Chapter 2 — Hedge Accounting Requirements

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.

Pending Content (Transition Guidance: ASC 105-10-65-9)

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.
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:
1. The portion of the change in time value attributable to the passage of time (theta)
2. The portion of the change in time value attributable to changes due to volatility (vega)
3. 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	Time value — The difference between the change in fair value and the change in intrinsic value Volatility value — The difference between the change in fair value and the change in the discounted intrinsic or minimum value Components of time value (as outlined in ASC 815-20-25-82(c) above): Theta — “The portion of the change in time value attributable to the passage of time” Vega — “The portion of the change in time value attributable to [the change in] volatility” Rho — “The portion of the change in time value attributable to [the change] in interest rates”
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:
1. The same notional amount
2. The same repricing dates
3. 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)
4. Mirror image caps and floors
5. 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 term SOFR 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 term SOFR. 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 term SOFR while the swap resets quarterly on the basis of three-month term SOFR.

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. 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 term SOFR (unlike the actual swap, which resets quarterly on the basis of three-month term SOFR). 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 instrument is a derivative 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.

Connecting the Dots

Since the issuance of ASU 2017-12, we have observed that entities are increasingly interested in seeking to establish net investment hedges in which the notional of the hedging instrument is intentionally set at an amount greater than or less than the portion of the entity’s net investment that is designated as being hedged. Although this strategy would preclude an entity from assuming that the hedging relationship is perfectly effective in accordance with ASC 815-35-35-9(a) or ASC 815-35-35-18(a), if the forward method is used, entities are not precluded from intentionally overhedging or underhedging if the hedging relationship is highly effective.

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:
1. The change in fair value of the actual derivative instrument designated as the hedging instrument
2. 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:
1. The change in fair value of the actual cross-currency hedging instrument
2. 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: Hypothetical-derivative method (including the critical-terms-match method). Change-in-variable-cash-flows method. 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 derivative 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 (MBS) 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 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 $137.61 per 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 (see Example 4-18A) 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 term SOFR-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

Changes in U.S. interest rates 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” strategy11 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. Entities using a blend and extend strategy should also carefully consider whether the “new” derivative includes an other-than-insignificant financing element at inception; if so, the deemed “borrower” would be required to classify all cash flows associated with that derivative instrument as financing activities in the statement of cash flows. For more information, see Section 7.4.2 of Deloitte’s Roadmap Statement of Cash Flows.

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	Section 2.5.2.2.1
Critical-terms-match method	At inception and subsequently	Section 2.5.2.2.2
Critical-terms-match method — options: terminal value (DIG Issue G20)	At inception and subsequently	Section 2.5.2.2.3
Perfect net investment hedge	At inception and subsequently	Section 2.5.2.2.4
Simplified hedge accounting approach for private companies	At inception and subsequently	Section 2.5.2.2.5
Certain highly effective hedges	Only after inception of hedge	Section 2.5.2.2.6

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:
1. The terms of the two call options match exactly, including all of the following:
  
  01. Maturities
  
  02. 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 called
  
  03. Related notional amounts
  
  04. Timing and frequency of payments
  
  05. Dates on which the instruments may be called.
2. The entity is the writer of one call option and the holder (purchaser) of the other call option.
3. Subparagraph not used. . . .

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:
1. The debtor’s failure to make timely payment, thus making it delinquent
2. The debtor’s failure to meet specific covenant ratios
3. The debtor’s disposition of specific significant assets (such as a factory)
4. A declaration of cross-default
5. 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:
1. It is not probable at the time of debt issuance.
2. It is unrelated to changes in benchmark interest rates, contractually specified interest rates, or any other market variable.
3. 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:
1. It is not probable at the time of debt issuance.
2. It is unrelated to changes in benchmark interest rates, contractually specified interest rates, or any other market variable.
3. 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
Interest rate related Market variable Any future condition whose occurrence is probable	Any of the following events whose occurrence is not probable: Debtor’s or creditor’s death Regulatory or legislative actions Other events that are out of the control of the debtor or creditor

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 a 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: “It is not probable [that the feature will be triggered] 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.” 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 term SOFR, 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 term SOFR). 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 term SOFR).
- 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:
1. 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.
2. 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 fair 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 term SOFR). (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.

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.” ASU 2020-04 provides an 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; in such a case, the entity does not necessarily need to change its method of assessing the effectiveness of similar preexisting hedges (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

See Section 2.6.1 for a discussion of the required timing of the initial hedge effectiveness assessment.

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.

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.

Entities using foreign currency forwards or cross currency interest rate swaps to hedge foreign currency exposures have experienced recent challenges as a result of changes in foreign currency exchange rates, requiring some entities to make unfavorable final settlement payments. In these situations, entities are more frequently considering blend and extend strategies to avoid the unfavorable outlay of cash at final settlement.

Paragraph 68(e) of FASB Statement 133 is codified in ASC 815-20-25-104(g).

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