause would not cause the debt to
be considered prepayable because the amount paid upon early
settlement would always exceed the debt’s fair value. While
it may be unlikely that the entity’s credit spread would
decrease to 50 basis points above the Treasury rate, it is
not impossible. Accordingly, the logic in this exception is
flawed. We have had multiple discussions with the FASB staff
regarding this issue. In our latest discussion, the staff
indicated that it would recommend that the Board address
this inconsistency by (1) removing the example in debt
instrument 4 as part of the FASB’s annual improvements and
technical correction process and (2) providing appropriate
transition for entities that had previously concluded that
their debt instrument was not prepayable on the basis of the
conclusion in debt instrument 4.
We believe that when applying the shortcut
method, an entity may conclude that a debt instrument with a
make-whole provision similar to the one in debt instrument 4
is not prepayable. This conclusion would be appropriate as
long as there is only a remote likelihood that the debtor’s
credit spread will decline below the spread in the
make-whole redemption calculation. Stay tuned for further
developments.
When an entity designates a partial-term hedge (either a fair value
or cash flow hedge), its analysis of whether the debt is prepayable
in the assessment of shortcut method eligibility should take into
account only those terms that are operable during the designated
term of the hedging relationship. For example, assume that the
entity wants to hedge a 10-year fixed-rate debt instrument that (1)
is callable by the issuer at any time after the five-year
anniversary and (2) has no other prepayment features. If the entity
designates as the hedging instrument an interest rate swap that
matures in five years and identifies the hedged item as the first
five years of interest payments (see Section
2.2.2.1.1.2), the debt would not be considered
prepayable in the analysis of shortcut method eligibility. This is
because the call option cannot be exercised during the designated
term of the hedge. The analysis of prepayment features in the debt
should cover the entire period represented by the hedged interest
payments.
Now that we have
discussed how to determine when a prepayment feature in a debt
instrument needs to be mirrored in the interest rate swap to qualify
for the shortcut method, we will explain how to mirror the terms in
the swap. As indicated in ASC 815-20-25-104(e)(2), the prepayment
features are considered to be mirrored if there is an exact match of
the terms of the prepayment options. including all of the following
features:
- Maturities.
- Strike price. If the amount for which the debt could be called is at a premium or discount to the face amount of the debt, the swap must have a termination payment that is equal to that premium or discount.
- Related notional amounts.
- Timing and frequency of payments.
- Dates on which the instruments may be prepaid.
In addition, the entity must be the writer of one option and the
holder (purchaser) of the other option.
Example 2-27
Shortcut Method With a Balance Guarantee
Swap
Insurance Company X owns a fixed-rate MBS that
it classifies as AFS. It enters into a
receive-variable, pay-fixed interest rate swap
whose notional amount declines in proportion to
the declines in the contractual principal of the
MBS.
Such a swap is considered a balance guarantee
swap because its notional amount is tied to a
reference asset (or pool of assets). Since the
referenced asset (or assets) and the designated
hedged item are the same, the balance guarantee
swap satisfies the mirrored call option criterion
of the shortcut method. In accordance with ASC
815-20-25-104, the balance guarantee is a mirror
purchased call option that offsets the mirror
written call option that is embedded in a typical
MBS.
There are typically not any other features in
an MBS that would otherwise prevent a hedging
relationship from qualifying for the shortcut
method; however, each security should be evaluated
separately. We do not believe that this would
violate the condition that all settlements must be
calculated in the same manner (see
Section 2.5.2.2.1.4) because
ASC 815-25-104(d) only requires the rates used for
each leg in every settlement to be consistent.
2.5.2.2.1.4 All Settlements Are Calculated the Same Way
ASC 815-20
25-104 All of
the following conditions apply to both fair value
hedges and cash flow hedges: . . .
d. The
formula for computing net settlements under the
interest rate swap is the same for each net
settlement. That is, both of the following
conditions are met:
- The fixed rate is the same throughout the term.
- The variable rate is based on the same index and includes the same constant adjustment or no adjustment. The existence of a stub period and stub rate is not a violation of the criterion in (d) that would preclude application of the shortcut method if the stub rate is the variable rate that corresponds to the length of the stub period. . . .
The shortcut method was developed to reduce the complexity of
applying the hedge accounting model when entities want to use
plain-vanilla interest rate swaps to hedge typical debt instruments
for interest rate risk. In a typical interest rate swap, the
settlement formula does not change during the life of the swap. In
other words, the swap has the same indexed rate with a fixed (or no)
basis adjustment on its variable leg and the same fixed rate on its
fixed leg throughout its life. However, if the swap agreement calls
for a change in the payment terms from one period to the next, the
change in terms (i.e., moving partial payments from one period to
the other) would essentially represent an embedded financing
component in the swap, which would be inconsistent with the notion
that a hedging relationship is perfectly effective and that no hedge
effectiveness assessments are required. Therefore, a hedging
relationship with a swap whose payment terms change during the swap
term would not qualify for application of the shortcut method.
The existence of a stub period and a stub rate would not violate the
criterion in ASC 815-20-25-104(d) as long as the stub rate is the
variable rate that corresponds to the length of the stub period. For
example, assume that (1) an entity issues fixed-rate debt with a
term of 10 years and three months, (2) interest is due semiannually
through the first 10 years, and (3) at maturity, the issuer must pay
three months of interest and the principal amount. If the entity
wants to hedge its interest rate risk for the entire term of the
debt and apply the shortcut method, it should use a swap that is
repriced and settled on each payment date. In such a case, all of
the semiannual periods covered by the swap would be repriced on the
basis of six-month benchmark rates; however, the repricing for the
final stub period should be based on the three-month benchmark rates
(the variable rate that corresponds to the length of the final stub
period).
Example 2-28
Shortcut Method Not Appropriate for
Hedging Choose-Your-Rate Debt
Entity C issues variable-rate debt that gives
it the option of performing interest rate
repricings on the basis of several different
interest rate tenors or indexes — one- or
three-month LIBOR, the three-month U.S. Treasury
rate, or the prime rate. Debt with this feature is
commonly referred to as either “you-pick-‘em” or
“choose-your-rate” debt. To hedge the interest
payments on the debt, C enters into a swap that
mirrors the rate options provided by the debt.
Even though the rate optionality is mirrored in
the swap, C cannot apply the shortcut method to
its hedge of interest payments on the
choose-your-rate debt. A swap with a variable leg
that has more than one potential rate would not
meet the condition in ASC 815-20-25-104(d)(2) that
the “variable rate is based on the same index and
includes the same constant adjustment or no
adjustment.”
Note that a more common
hedging strategy involves entering into a
plain-vanilla interest rate swap whose variable
leg is indexed to one of the rate options in the
swap (e.g., three-month LIBOR). If the optionality
in the variable leg of the swap does not match the
optionality in the debt, the hedging relationship
would not qualify for the shortcut method under
ASC 815-20-25-104(g) because the debt contains an
optionality feature that is not mirrored in the
swap, which invalidates an assumption of perfect
effectiveness. (See the next section for further
discussion of ASC 815-20-25-104(g) and
Section 4.2.1.1.2 for a more
detailed discussion of hedging choose-your-rate
debt.)
2.5.2.2.1.5 Terms Are Typical
ASC 815-20
25-104 All of the following
conditions apply to both fair value hedges and
cash flow hedges: . . .
g. Any other terms in the
interest-bearing financial instruments or interest
rate swaps meet both of the following conditions:
- The terms are typical of those instruments.
- The terms do not invalidate the assumption of perfect effectiveness.
ASC 815-20-25-104(g) is commonly referred to as a “catch-all”
criterion that prevents any hedges from qualifying for the shortcut
method other than plain-vanilla hedging relationships in which
“typical” interest rate swaps hedge the interest rate risk of
“typical” debt. This criterion can be difficult to interpret because
what is “typical” in accordance with ASC 815-20-25-104(g)(1) can
change over time as market conventions evolve. Note that the
shortcut method (1) allows an entity to assume that a hedging
relationship is perfectly effective without having to perform any
quantitative assessments of hedge effectiveness and (2) simplifies
financial reporting. Consequently, in the evaluation of the criteria
for the shortcut method, the determination of whether the catch-all
provision has been satisfied should not be viewed as a simple
check-the-box process. If either the swap or the debt is highly
structured, the hedging relationship is not likely to meet this
condition and therefore would not qualify for the shortcut
method.
Example 2-29
Shortcut Method Not Appropriate for Debt
With Interest Deferral Option
Entity Y issues fixed-rate debt with a
provision that gives the issuer the option to
defer making interest payments if the issuer has
net income of $0 or less over a period of two
quarters. In such circumstances, the deferred
interest payments are accrued and added to the
principal of the debt.
To hedge the interest payments on its
fixed-rate debt, Y designates as the hedging
instrument a compound derivative composed of an
interest rate swap and an option that is the
mirror image of the option embedded in the
fixed-rate date (i.e., the hedged item). Entity Y
cannot apply shortcut accounting to the hedging
relationship because the hedged item contains a
provision that gives the issuer the option to
defer making interest payments on the debt.
During informal discussions, the SEC staff has
expressed its belief that only embedded options
that are explicitly discussed in ASC
815-20-25-104(e) and ASC 815-20-25-106(c) can be
mirrored in a hedged interest rate swap under the
shortcut accounting requirements of ASC 815. An
interest deferral option is not a term that is
“typical” in a debt arrangement, and it also would
not be typical in an interest rate swap. If a
hedging relationship includes other embedded
options, even if mirrored in the hedging interest
rate swap, use of the shortcut method is
precluded. Staff members from the SEC’s Division
of Corporation Finance also have taken the same
position and asserted that the shortcut method
cannot be applied to hedges of trust-preferred
securities, even if the interest deferral feature
of the security is mirrored in the hedging
interest rate swap.
However, if an interest deferral option is only
exercisable after a certain period and an entity
elects to designate partial-term hedges of
interest rate risk under ASC 815-25-35-13B, the
hedging relationship may qualify for shortcut
accounting if the assumed maturity of the hedged
item does not exceed the nonexercisable
period.
Note that securities that contain these types
of features (or provisions in which the issuer can
defer making interest payments at its discretion)
include those issued by sponsors of trust
preferred security arrangements, such as monthly
income preferred securities, quarterly income
preferred securities, and trust-originated
preferred securities and enhanced capital
advantaged preferred securities. These securities
are particularly advantageous for banks because
the Federal Reserve Board allows bank holding
companies to include qualifying issues as part of
their “tier 1 capital” for regulatory capital
purposes, subject to certain limitations.
Example 2-30
Shortcut Method for Late-Term Hedges
Entity X enters into an interest rate swap to
hedge interest rate risk in preexisting debt
(i.e., a late-term hedge). Since the debt is
fixed-rate debt, it is highly unlikely that the
benchmark interest rate at the inception of the
hedging relationship will be the same as it was on
the debt’s issuance date. Accordingly, the debt’s
fair value will not be equal to its face amount,
even if credit spreads were held constant since
issuance.
We believe that in such a
case, X could still apply the shortcut method to
the hedging relationship if the criteria for its
application are met. The application of the
shortcut method to late-term hedges was addressed
when DIG Issue E23 was being discussed in 2008. At
that time, the FASB proposed the following
clarification of paragraph 68(e) of Statement
133:12
Any other terms in the
interest-bearing financial instruments or interest
rate swaps are both typical of those instruments
and do not invalidate the assumption of no
ineffectiveness. That is, the terms of the
interest rate swap and the interest-bearing
financial instrument must both:
- Be typical for those instruments; and
- Not invalidate the assumption of no ineffectiveness
For example, in a fair value
hedging relationship the fair value of the hedged
item must equal its par value at inception of the
hedging relationship because the amortization of
the initial difference (a discount or premium)
would create ineffectiveness. However, an
exception to this principle exists, as follows: A
difference between fair value and par value of the
hedged item would not invalidate the assumption of
no ineffectiveness if the difference is a discount
or premium attributable solely to the market
convention of rounding the coupon rate of the
hedged item at issuance.
This clarification would have precluded
application of the shortcut method in a late-term
fair value hedge. However, the clarification was
not finalized when the FASB issued DIG Issue E23.
In addition, the Alternative Views section of
proposed DIG Issue E23 stated:
Three Board members dissented to the issuance of this proposed Implementation Issue. Those Board members generally support the conclusions reached in this proposed Implementation Issue but disagree with the conclusion that a condition of the shortcut method is that the fair value of the hedged item has to equal its principal amount (which disqualifies hedge transactions that are entered into after the initial issuance or purchase of the debt instrument). Those Board members believe that Statement 133 does not currently include this requirement, and they do not support amending Statement 133 to add such a
requirement.
Paragraph 68 enumerates the requirements for
the shortcut method. Paragraph 68(a) states: “The
notional amount of the swap matches the principal
amount of the interest-bearing asset or liability
being hedged.” Paragraph 68(b) imposes an
additional requirement for the swap — its fair
value must equal zero at inception. No other
condition states that the fair value of the hedged
item must equal its principal amount.
Paragraph 114 sets forth the computational
steps in the shortcut method for a fair value
hedge. Subparagraph (c) states:
Compute and
recognize interest expense using that combined
rate and the fixed-rate liability’s principal
amount. (Amortization of any purchase premium or
discount on the liability also must be considered,
although that complication is not incorporated in
this example.)
The table following that guidance also states
that the trade date of the swap and the borrowing
date of the debt “need not match for the
assumption of no ineffectiveness to be
appropriate.” Those Board members believe this
guidance explicitly permits the hedged item to
have a purchase premium or discount and still
qualify for the shortcut method. Therefore, those
Board members reject the suggestion that paragraph
68(e) implicitly requires that the fair value of
the hedged item equal its principal amount.
Those Board members also observe that [DIG
Issue E10], “Application of the Shortcut Method to
Hedges of a Portion of an Interest-Bearing Asset
or Liability (or Its Related Interest) or a
Portfolio of Similar Interest-Bearing Assets or
Liabilities,” refers to either the principal
amount or the notional amount of the hedged item.
It does not mention the fair value of the hedged
item. Likewise, [DIG Issue E15], concludes the
shortcut method would generally not be permitted
because the fair value of the swap is unlikely to
be zero at the date of the acquisition. The
guidance does not mention that the fair value of
the hedged items would not likely equal their
principal or notional amounts.
Those Board members would not amend Statement
133 to impose this new requirement. They believe
that changes in the fair value of a debt
instrument prior to the hedge transaction do not
distort the effectiveness of the hedging
relationship going forward, provided that the
terms of the swap match the remaining terms of the
debt. In that case, it is still reasonable to
assume that changes in the fair value of the swap
will be highly effective in offsetting subsequent
changes in the fair value of the debt attributable
solely to subsequent changes in the benchmark
interest rate. Other accounting standards would
govern the recognition in earnings of any premium
or discount on the hedged item prior to the
inception of the hedge. That element does not
represent ineffectiveness in the current hedging
transaction. Those Board members observe that the
same economic phenomenon exists in the issues
involving differences between the fair value of
the hedged item and the principal amount due to
differences in the trade date of the derivative
and settlement date of the debt, or due to a
rounding down of the coupon at issuance (that is,
the fair value of the hedged item might be
different from its principal amount). The Board
appropriately decided to permit the shortcut
method in those cases albeit primarily on the
basis of the expected insignificance of the
premiums and discounts and also because of
prevalent market conventions relating to the
hedged items.
We believe that the statements from the
dissenting FASB members, along with the fact that
proposed DIG Issue E23 contained transition
provisions (i.e., previous applications of the
shortcut method in late-term fair value hedges
would not have been considered errors), make it
clear that the requirements for shortcut method
eligibility do not include a condition that the
fair value of the hedged item must equal its par
amount on the date on which hedge accounting is
applied. Although the FASB had proposed such a
requirement, it was not ultimately included in DIG
Issue E23; therefore, the shortcut method can
still be applied in a fair value hedge that is
designated after the inception of the hedged item.
In other words, since the amendment to ASC 815 was
not finalized as proposed, it is reasonable to
conclude that the shortcut method is not
prohibited in a late-term fair value hedge.
Example 2-31
Shortcut
Method When Fixed Rate on Swap Does Not Match
Fixed Rate on Debt
Entity A enters into a swap to hedge the
interest payments on its fixed-rate debt. Although
the rate on the fixed leg of the swap does not
match the fixed rate on the debt, A can apply the
shortcut method to the hedging relationship as
long as all of the other criteria for its
application are met.
ASC 815-20-25-109 explicitly
allows the shortcut method to be applied in a fair
value hedging relationship in which the fixed rate
on the swap does not match that on the hedged
debt. However, the interest rate swap must have a
fair value of zero at inception (aside from the
exceptions noted in Section
2.5.2.2.1.2). If the fixed leg of the
swap is set to equal the fixed rate on the debt,
the variable leg of the swap must have a fixed
adjustment to ensure that the swap has a fair
value of zero at inception. This would result in
no change in net settlements.
In addition, the variable rate on the swap does
not need to match the interest rate on the
variable-rate debt for an entity to apply the
shortcut method in a cash flow hedging
relationship. The contractually specified interest
rate index must match; however, for the reasons
discussed above, there is no need to match up any
existing fixed credit spread on the debt.
Example 2-32
Shortcut Method Not Appropriate for
Forward-Starting Swaps
Entity Y enters into a
forward-starting swap to hedge interest rate risk
and would like to apply the shortcut method to the
hedging relationship. While hedge accounting is
not prohibited for interest rate hedging
strategies that involve forward-starting swaps,
the shortcut method is not appropriate for such
strategies, although views differ on which
shortcut method criterion would not be satisfied.
Some believe that the condition in ASC
815-20-25-104(d) would not be met because not all
of the net settlements are calculated the same way
(see Section 2.5.2.2.1.4).
Another view is that a forward-starting swap is
not a “typical” swap and that the shortcut method
is limited to plain-vanilla swaps under ASC
815-20-25-104(g) (see Section
2.5.2.2.1.5). In addition, ASC
815-20-25-102 states that “[i]f all of the
applicable conditions in the list in paragraph
815-20-25-104 are met, an entity may assume
perfect effectiveness in a hedging relationship of
interest rate risk involving a recognized
interest-bearing asset or liability (or a firm
commitment arising on the trade [pricing] date to
purchase or issue an interest-bearing asset or
liability) and an interest rate swap (or a
compound hedging instrument composed of an
interest rate swap and a mirror-image call or put
option as discussed in paragraph
815-20-25-104[e]).” A forward-starting swap is a
compound hedging instrument composed of an
interest rate swap and a forward, not a “compound
hedging instrument composed of an interest rate
swap and a mirror-image call or put option.”
We understand that in response to questions
from stakeholders, the FASB staff has indicated
that it would be inappropriate to apply the
shortcut method to a hedging relationship that
involves a forward-starting swap.
2.5.2.2.1.6 Fair Value Hedge — Requirements for Swap Terms
ASC 815-20
25-105 All of
the following incremental conditions apply to fair
value hedges only:
a. The expiration date of the interest rate
swap matches the maturity date of the
interest-bearing asset or liability or the assumed
maturity date if the hedged item is measured in
accordance with paragraph 815-25-35-13B.
b. There is no floor or cap on the variable
interest rate of the interest rate swap.
c. The interval between repricings of the
variable interest rate in the interest rate swap
is frequent enough to justify an assumption that
the variable payment or receipt is at a market
rate (generally three to six months or less). . .
.
f. The index on which the variable leg of the
interest rate swap is based matches the benchmark
interest rate designated as the interest rate risk
being hedged for that hedging relationship.
For a hedge of the interest rate risk related to fixed-rate debt to
be eligible for application of the shortcut method, the hedge must
meet all of the conditions discussed in Sections
2.5.2.2.1.1 through 2.5.2.2.1.5 as well as the
following:
- The expiration date of the swap must match either the actual maturity of the debt or, in the case of a partial-term hedge, the assumed maturity of the debt.
- The variable leg on the swap must be indexed to the designated benchmark interest rate.
- The variable leg on the swap cannot have a cap or floor.
- The swap must be repriced frequently enough to justify an assumption that the rate is at-market.
An interest rate swap and a debt instrument with different maturities
would not be expected to react to changes in interest rates
similarly, which would invalidate an assumption of perfect hedge
effectiveness. Therefore, the expiration date of a swap must match
the actual maturity date of the debt unless a partial-term hedging
strategy is employed.
Before the issuance of ASU 2017-12, an entity could not apply the
shortcut method to a partial-term fair value hedge. In fact, such a
hedge was unlikely to be eligible for hedge accounting because of
the potentially significant ineffectiveness. However, under ASC
815-25-35-13B, which was added by ASU 2017-12, if an entity hedges
selected cash flows of an existing debt instrument, it can measure
the change in fair value that is attributable to changes in interest
rates by using an assumed maturity that occurs on the date on which
the last hedged cash flow is due and payable. In addition, ASC
815-20-25-105(a) was amended to explicitly allow a partial-term fair
value hedge to qualify for the shortcut method, provided that the
other conditions for the shortcut method are also met. See further
discussion of partial-term hedges in Section
3.2.1.1. Note that partial-term cash flow hedges
already qualified for the shortcut method before the issuance of ASU
2017-12.
In addition, for an entity to assume that a hedge is perfectly
effective, the terms of the variable leg of the swap must (1) match
the designated benchmark interest rate, (2) not incorporate caps or
floors, and (3) be repriced often enough that the rate at any given
time is close to a market rate. In practice, this means that the
swap must be repriced at least every six months. Note that the
timing of the repricing and settlements of the swap does not need to
match the timing of coupon payments on the fixed-rate debt.
2.5.2.2.1.7 Cash Flow Hedge — Requirements for Swap Terms
ASC 815-20
25-106 All of
the following incremental conditions apply to cash
flow hedges only:
a. All interest receipts
or payments on the variable-rate asset or
liability during the term of the interest rate
swap are designated as hedged.
b. No interest payments
beyond the term of the interest rate swap are
designated as hedged.
c. Either of the following
conditions is met:
- There is no floor or cap on the variable interest rate of the interest rate swap.
- The variable-rate asset or liability has a floor or cap and the interest rate swap has a floor or cap on the variable interest rate that is comparable to the floor or cap on the variable-rate asset or liability. For purposes of this paragraph, comparable does not necessarily mean equal. For example, if an interest rate swap’s variable rate is based on LIBOR and an asset’s variable rate is LIBOR plus 2 percent, a 10 percent cap on the interest rate swap would be comparable to a 12 percent cap on the asset.
d. The repricing dates of
the variable-rate asset or liability and the
hedging instrument must occur on the same dates
and be calculated the same way (that is, both
shall be either prospective or retrospective). If
the repricing dates of the hedged item occur on
the same dates as the repricing dates of the
hedging instrument but the repricing calculation
for the hedged item is prospective whereas the
repricing calculation for the hedging instrument
is retrospective, those repricing dates do not
match. . . .
g. The index on which the
variable leg of the interest rate swap is based
matches the contractually specified interest rate
designated as the interest rate being hedged for
that hedging relationship.
For a hedge of the interest rate risk related to
variable-rate debt to be eligible for application of the shortcut
method, the hedge must meet all of the conditions discussed in
Sections 2.5.2.2.1.1 through
2.5.2.2.1.5 as well as the following:
- The term of the hedged interest payments
match the term of the swap, which means:
- No debt interest payments are excluded during the term of the swap.
- No debt interest payments beyond the term of the swap are identified as hedged.
- The variable leg on the swap mirrors the
interest rate reset features of the debt (ignoring fixed
credit spreads), which means:
- The designated contractually specified interest rate in the debt is the same as the interest rate index of the variable leg of the swap (e.g., three-month LIBOR).
- The repricing dates and calculation of the variable-rate debt and the swap match (frequency, prospective vs. retrospective rate).
- Any floors or caps on the variable rate are the same in both the debt and the swap.
It is not necessary for an entity to hedge all of the interest
payments on variable-rate debt to qualify for the shortcut method;
however, an entity cannot use a forward-starting swap in a
qualifying shortcut method hedge (see Example
2-32).
Example 2-33
Applicability of Shortcut Method to
Hedging Nonbenchmark Interest Payments on
Variable-Rate Debt
Entity B enters into an interest rate swap and
designates a cash flow hedge of its variable-rate
debt. Although the variable leg of the interest
rate swap is not a benchmark interest rate, the
interest rate index in the debt and the swap
match. Therefore, Entity B may apply the shortcut
method.
ASU 2017-12 eliminated the concept of benchmark
interest rates from the guidance on hedging
variable-rate debt instruments in cash flow
hedges. As a result, under ASC 815-20-25-106(g),
such a hedge would qualify for application of the
shortcut method (and a qualitative assumption of
perfect effectiveness) as long as all of the other
shortcut method criteria were met. ASC
815-20-25-106(g) requires that the “index on which
the variable leg of the interest rate swap is
based matches the contractually specified interest
rate designated as the interest rate being hedged
for that hedging relationship.”
2.5.2.2.1.8 Credit Risk — Nonperformance Risk
ASC 815-20
25-103 Implicit in the
conditions for the shortcut method is the
requirement that a basis exist for concluding on
an ongoing basis that the hedging relationship is
expected to be highly effective in achieving
offsetting changes in fair values or cash flows.
In applying the shortcut method, an entity shall
consider the likelihood of the counterparty’s
compliance with the contractual terms of the
hedging derivative that require the counterparty
to make payments to the entity.
25-111 Comparable credit risk
at inception is not a condition for assuming
perfect effectiveness even though actually
achieving perfect offset would require that the
same discount rate be used to determine the fair
value of the swap and of the hedged item or hedged
transaction. To justify using the same discount
rate, the credit risk related to both parties to
the swap as well as to the debtor on the hedged
interest-bearing asset (in a fair value hedge) or
the variable-rate asset on which the interest
payments are hedged (in a cash flow hedge) would
have to be the same. However, because that
complication is caused by the interaction of
interest rate risk and credit risk, which are not
easily separable, comparable creditworthiness is
not considered a necessary condition for assuming
perfect effectiveness in a hedge of interest rate
risk.
The shortcut method allows an entity to qualitatively assess hedge
effectiveness without recognizing ineffectiveness in the income
statement. If a cash flow hedge is highly effective, all changes in
fair value are already initially recorded in OCI. While
ineffectiveness is not separately tracked and reported for a highly
effective fair value hedge (see Chapter 3 for
further discussion), any differences between the changes in the
derivative’s fair value and changes in the hedged item’s fair value
that are attributable to changes in the designated risk will affect
the income statement. However, if the shortcut method is applied,
entities may recognize an adjustment to the basis of the hedged debt
that is equal to the changes in the derivative’s fair value. In that
sense, the shortcut method is a simplified way of measuring changes
in the debt’s fair value that are attributable to changes in the
designated benchmark interest rate.
A hedge of a debt instrument’s interest rate risk already excludes
credit risk from the hedging relationship, which means that changes
in the debt issuer’s creditworthiness are not directly considered.
However, under the cash flow hedging model, it must be probable that
the hedged transaction will occur. Accordingly, for variable-rate
debt to qualify for the application of hedge accounting, it must be
probable that the interest payments (i.e., the hedged item) will
occur; therefore, the hedging entity must be able to continually
assert that it is probable that the hedged interest payments will be
made. If the entity is hedging its own debt, it must assess its own
performance risk. If the entity is hedging an asset, it must assess
whether it is probable that the issuer or borrower will continue to
make the payments being hedged. The entity must discontinue the use
of hedge accounting, even under the shortcut method, if the entity
concludes that it is no longer probable that hedged payments will be
made on the debt instrument (see Section 4.1.5
for further discussion of discontinued cash flow hedges).
Although the creditworthiness of both parties to the derivative
contract must also be monitored when the shortcut method is applied,
the only real purpose of such monitoring is to assess the
probability of default. ASC 815-20-25-111 acknowledges that
“[c]omparable credit risk at inception is not a condition for
assuming perfect effectiveness even though actually achieving
perfect offset would require that the same discount rate be used to
determine the fair value of the swap and of the hedged item or
hedged transaction.” However, ASC 815-20-25-103 does note that “an
entity shall consider the likelihood of the counterparty’s
compliance with the contractual terms of the hedging derivative that
require the counterparty to make payments to the entity.” While an
entity is only explicitly required to consider the performance risk
of the counterparty to the derivative, if either party to the
hedging interest rate swap experiences a significant decline in its
creditworthiness, that party’s ability to comply with the
contractual provisions of the arrangement may be called into
question. Consequently, the entity may be unable to assert that the
hedging relationship is expected to be highly effective (i.e.,
because it is questionable whether either party to the arrangement
will be able to fulfill its contractual obligations under the
arrangement).
If there is a deterioration in the creditworthiness of either the
entity itself or a counterparty, the impact on a hedging
relationship that qualifies for the shortcut method depends on (1)
the severity of the deterioration and (2) the likelihood of
performance by both parties to the derivative. An expectation of
“offset” is a prerequisite for all hedging relationships, and the
effects of credit are a required element of that consideration.
ASC 815-20-35-18 notes:
Paragraph 815-20-25-103 states that, in
applying the shortcut method, an entity shall consider the
likelihood of the counterparty’s compliance with the contractual
terms of the hedging derivative that require the counterparty to
make payments to the entity. That paragraph explains that
implicit in the criteria for the shortcut method is the
requirement that a basis exist for concluding on an ongoing
basis that the hedging relationship is expected to be highly
effective in achieving offsetting changes in fair values or cash
flows.
Even if there is a deterioration in the creditworthiness of one of
the parties to the interest rate swap, an entity may still be able
to conclude that (1) it is probable that each counterparty will
perform in accordance with the contractual provisions of the
arrangement and (2) the hedging relationship continues to satisfy
all of the requirements of the shortcut method. ASC 815 is clear
that in such a case, the changes in creditworthiness that affect the
fair value of the interest rate swap will not be recognized in
income as hedge ineffectiveness.
ASC 815-20-35-18 addresses considerations of creditworthiness in the
context of hedge effectiveness. Note that it does not change the
overall guidance on measuring the fair value of the hedging
derivative, such as the requirement that the change in the hedging
instrument’s fair value include adjustments for nonperformance risk
(as the term is defined in ASC 820).
2.5.2.2.1.9 Backup Quantitative Assessment
Some entities have applied the shortcut method to ineligible hedging
relationships and subsequently needed to issue restatements, which
has been a topic of public discussion. In fact, at the 2005 AICPA
Conference on Current SEC and PCAOB Developments, an SEC staff
member shared the staff’s view on the consequences of
inappropriately applying the shortcut method:
[O]ne of the more
frequent questions that we have been asked relates to the
quantification of errors that arose from an inappropriate
application of the shortcut method. Some believe that the amount
of the error should be measured as the ineffectiveness that
would have been recognized under other hedge accounting methods.
The staff has often objected to this approach for quantification
of errors for these hedging relationships because it assumes
that the error only concerned the measurement of ineffectiveness
and that the requirements for hedge accounting were still met.
As I stated earlier, one of the general hedge accounting
requirements is prospective and retrospective testing of hedge
effectiveness. If a company has been relying on the application
of the shortcut method, these tests may very well not have been
performed. As such, the provisions to allow hedge accounting
under other methods may not have been complied with. Thus, if
the shortcut method has been applied inappropriately, it may be
that the error needs to be quantified as if hedge accounting was
not applied in those periods.
According to the SEC staff, when an entity is assessing the
materiality of an error that resulted from inappropriately applying
the shortcut method, it is not acceptable to quantify the error as
the amount of ineffectiveness that would have been recognized under
a long-haul method unless the hedging relationship also meets all of
the other criteria for long-haul hedge accounting in ASC 815 (e.g.,
prospective and retrospective testing of hedge effectiveness). If
the hedging relationship had not complied with the long-haul
criteria since the hedge’s inception, the error to be evaluated
would be the difference between (1) the recorded amounts that
resulted from applying the shortcut method and (2) the amounts that
would have been reported if hedge accounting had not been used
(i.e., if the derivative had been marked to fair value through
earnings since inception). When evaluating an error related to fair
value hedges, the entity must also consider the amount of the
reversal of the basis adjustments that were made to the hedged item.
The shortcut method provides an exception to the overriding principle
that an entity can only apply hedge accounting if it can (1)
quantitatively establish, at inception, an expectation that the
hedging relationship will be highly effective and then (2)
continuously reassess the effectiveness both prospectively and
retrospectively on an ongoing basis. If the rigorous conditions for
eligibility are met and the shortcut method is applied, the
effectiveness assessment will be qualitative and the financial
reporting will also be simplified.
Because the shortcut method is an exception to the overall principles
of hedge accounting, its application is rules-based. If any
condition for shortcut eligibility is not met exactly, application
of the shortcut method is inappropriate, and entities’ failure to
comply explicitly with all of the criteria has led to many
restatements. In fact, the SEC staff has rejected the notion that
entities could qualify for the shortcut method by complying with
“the spirt” of its criteria. When deliberating ASU 2017-12, the FASB
considered the number of restatements and noted the following in the
Background Information and Basis for Conclusions:
To address the
restatements that had resulted from the application issues
associated with the shortcut method in practice, the Board
decided to ease application in instances in which an entity
determines that the shortcut method should not have been
applied, but the hedging relationship was and remains highly
effective.
Consequently, the Board amended ASC 815 to permit entities to use a
backup method of quantitatively assessing the effectiveness of a
hedging relationship in cases in which application of the shortcut
method was not or is no longer appropriate.
ASC 815-20
25-117A In the period in
which an entity determines that use of the
shortcut method was not or no longer is
appropriate, the entity may use a quantitative
method to assess hedge effectiveness and measure
hedge results without dedesignating the hedging
relationship if both of the following criteria are
met:
- The entity documented at hedge inception in accordance with paragraph 815-20-25-3(b)(2)(iv)(04) which quantitative method it would use to assess hedge effectiveness and measure hedge results if the shortcut method was not or no longer is appropriate during the life of the hedging relationship.
- The hedging relationship was highly effective on a prospective and retrospective basis in achieving offsetting changes in fair value or cash flows attributable to the hedged risk for the periods in which the shortcut method criteria were not met.
25-117B If the criterion in
paragraph 815-20-25-117A(a) is not met, the
hedging relationship shall be considered invalid
in the period in which the criteria for the
shortcut method were not met and in all subsequent
periods. If the criterion in paragraph
815-20-25-117A(a) is met, the hedging relationship
shall be considered invalid in all periods in
which the criterion in paragraph 815-20-25-117A(b)
is not met.
25-117C If an entity cannot
identify the date on which the shortcut criteria
ceased to be met, the entity shall perform the
quantitative assessment of effectiveness
documented at hedge inception for all periods
since hedge inception.
25-117D The terms of the
hedged item and hedging instrument used to assess
effectiveness, in accordance with paragraph
815-20-25-117A(b), shall be those existing as of
the date that the shortcut criteria ceased to be
met. For cash flow hedges, if the hypothetical
derivative method is used as a proxy for the
hedged item, the value of the hypothetical
derivative shall be set to zero as of hedge
inception.
With respect to the two criteria outlined in ASC 815-20-25-117A
above, there are three possible scenarios that could arise after an
entity determines that the shortcut method was not or is no longer
appropriate:
- Scenario A — The entity (1) appropriately documents at hedge inception the backup quantitative (or long-haul) method it would use to assess hedge effectiveness if it subsequently determines that it is not appropriate to apply the shortcut method and (2) later determines that the hedging relationship is highly effective both prospectively and retrospectively for the periods in which the shortcut method criteria were not met (i.e., the criteria in both ASC 815-20-25-117A(a) and (b) are met).
- Scenario B — The entity does not appropriately document at hedge inception its backup quantitative (or long-haul) method (i.e., the criterion in ASC 815-20-25-117A(a) is not met).
- Scenario C — The entity (1) appropriately documents at hedge inception its backup quantitative (or long-haul) method but (2) later determines that the hedging relationship is not highly effective on both a prospective and retrospective basis for the periods in which the shortcut method criteria are not met (i.e., the criterion in ASC 815-20-25-117A(a) is met, but the criterion in ASC 815-20-25-117A(b) is not met).
The impact of each scenario on the hedging relationship is described
below:
-
Scenario A — The entity used a backup quantitative hedge effectiveness assessment method that was documented at hedge inception and determined that the hedging relationship was highly effective both prospectively and retrospectively. Therefore, for a cash flow hedge, there would be no difference between how the hedging relationship would be accounted for under the long-haul method and how it would have been accounted for under the shortcut method. That is, even if an entity determines that a cash flow hedging relationship is not perfectly effective, the accounting for any mismatch between the change in the fair value of the hedging instrument and the change in the fair value or cash flows of the hedged item would be the same under both the long-haul and shortcut methods because all changes in the fair value of a derivative in a highly effective cash flow hedging relationship are initially recorded in OCI. Going forward, the entity would continue to use the documented quantitative method to assess hedge effectiveness (for both the prospective and retrospective hedge effectiveness assessments).For a fair value hedge, the entity would apply the guidance in ASC 250 on error corrections. The error to be evaluated would be the difference between (1) the recorded amounts that resulted from the application of the shortcut method and (2) the amounts that would have been recorded if the shortcut method had not been applied (i.e., the amounts that would have been recorded under the long-haul method). This is because for a fair value hedge, there may be a difference between the change in fair value of the derivative and the change in the fair value of the hedged item that is attributable to the hedged risk, which must be considered in the evaluation of the error (i.e., the basis adjustments made to the hedged item may need to be adjusted). Such an error could result in a restatement of prior period results.
-
Scenario B — The entity did not appropriately document at hedge inception its backup quantitative (or long-haul) method. Thus, the hedging relationship would be invalid for the periods in which the shortcut method criteria were not satisfied and all subsequent periods through the date of the analysis. The entity would apply the guidance in ASC 250 on error corrections; the error to be evaluated would be the difference between (1) the recorded amounts that resulted from the application of the shortcut method and (2) the amounts that would have been recorded if hedge accounting had not been applied (i.e., if the derivative had been marked to fair value through earnings since inception). When evaluating an error associated with a fair value hedge, an entity would also consider the reversal of the basis adjustments made to the hedged item during periods in which hedge accounting was not appropriate, which could lead to a restatement of prior-period results.
-
Scenario C — The entity used a backup quantitative hedge effectiveness assessment method that was documented at hedge inception and determined that the hedging relationship was not highly effective for one or more periods. Thus, the hedging relationship would be invalid for the period(s) in which the shortcut criteria were not satisfied. The entity would apply the guidance in ASC 250 on error corrections; for the period(s) in which the hedging relationship was not highly effective, the error to be evaluated would be the difference between (1) the recorded amounts that resulted from the application of the shortcut method and (2) the amounts that would have been recorded if hedge accounting had not been used in those periods (i.e., if the derivative had been marked to fair value through earnings during those periods). When evaluating an error associated with a fair value hedge, an entity would also consider the reversal of the basis adjustments made to the hedged item during periods in which hedge accounting was not appropriate.In addition, for fair value hedges, for any periods in which the shortcut criteria were not satisfied but the hedge was determined to be highly effective, there may be differences between (1) the change in the fair value of the derivative and (2) the change in the fair value of the hedged item that is attributable to the hedged risk. An entity must consider these differences when evaluating such an error (i.e., the entity may need to alter the basis adjustments it made to the hedged item when applying the shortcut method). Such consideration may lead to a restatement of prior-period results.Further, in accordance with ASC 815-20-25-117C, “[i]f an entity cannot identify the date on which the shortcut criteria ceased to be met, the entity shall perform the quantitative assessment of effectiveness documented at hedge inception for all periods since hedge inception.”Under ASC 815-20-25-117D, when an entity uses a documented backup quantitative method to assess hedge effectiveness, the terms of the hedging instrument and hedged item “shall be those existing as of the date that the shortcut criteria ceased to be met.” For cash flow hedges, if an entity uses the hypothetical-derivative method as a proxy for the hedged item in the hedge effectiveness assessments, “the value of the hypothetical derivative shall be set to zero as of hedge inception.”
In light of these scenarios, it would be prudent for an entity that
applies the shortcut method to specify a backup method for
quantitatively assessing the effectiveness of the hedging
relationship as part of the hedge designation documentation it
prepares at the inception of the relationship. By providing such
documentation, an entity would avoid scenario B above, in which the
error correction guidance in ASC 250 must be applied if the entity
determines that use of the shortcut method was not or no longer is
appropriate regardless of whether the hedging relationship was
highly effective.
2.5.2.2.2 Critical-Terms-Match Method
ASC 815-20
25-84 If the critical terms
of the hedging instrument and of the hedged item
or hedged forecasted transaction are the same, the
entity could conclude that changes in fair value
or cash flows attributable to the risk being
hedged are expected to completely offset at
inception and on an ongoing basis. For example, an
entity may assume that a hedge of a forecasted
purchase of a commodity with a forward contract
will be perfectly effective if all of the
following criteria are met:
- The forward contract is for purchase of the same quantity of the same commodity at the same time and location as the hedged forecasted purchase. Location differences do not need to be considered if an entity designates the variability in cash flows attributable to changes in a contractually specified component as the hedged risk and the requirements in paragraphs 815-20-25-22A through 25-22B are met.
- The fair value of the forward contract at inception is zero.
- Either of the following
criteria is met:
- The change in the discount or premium on the forward contract is excluded from the assessment of effectiveness pursuant to paragraphs 815-20-25-81 through 25-83.
- The change in expected cash flows on the forecasted transaction is based on the forward price for the commodity.
25-84A In a cash flow hedge
of a group of forecasted transactions in
accordance with paragraph 815-20-25-15(a)(2), an
entity may assume that the timing in which the
hedged transactions are expected to occur and the
maturity date of the hedging instrument match in
accordance with paragraph 815-20-25-84(a) if those
forecasted transactions occur and the derivative
matures within the same 31-day period or fiscal
month.
25-85 If all of the criteria
in paragraphs 815-20-25-84 through 25-84A are met,
an entity shall still perform and document an
assessment of hedge effectiveness at the inception
of the hedging relationship and, as discussed
beginning in paragraph 815-20-35-9, on an ongoing
basis throughout the hedge period. No quantitative
effectiveness assessment is required at hedge
inception if the criteria in paragraphs
815-20-25-84 through 25-84A are met (see paragraph
815-20-25-3(b)(2)(iv)(01)).
35-9 If, at inception, the
critical terms of the hedging instrument and the
hedged forecasted transaction are the same (see
paragraphs 815-20-25-84 through 25-84A), the
entity can conclude that changes in cash flows
attributable to the risk being hedged are expected
to be completely offset by the hedging derivative.
Therefore, subsequent assessments can be performed
by verifying and documenting whether the critical
terms of the hedging instrument and the forecasted
transaction have changed during the period in
review.
35-10 Because the assessment
of hedge effectiveness in a cash flow hedge
involves assessing the likelihood of the
counterparty’s compliance with the contractual
terms of the derivative instrument designated as
the hedging instrument, the entity must also
assess whether there have been adverse
developments regarding the risk of counterparty
default, particularly if the entity planned to
obtain its cash flows by liquidating the
derivative instrument at its fair value.
35-11 If there are no such
changes in the critical terms or adverse
developments regarding counterparty default, the
entity may conclude that the hedging relationship
is perfectly effective. In that case, the change
in fair value of the derivative instrument can be
viewed as a proxy for the present value of the
change in cash flows attributable to the risk
being hedged.
35-12 However, the entity
must assess whether the hedging relationship is
expected to continue to be highly effective using
a quantitative assessment method (either a
dollar-offset test or a statistical method such as
regression analysis) if any of the following
conditions exist:
- The critical terms of the hedging instrument or the hedged forecasted transaction have changed.
- There have been adverse developments regarding the risk of counterparty default.
When the critical terms of the hedging instrument and
the designated risk of the hedged item match, an entity may assume that
the hedge is perfect, at least at inception, and perform a qualitative
assessment of hedge effectiveness. The critical-terms-match method can
be applied to hedging relationships with forward and futures contracts
that hedge risks other than interest rate risk as well as to certain
option hedging strategies, depending on how the risk of the hedged item
is defined. ASC 815-20-25-84 states that the critical-terms-match method
applies to situations in which an “entity could conclude that changes in
fair value or cash flows attributable to the risk being hedged are
expected to completely offset at inception and on an ongoing basis.”
However, while it would appear that entities can use the
critical-terms-match method for both fair value and cash flow hedges, in
most cases, the critical-terms-match method is applied to cash flow
hedges of forecasted transactions. It is very rare to see a fair value
hedge in which all of the critical terms of a derivative match the
hedged item since there are usually some sources of ineffectiveness
(e.g., location differences, grade differences). See Section 5.2.1.1.1 for a discussion of
the application of the critical-terms-match method to a cross-currency
interest rate swap hedging foreign-currency-denominated debt.
An entity applies the critical-terms-match method if the terms of the
hedging instrument match the designated risk of the hedged item (except
for the timing of a group of forecasted transactions, as discussed
below). ASC 815-20-25-84 provides an example of a match in which a
forward contract hedges a forecasted purchase of a commodity under the
following circumstances:
- The forward and the forecasted purchase have the same:
- Notional (quantity).
- Underlying commodity.
- Time.
- Location (or contractually specified component).
- The forward contract has a fair value of zero at hedge inception.
- The hedge effectiveness assessment will be based on either:
- Changes in forward prices.
- Changes in spot prices (the forward points are excluded from the assessment).
ASU 2017-12 added ASC 815-20-25-84A to U.S. GAAP. Accordingly, an entity
is allowed to assume that the timing of a group of hedged transactions
and the maturity date of the hedging instrument match “if those
forecasted transactions occur and the derivative matures within the same
31-day period or fiscal month.” This “exception” can also be applied to
hedges with a purchased option if the assessment is based on changes in
the option’s terminal value (see Section
2.5.2.2.3).
Under the critical-terms-match method, an entity is required to have a
formal ongoing process for assessing whether the terms still match and
to identify a quantitative method that will be applied if they no longer
match. These requirements differ from those of the shortcut method,
discussed in Section 2.5.2.2.1, which is used for
hedges of the interest rate risk of an existing debt instrument with an
interest rate swap. Since the terms of the debt and swap are, by their
nature, fixed at the inception of the hedge, the only ongoing
requirement for an entity applying the shortcut method is to assess the
default risk of the debtor and of the counterparties to the swap (see
Section 2.5.2.2.1.8).
By contrast, the critical-terms-match method often
applies to scenarios in which the derivative hedges forecasted
transactions that are exposed to potential changes in terms (except for
all-in-one hedges in which the terms are firmly committed; see Section
4.1.1.3.2). Accordingly, an entity applying this method is
required to have an ongoing process for either confirming that the
critical terms still match or performing a quantitative assessment of
hedge effectiveness. In that sense, the critical-terms-match method is
really a hybrid of qualitative and quantitative assessment methods. In
fact, some would say that it is really a quantitative assessment model
overlaid with a qualitative expedient for periods in which (1) the
critical terms match and (2) there have been no adverse developments
regarding the default risk of any of the parties to the derivative or
the hedged transaction. For example, if an entity was using the
hypothetical-derivative method (see Section 2.5.2.1.2.4) to assess
hedge effectiveness and the critical terms of the derivative matched the
terms of the hedged item, the hypothetical derivative would have the
same terms as the actual derivative; therefore, the entity would not
need to perform the same fair value calculations twice.
Connecting the Dots
Even though ASC 815-20-25-85 states that “[n]o
quantitative effectiveness assessment is required at hedge
inception if the criteria in paragraphs 815-20-25-84 through
25-84A are met (see paragraph 815-20-25-3(b)(2)(iv)(01)),” we
believe that it would be a best practice for an entity to
document a quantitative method of hedge assessment as part of
its hedge designation documentation when it plans to use the
critical-terms-match method (see Section 2.6 for further
discussion of hedge designation requirements). ASC 815-20-35-12
clearly states that an entity would need to perform a
quantitative analysis if the critical terms no longer match or
if there have been adverse developments related to default risk.
Some may argue that it is implicit in the critical-terms-match
method that the fallback effectiveness assessment method would
be the hypothetical-derivative method (see Section
2.5.2.1.2.4); however, the
hypothetical-derivative method is specifically required in
certain circumstances in which the critical terms do not match
(i.e., for the “terminal value” method discussed in Section
2.5.2.1.2.2 and the net investment hedges
discussed in Section 2.5.2.1.2.5), and there is no explicit
requirement to use it for other hedging relationships in which
the critical terms do not match. Accordingly, we believe that
entities should document the quantitative method of assessing
hedge effectiveness if the critical-terms-match method is no
longer applicable.
2.5.2.2.3 Critical-Terms-Match Method — Options: Terminal Value
ASC 815-20
25-129 A hedging relationship
that meets all of the conditions in paragraph
815-20-25-126 may be considered to be perfectly
effective if all of the following conditions are
met:
- The critical terms of the hedging instrument (such as its notional amount, underlying, maturity date, and so forth) completely match the related terms of the hedged forecasted transaction (such as the notional amount, the variable that determines the variability in cash flows, the expected date of the hedged transaction, and so forth).
- The strike price (or prices) of the hedging option (or combination of options) matches the specified level (or levels) beyond (or within) which the entity’s exposure is being hedged.
- The hedging instrument’s inflows (outflows) at its maturity date completely offset the change in the hedged transaction’s cash flows for the risk being hedged.
- The hedging instrument can be exercised only on a single date — its contractual maturity date.
The condition in (d) is consistent with the
entity’s focus on the hedging instrument’s
terminal value. If the holder of the option
chooses to pay for the ability to exercise the
option at dates before the maturity date (for
example, by acquiring an American-style option),
the hedging relationship would not be perfectly
effective.
25-129A In a hedge of a group
of forecasted transactions in accordance with
paragraph 815-20-25-15(a)(2), an entity may assume
that the timing in which the hedged transactions
are expected to occur and the maturity date of the
hedging instrument match in accordance with
paragraph 815-20-25-129(a) if those forecasted
transactions occur and the derivative matures
within the same 31-day period or fiscal month.
If an entity focuses on an option’s terminal value when assessing the
effectiveness of a hedging relationship that involves a purchased
option, the entity may assume that the hedging relationship is perfectly
effective if the terms of the option match the terms of the forecasted
transaction that are related to the hedged risk. The following
conditions would be indicators of a perfectly effective hedging
relationship:
- The terms of the option match the related terms of the
forecasted transaction(s) with respect to the:
- Notional amount.
- Underlying risk being hedged.
- Maturity date or transaction date (exception for groups of transactions).
- The option’s strike price(s) matches the levels of exposure that are designated as hedged.
- The option’s inflows (outflows) at maturity completely offset the change in cash flows of the hedged item related to the hedged risk.
- The option can only be exercised at its maturity (i.e., it is a European option). Note that this does not disqualify a series of options as long as each option is a European option.
ASU 2017-12 added ASC 815-20-25-129A, which allows an entity that is
hedging a group of forecasted transactions to assume that the timing of
the hedging option’s maturity matches the timing of the transactions as
long as the forecasted transactions occur and the derivative matures
within the same 31-day period or fiscal month.
If any of the above conditions is not met, the entity cannot assume that
the hedging relationship is perfectly effective, and any effectiveness
assessment should include a comparison of the changes in the terminal
values of (1) the actual option and (2) a hypothetical option that would
meet the criteria for perfect effectiveness to be assumed (i.e., one
that would meet the conditions in ASC 815-20-25-129).
If an entity is hedging a series of forecasted transactions with one
purchased option but is unable to assume that the hedge is perfectly
effective, it should assess the effectiveness of the hedging
relationship by comparing the change in the fair value of the actual
derivative with the change in the fair value of a hypothetical
derivative that would meet the conditions to be considered a perfectly
effective hedge (i.e., one that meets the conditions in ASC
815-20-25-129 and 25-129A). The entity should view the option as a
series of smaller options, each hedging one of those purchases
(forecasted purchases that are expected to occur on the same day may be
aggregated). Although the maturity date of each hypothetical option
should “match” the forecasted date of each purchase, as noted in ASC
815-20-25-129A, such dates are considered matched as long as the
forecasted transactions all occur in the same 31-day period or fiscal
month in which the derivative matures.
Accordingly, in constructing a hypothetical derivative, an entity may
group forecasted transactions that occur over a period that is greater
than 31 days or a fiscal month into subsets of forecasted transactions,
with each subset occurring within the same 31-day period or fiscal
month. For each group of transactions, the entity can then construct a
separate smaller option whose maturity date is within the 31-day period
or fiscal month. To assess whether the hedging relationship is expected
to be highly effective (at inception and during the term of the hedge),
the entity should compare the actual derivative to the aggregation of
the smaller hypothetical derivatives.
An entity should clearly state in its hedging policies how it determines
the terms of the hypothetical option(s), and it should apply such
policies consistently.
Example 2-34
Constructing Hypothetical Derivative for
Period Greater Than One Month
Golden Age wants to hedge its forecasted
purchases of gold for the first quarter of 20X2.
In January 20X1, it enters into an option to
purchase 1,000 ounces of gold at $275 per ounce on
February 15, 20X2. Golden Age designates the
option as a hedge of the purchase of the first
1,000 ounces of gold in the first quarter of 20X2.
Its forecasted gold purchases in the first quarter
of 20X2 are as follows:
Golden Age’s policy is to establish the maturity
date of its hypothetical derivatives as the 15th
of the month. In accordance with the guidance
discussed above, Golden Age’s hypothetical
derivative would be a combination of three
European options to purchase gold at $275 per
ounce, with the following maturities and notional
amounts:
Note that the hedged item is the first 1,000
ounces of gold purchased in the first quarter of
20X2. Therefore, the notional amount of the
hypothetical derivative with a maturity date of
March 15, 20X2, is 300 ounces, which is not the
same as the forecasted purchases for March 20X2
(350 ounces) because the total notional amount of
the hypothetical derivative should not exceed the
amount of the hedged forecasted transactions.
2.5.2.2.4 Perfect Net Investment Hedges
ASC 815-20
Formal Designation and Documentation at Hedge
Inception
25-3 Concurrent designation
and documentation of a hedge is critical; without
it, an entity could retroactively identify a
hedged item, a hedged transaction, or a method of
measuring effectiveness to achieve a desired
accounting result. To qualify for hedge
accounting, there shall be, at inception of the
hedge, formal documentation of all of the
following:
- Subparagraph not used.
-
Documentation requirement applicable to fair value hedges, cash flow hedges, and net investment hedges: . . .2. The entity’s risk management objective and strategy for undertaking the hedge, including identification of all of the following: . . .iv. The method that will be used to retrospectively and prospectively assess the hedging instrument’s effectiveness in offsetting the exposure to changes in the hedged item’s fair value (if a fair value hedge) or hedged transaction’s variability in cash flows (if a cash flow hedge) attributable to the hedged risk. There shall be a reasonable basis for how the entity plans to assess the hedging instrument’s effectiveness.01. An entity shall perform an initial prospective assessment of hedge effectiveness on a quantitative basis (using either a dollar-offset test or a statistical method such as regression analysis) unless one of the following applies: . . .G. In a net investment hedge, the entity assesses hedge effectiveness using a method based on changes in spot exchange rates, and the conditions in paragraph 815-35-35-5 (for derivative instruments) or 815-35-35-12 (for nonderivative instruments) are met.H. In a net investment hedge, the entity assesses hedge effectiveness using a method based on changes in forward exchange rates, and the conditions in paragraph 815-35-35-17A are met. . . .
ASC 815-20-25-79 does not explicitly discuss the
application of prospective considerations and retrospective evaluation
to a net investment hedge in foreign operations. ASC 815-35-35-4 states,
in part, that “[i]f a derivative instrument is used as the hedging
instrument, an entity may assess the effectiveness of a net investment
hedge using either a method based on changes in spot exchange rates (as
specified in paragraphs 815-35-35-5 through 35-15) or a method based on
changes in forward exchange rates (as specified in paragraphs
815-35-35-17 through 35-26).” In addition, ASC 815-35-35-4A states that
“[h]edge effectiveness shall be assessed on a quantitative basis at
hedge inception in accordance with paragraph 815-20-25-3(b)(2)(iv)(01)
unless one of the exceptions in that paragraph applies. Subsequent
assessments of hedge effectiveness may be performed either on a
quantitative basis or on a qualitative basis in accordance with
paragraphs 815-20-35-2 through 35-2F.”
ASC 815-20-25-3(b)(2)(iv)(01) indicates that an entity does not need to
perform an initial quantitative prospective effectiveness assessment for
certain net investment hedges that are deemed to be perfectly effective
under the criteria in ASC 815-35.
ASC 815-35
Method Based on Changes in Spot Exchange
Rates
Hedging Instrument Is a Derivative Instrument
35-5 The change in the fair
value of the derivative instrument attributable to
changes in the difference between the forward rate
and spot rate would be excluded from the
assessment of hedge effectiveness if all of the
following conditions are met:
- The notional amount of the derivative instrument designated as a hedge of a net investment in a foreign operation matches (that is, equals) the portion of the net investment designated as being hedged.
- The derivative instrument’s underlying exchange rate is the exchange rate between the functional currency of the hedged net investment and the investor’s functional currency.
- When the hedging derivative instrument is a cross-currency interest rate swap, it is eligible for designation in a net investment hedge in accordance with paragraph 815-20-25-67.
In that circumstance, the hedging relationship
would be considered perfectly effective, and no
quantitative effectiveness assessment is required
at hedge inception. (See paragraph
815-20-25-3(b)(2)(iv)(01).)
Hedging Instrument Is Not a Derivative Instrument
35-12 The translation gain or
loss determined under Subtopic 830-30 by reference
to the spot exchange rate between the transaction
currency of the debt and the functional currency
of the investor (after tax effects, if
appropriate) shall be reported in the same manner
as the translation adjustment associated with the
hedged net investment (that is, reported in the
cumulative translation adjustment section of other
comprehensive income) if both of the following
conditions are met:
- The notional amount of the nonderivative instrument matches the portion of the net investment designated as being hedged.
- The nonderivative instrument is denominated in the functional currency of the hedged net investment.
In that circumstance, the hedging relationship
would be considered perfectly effective, and no
prospective quantitative effectiveness assessment
is required at hedge inception (see paragraph
815-20-25-3(b)(2)(iv)(01)).
Method Based on Changes in Forward Exchange
Rates
Assessment of Effectiveness
35-17A If the notional amount
of the derivative instrument designated as a hedge
of a net investment in a foreign operation matches
(that is, equals) the portion of the net
investment designated as being hedged and the
derivative instrument’s underlying relates solely
to the foreign exchange rate between the
functional currency of the hedged net investment
and the investor’s functional currency, the
hedging relationship would be considered perfectly
effective, and no quantitative effectiveness
assessment is required at hedge inception (see
paragraph 815-20-25-3(b)(2)(iv)(01)).
While the guidance is split up according to whether the hedging
instrument is a derivative or a nonderivative and whether the spot
method or forward method is being applied, an entity’s ability to
perform a qualitative assessment is essentially the same in each
situation. A hedge is considered to be perfectly effective if the terms
of the hedging instrument and the portion of the net investment that is
being hedged match with respect to the following:
- They have the same notional amount.
- They have the same underlying currency.
- If the hedging instrument is a float-for-float cross-currency interest rate swap, both legs are based on comparable interest rate curves.
Because of the nature of a net investment in foreign operations, the
qualitative assessment process for a net investment hedge is less likely
to be an “autopilot” type of assessment. The balance of an entity’s net
investment in foreign operations is subject to change in each reporting
period on the basis of (1) the operating results of the investee and (2)
capital transactions between the entity and the investee
(e.g., dividends). Accordingly, the entity should continually assess the
balance of the net investment to ensure that it is not overhedged before
the start of a reporting period (i.e., when it would be performing the
prospective assessment for the upcoming period).
ASC 815-35
Redesignation
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.
Fortunately, ASC 815-35-35-27 addresses some of the potential operational
difficulties associated with becoming overhedged with respect to a net
investment hedge. Accordingly, an entity is required to assess whether
redesignation of its net investment hedge is necessary only as
frequently as it would perform its hedge effectiveness assessments
(i.e., at least quarterly). If the entity determines that it is
overhedged at the beginning of a reporting period, it does not need to
determine when in the prior period the balance of the net investment
fell below the notional amount of the hedging instrument, “even when a
significant transaction (for example, a dividend) occur[ed] during the
interim period.” Although a hedging relationship may continue to be
highly effective in periods in which the entity is overhedged, the
entity may still be required to redesignate the relationship because the
designated hedged item may need to be changed (see Section
5.4.3).
In addition, as discussed in Section 2.5.2.2.7, an
entity needs to monitor the credit of both parties to the hedging
instrument; if it is no longer probable that neither party will default,
hedge accounting must be discontinued.
2.5.2.2.5 Private Companies — Simplified Hedge Accounting Approach
ASC 815-20
Hedge Accounting Provisions Applicable to
Certain Private Companies
Assuming Perfect Hedge Effectiveness in a
Cash Flow Hedge of a Variable-Rate Borrowing With
a Receive-Variable, Pay-Fixed Interest Rate Swap
Recorded Under the Simplified Hedge Accounting
Approach
25-133 Paragraphs
815-10-35-1A through 35-1C, 815-10-50-3,
815-20-25-3A, 815-20-25-119, 815-20-25-134 through
25-138, 815-20-55-79A through 55-79B, 825-10-50-3,
and 825-10-50-8 provide guidance for an entity
electing the simplified hedge accounting approach.
See paragraph 815-10-65-6 for transition guidance
on applying the simplified hedge accounting
approach.
25-134 The conditions for the
simplified hedge accounting approach determine
which cash flow hedging relationships qualify for
a simplified version of hedge accounting. If all
of the conditions in paragraphs 815-20-25-135 and
815-20-25-137 are met, an entity may assume
perfect effectiveness in a cash flow hedging
relationship involving a variable-rate borrowing
and a receive-variable, pay-fixed interest rate
swap.
25-135 Provided all of the
conditions in paragraph 815-20-25-137 are met, the
simplified hedge accounting approach may be
applied by a private company except for a
financial institution as described in paragraph
942-320-50-1. An entity may elect the simplified
hedge accounting approach for any
receive-variable, pay-fixed interest rate swap,
provided that all of the conditions for applying
the simplified hedge accounting approach specified
in paragraph 815-20-25-137 are met. Implementation
guidance on the conditions set forth in paragraph
815-20-25-137 is provided in paragraphs
815-20-55-79A through 55-79B.
25-136 In applying the
simplified hedge accounting approach, the
documentation required by paragraph 815-20-25-3 to
qualify for hedge accounting must be completed by
the date on which the first annual financial
statements are available to be issued after hedge
inception rather than concurrently at hedge
inception.
25-137 An eligible entity
under paragraph 815-20-25-135 must meet all of the
following conditions to apply the simplified hedge
accounting approach to a cash flow hedge of a
variable-rate borrowing with a receive-variable,
pay-fixed interest rate swap:
- Both the variable rate on the swap and the borrowing are based on the same index and reset period (for example, both the swap and borrowing are based on one-month London Interbank Offered Rate [LIBOR] or both the swap and borrowing are based on three-month LIBOR).
- The terms of the swap are typical (in other words, the swap is what is generally considered to be a “plain-vanilla” swap), and there is no floor or cap on the variable interest rate of the swap unless the borrowing has a comparable floor or cap.
- The repricing and settlement dates for the swap and the borrowing match or differ by no more than a few days.
- The swap’s fair value at inception (that is, at the time the derivative was executed to hedge the interest rate risk of the borrowing) is at or near zero.
- The notional amount of the swap matches the principal amount of the borrowing being hedged. In complying with this condition, the amount of the borrowing being hedged may be less than the total principal amount of the borrowing.
- All interest payments occurring on the borrowing during the term of the swap (or the effective term of the swap underlying the forward starting swap) are designated as hedged whether in total or in proportion to the principal amount of the borrowing being hedged.
25-138 A cash flow hedge
established through the use of a forward starting
receive-variable, pay-fixed interest rate swap may
be permitted in applying the simplified hedge
accounting approach only if the occurrence of
forecasted interest payments to be swapped is
probable. When forecasted interest payments are no
longer probable of occurring, a cash flow hedging
relationship will no longer qualify for the
simplified hedge accounting approach and the
General Subsections of this Topic shall apply at
the date of change and on a prospective basis.
In January 2014, the FASB issued ASU 2014-03 in response to feedback received from
the Private Company Council. Since private companies generally find it
difficult to obtain fixed-rate financing and do not want to be exposed
to rising interest rates, some enter into interest rate swaps to
effectively convert their debt to fixed-rate debt. However, because of
their limited resources and the complexities associated with hedge
accounting, many private companies lack the expertise to apply hedge
accounting. Consequently, the Board issued ASU 2014-03 to provide a
simplified approach (i.e., a practical expedient) that private companies
other than financial institutions can use to qualify for cash flow hedge
accounting under ASC 815 if certain conditions are met. The simplified
approach is not available for any of the following:
- Public business entities.
- Not-for-profit entities.
- Employee benefit plans within the scope of ASC 960 through 965 on plan accounting.
- Financial institutions.
Under the simplified hedge accounting approach, an entity may assume that
a hedge is perfectly effective when it is hedging variable-rate debt
(only the liability) with a receive-variable, pay-fixed interest rate
swap, provided that it meets all of the following conditions:
- The rate on the swap and the debt are based on the same index and reset period (e.g., three-month LIBOR). (The rate does not need to be a benchmark rate.)
- The swap is plain vanilla.
- Any cap or floor on interest rates is mirrored in the swap.
- The repricing and settlement dates for the swap and the borrowing are within a few days of each other.
- The swap’s fair value at inception is at or near zero.
- The notional amount of the swap matches the principal amount of debt being hedged.
- All interest payments related to the hedged proportion of the debt are hedged for the entire term of the swap.
All of the other requirements for cash flow hedge accounting must be met
(except the documentation requirements, which are discussed in
Section 2.6.2). Therefore, an entity that
applies the simplified hedge accounting approach still needs to (1)
assert that it is probable that the hedged interest payments will occur
and (2) monitor the creditworthiness of the counterparties to the swap
for adverse developments (i.e., it must still be probable that neither
party will default under the swap).
The simplified hedge accounting approach is discussed in
more detail in Section
4.2.1.1.5.
2.5.2.2.6 Qualitative Assessments for Imperfect Hedges
ASC 815-20
Effectiveness Assessments on a Qualitative
Basis
35-2A An entity may
qualitatively assess hedge effectiveness if both
of the following criteria are met:
- An entity performs an initial quantitative test of hedge effectiveness on a prospective basis (that is, it is not assuming that the hedging relationship is perfectly effective at hedge inception as described in paragraph 815-20-25-3(b)(2)(iv)(01)(A) through (H)), and the results of that quantitative test demonstrate highly effective offset.
- At hedge inception, an entity can reasonably support an expectation of high effectiveness on a qualitative basis in subsequent periods.
See paragraphs 815-20-55-79G through 55-79N for
implementation guidance on factors to consider
when determining whether qualitative assessments
of effectiveness can be performed after hedge
inception.
35-2B An entity may elect to
qualitatively assess hedge effectiveness in
accordance with paragraph 815-20-35-2A on a
hedge-by-hedge basis. If an entity makes this
qualitative assessment election, only the
quantitative method specified in an entity’s
initial hedge documentation must comply with
paragraph 815-20-25-81.
35-2C When an entity performs
qualitative assessments of hedge effectiveness, it
shall verify and document whenever financial
statements or earnings are reported and at least
every three months that the facts and
circumstances related to the hedging relationship
have not changed such that it can assert
qualitatively that the hedging relationship was
and continues to be highly effective. While not
all-inclusive, the following is a list of
indicators that may, individually or in the
aggregate, allow an entity to continue to assert
qualitatively that the hedging relationship is
highly effective:
- An assessment of the factors that enabled the entity to reasonably support an expectation of high effectiveness on a qualitative basis has not changed such that the entity can continue to assert qualitatively that the hedging relationship was and continues to be highly effective. This shall include an assessment of the guidance in paragraph 815-20-25-100 when applicable.
- There have been no adverse developments regarding the risk of counterparty default.
35-2D If an entity elects to
assess hedge effectiveness on a qualitative basis
and then facts and circumstances change such that
the entity no longer can assert qualitatively that
the hedging relationship was and continues to be
highly effective in achieving offsetting changes
in fair values or cash flows, the entity shall
assess effectiveness of that hedging relationship
on a quantitative basis in subsequent periods. In
addition, an entity may perform a quantitative
assessment of hedge effectiveness in any reporting
period to validate whether qualitative assessments
of hedge effectiveness remain appropriate. In both
cases, the entity shall apply the quantitative
method that it identified in its initial hedge
documentation in accordance with paragraph
815-20-25-3(b)(2)(iv)(03).
35-2E When an entity
determines that facts and circumstances have
changed and it no longer can assert qualitatively
that the hedging relationship was and continues to
be highly effective, the entity shall begin
performing subsequent quantitative assessments of
hedge effectiveness as of the period that the
facts and circumstances changed. If there is no
identifiable event that led to the change in the
facts and circumstances of the hedging
relationship, the entity may begin performing
quantitative assessments of effectiveness in the
current period.
35-2F After performing a
quantitative assessment of hedge effectiveness for
one or more reporting periods as discussed in
paragraphs 815-20-35-2D through 35-2E, an entity
may revert to qualitative assessments of hedge
effectiveness if it can reasonably support an
expectation of high effectiveness on a qualitative
basis for subsequent periods. See paragraphs
815-20-55-79G through 55-79N for implementation
guidance on factors to consider when determining
whether qualitative assessments of effectiveness
can be performed after hedge inception.
As indicated in ASC 815-20-35-2A, if an entity’s initial prospective
quantitative effectiveness assessment of a hedging relationship
demonstrates that (1) there is a highly effective offset and (2) the
entity can, at hedge inception, “reasonably support an expectation of
high effectiveness on a qualitative basis in subsequent periods,” the
entity may elect to perform subsequent retrospective and prospective
effectiveness assessments qualitatively. To do so, the entity must, in
the hedge documentation it prepares at hedge inception, specify how it
will perform the qualitative assessments and document the alternative
quantitative assessment method that it would use if it later concludes,
on the basis of a change in the hedging relationship’s facts and
circumstances, that subsequent quantitative assessments will be
necessary. The entity may make this election on a hedge-by-hedge basis.
An entity should exercise judgment when it assesses whether it can
reasonably support an expectation of high effectiveness for the hedging
relationship on a qualitative basis in subsequent periods. Factors to
consider include (1) the results of the initial prospective quantitative
assessment and (2) the entity’s assessment of whether the critical terms
of the hedging relationship are aligned. If the entity determines that
one or more critical terms of the hedging instrument and the hedged item
are not aligned, it should consider whether a change in market
conditions could reduce the extent of the offset between the changes in
the fair values or cash flows of the hedging instrument and those of the
hedged item that are attributable to the hedged risk. In other words, an
entity should consider the sources of ineffectiveness in the hedging
relationship that are identified in the hedge effectiveness assessment
and determine how volatile those sources of ineffectiveness could be.
Below are examples of
some general sources of a potential mismatch between (1) the change in
the fair value or cash flows of the hedging instrument and (2) the
change in the fair value or cash flows of the hedged item or hedged
transaction that can arise in hedging relationships:
|
Type of Risk
|
Example
|
|---|---|
|
Index risk
|
British pound exposure hedged
with a euro derivative
|
|
Location risk
|
Commodity priced on Chicago
Board of Trade for delivery in Florida
|
|
Grade/quality risk
|
A purchase of wheat that is a
different grade or quality level than that
referenced in a wheat futures contract
|
|
Credit spread
|
A hedge of all the changes in
interest payments (not only interest rate risk)
from a forecasted issuance of fixed-rate debt and
changes in credit spreads
|
|
Timing
|
Interest rate swap whose reset
dates differ from interest rate reset dates on
variable-rate debt
|
|
Off-market derivative
|
Off-market derivatives that have
a financing element in them (see Section
2.5.2.1.4)
|
As noted above, an entity that wants to perform subsequent qualitative
assessments should consider the potential sources of ineffectiveness in
the hedging relationship and the results of the initial prospective
quantitative effectiveness assessment. For example, as indicated in ASC
815-20-55-79G, if the hedging instrument and the hedged item have
different underlyings, the entity should carefully assess both “the
extent and consistency of the correlation exhibited between the changes
in the underlyings of the hedged item and hedging instrument.” In
circumstances in which those changes have not been consistently highly
correlated and the entity determines that expected changes in market
conditions could prevent the hedging relationship from achieving highly
effective offset, the entity would not be able to reasonably support a
decision to perform qualitative effectiveness assessments in subsequent
periods. ASC 815-20-55-79H through 55-79N provide other examples of how
an entity would gauge its ability to perform subsequent assessments of
hedge effectiveness qualitatively.
In accordance with ASC
815-20-35-2C, after an entity elects to perform subsequent qualitative
assessments of hedge effectiveness, it must “verify and document
whenever financial statements or earnings are reported and at least
every three months that the facts and circumstances related to the
hedging relationship have not changed such that it can assert
qualitatively that the hedging relationship was and continues to be
highly effective.” An entity may assert qualitatively that a hedging
relationship continues to be highly effective if indicators such as the
following exist:
- There have not been any events or circumstances that were significant enough to affect the factors that originally enabled the entity to conclude that it could reasonably support, qualitatively, an expectation that the hedging relationship was and will continue to be highly effective.
- There have not been any adverse developments related to the counterparty’s risk of default.
Other indicators may exist.
Connecting the Dots
When developing the parameters for performing a qualitative hedge
effectiveness assessment, entities should understand that is it
is unlikely that such an assessment can be performed purely
qualitatively on an ongoing basis.
Example 2-35
Qualitative Assessment — Parameters
for Performing Quantitative Assessment
Reprise is hedging forecasted purchases of
aluminum in Washington for total changes in cash
flows with a derivative whose underlying is the
Midwest Transaction Price. Additional
transportation costs, which vary on the basis of
actual transportation costs, are added to the
purchase price. Reprise might perform an analysis
to identify how much the transportation costs
would have to change compared with how much the
underlying Midwest Transaction Price of aluminum
has changed and, on the basis of that analysis,
establish some thresholds for when a formal
quantitative analysis should be performed. In
addition, Reprise should consider the default risk
of the counterparties to the derivative contract
in each period.
An entity may initially elect to perform subsequent qualitative
effectiveness assessments but later determine that the hedging
relationship’s facts and circumstances have changed so that qualitative
assessments are no longer sufficient to support a conclusion that the
relationship was and continues to be highly effective. In such a case,
the entity would be required to quantitatively assess effectiveness at
the time of the change by using the method it specified in its initial
hedge documentation. However, if no identifiable event triggered the
change in the facts and circumstances of the hedging relationship, the
entity may begin performing quantitative assessments of effectiveness in
the current period. ASC 815-20-35-2F states that after an entity has
performed a quantitative assessment (because the entity was required or
elected to do so, for example, to validate that its qualitative
assessments of hedge effectiveness remain appropriate), the entity may
revert to making qualitative assessments if “it can reasonably support
an expectation of high effectiveness on a qualitative basis for
subsequent periods.”
ASC 815-20-55-79G(b)(1)(ii) amplifies this guidance by noting that a
“specific event or circumstance” may temporarily disrupt a market and
cause an entity to conclude that it must make a quantitative assessment
of hedge effectiveness. In such a circumstance, if the results of the
newly performed quantitative assessment “do not significantly diverge
from the results of the initial [quantitative] assessment of
effectiveness,” it is likely that the entity can revert to performing
qualitative assessments in future periods. However, if the results of
the new quantitative effectiveness assessment significantly differ from
those of the original assessment, the entity would need to “continually
monitor” the market and assess whether the temporary disruption has
eased before it could consider reverting to qualitative hedge
effectiveness assessments in future periods.
2.5.2.2.7 Impact of Credit Risk on Qualitative Assessments
As noted in Section 2.5.2.1.2.6 and in the
discussions of the various qualitative methods above, hedge accounting
is not appropriate if an entity cannot assert that it is probable that
both parties to the derivative will perform under the derivative
contract. Under the shortcut method and the simplified hedge accounting
approach, it is not necessary to assess changes in credit risk other
than the probability of default. However, if an entity is applying
another qualitative method, the impact of credit spread changes on the
qualitative assessment depends on the quantitative method that would be
applied if a quantitative hedge effectiveness assessment were performed.
An entity should consider the discussion in Section 2.5.2.1.2.6 and the impacts of other changes in
credit risk when evaluating whether its qualitative assessment should
take into account changes in credit risk as well as the probability of
default.
2.5.3 Similar Hedges — Similar Methods of Assessment
ASC 815-20
25-81 This
Subtopic does not specify a single method for assessing
whether a hedge is expected to be highly effective. The
method of assessing effectiveness shall be reasonable.
The appropriateness of a given method of assessing hedge
effectiveness depends on the nature of the risk being
hedged and the type of hedging instrument used.
Ordinarily, an entity shall assess effectiveness for
similar hedges in a similar manner, including whether a
component of the gain or loss on a derivative instrument
is excluded in assessing effectiveness for similar
hedges. Use of different methods for similar hedges
shall be justified. The mechanics of isolating the
change in time value of an option discussed beginning in
paragraph 815-20-25-98 also shall be applied
consistently.
35-2B An
entity may elect to qualitatively assess hedge
effectiveness in accordance with paragraph 815-20-35-2A
on a hedge-by-hedge basis. If an entity makes this
qualitative assessment election, only the quantitative
method specified in an entity’s initial hedge
documentation must comply with paragraph
815-20-25-81.
As discussed throughout this section on hedge effectiveness
assessments, ASC 815 does not prescribe a particular method for assessing the
effectiveness of a hedging relationship. However, ASC 815-20-25-81 does specify
that an entity “shall assess effectiveness for similar hedges in a similar
manner, including whether a component of the gain or loss on a derivative
instrument is excluded in assessing effectiveness for similar hedges. Use of
different methods for similar hedges shall be justified.” ASC 815-20-65-3(i)
provides an exception that allows an entity to change its method of assessing
hedge effectiveness as part of its adoption of ASU 2017-12; in such a case, the
entity does not necessarily need to change its method of assessing the
effectiveness of similar preexisting hedges (see Chapter 7). In addition, ASU 2020-04 provides a similar exception
that allows an entity to change its method of assessing hedge effectiveness on a
hedge-by-hedge basis as part of its adoption of ASC 848 (see Chapter 8).
Note that a qualitative analysis, as discussed in Section
2.5.2.2.6, is not necessarily considered a different method of
hedge effectiveness assessment in this context. Before an entity can elect to
qualitatively assess the effectiveness of a hedging relationship, it must
identify and perform an initial prospective quantitative assessment of the
hedging relationship’s effectiveness and document that it will apply that
quantitative method in circumstances in which it believes that using a
qualitative method is not sufficient to support an assertion that the hedging
relationship is highly effective. Accordingly, an entity may elect to perform
this type of qualitative assessment on a hedge-by-hedge basis, as allowed by ASC
815-20-35-2B. However, the quantitative method of effectiveness assessment
specified should be consistent for similar hedges.
2.5.4 Changing Methods of Assessment
ASC 815-20
35-19 If the
entity identifies an improved method of assessing hedge
effectiveness in accordance with the guidance in
paragraph 815-20-25-80 and wants to apply that method
prospectively, it shall do both of the following:
- Discontinue the existing hedging relationship
- Designate the relationship anew using the improved method.
35-20 The new
method of assessing hedge effectiveness shall be applied
prospectively and shall also be applied to similar
hedges unless the use of a different method for similar
hedges is justified. A change in the method of assessing
hedge effectiveness by an entity shall not be considered
a change in accounting principle as defined in Topic
250.
An entity may change its method of assessing hedge effectiveness at any time.
However, before it can do so, the entity must be able to demonstrate that the
new method it would like to apply is “an improved method of assessing hedge
effectiveness” in accordance with ASC 815-20-35-19. ASC 815-20-35-20 states that
a change in the method of assessing hedge effectiveness is not considered a
change in accounting principle; therefore, the entity’s documentation of why the
new method is an improved method is not the same as a “preferability” analysis.
However, because the new method needs to be an improved method, an entity would
not generally be able to switch back and forth between two methods.
In addition, any change in assessment methods would be prospective and could only
be achieved through a dedesignation and redesignation of the hedging
relationship. For example, if an entity performs a retrospective assessment of
hedge effectiveness that indicates that its hedging relationship was not highly
effective, it cannot change its method of assessment and still apply hedge
accounting for the period just ended. Any change in the method of assessing
hedge effectiveness is prospective (see ASC 815-20-35-20) and can only be
achieved by de-designating and redesignating the hedging relationship.
Before making a change, an entity should also consider that (1) the effectiveness
of similar hedges should be assessed in a similar manner (see Section 2.5.3) and (2) because a redesignation
represents the inception of the new hedging relationship, the hedging derivative
is likely to be an off-market derivative. Off-market derivatives do not qualify
for most types of qualitative effectiveness assessments (e.g., the shortcut
method, critical-terms-match method, simplified hedge accounting approach)
because such derivatives create a source of ineffectiveness (see
Section 2.5.2.1.4).
Footnotes
8
See Section 2.6.1 for a discussion of the required timing of the
initial hedge effectiveness assessment.
9
As discussed in Sections 2.6.2 and 2.6.3, private
companies that are not financial institutions or not-for-profit entities
(other than those that have issued, or are a conduit bond obligor for,
securities that are traded, listed, or quoted on an exchange or an
over-the-counter [OTC] market) do not have to prepare this documentation
until their next set of financial statements (including interim financial
statements, if applicable) is available to be issued.
10
The slope of the regression should be
negative in the comparison of the change in the fair value
of the derivative to the change in the fair value or cash
flows of the hedged item that are attributable to the hedged
risk. This is because the purpose of a hedge is for the
effects of the derivative to offset the hedged risk.
However, in some cases, the slope should be positive (within
the same 0.8 to 1.25 parameters). For example, if an entity
is using the hypothetical-derivative method to assess
effectiveness, the purpose of the regression is to compare
changes in the fair value of the actual derivative to the
changes in the fair value of a hypothetical derivative that
would have been a “perfect” hedging derivative.
11
The hypothetical swap does not
need to meet the conditions in ASC
815-20-25-104(e) related to mirroring prepayment
features because those were developed with an
emphasis on fair value hedging relationships.
12
Paragraph 68(e) of FASB Statement 133 is codified in ASC
815-20-25-104(g).