3.1 Overview
As indicated in the ASC master glossary and discussed briefly in
Section 1.3.1, a fair value hedge is a
“hedge of the exposure to changes in the fair value of a recognized asset or
liability, or of an unrecognized firm commitment, that are attributable to a
particular risk.” Variability in that risk has the potential to affect reported
earnings.
ASC 815-25
35-1 Gains and losses on a
qualifying fair value hedge shall be accounted for as
follows:
- The gain or loss on the hedging instrument shall be recognized currently in earnings, except for amounts excluded from the assessment of effectiveness that are recognized in earnings through an amortization approach in accordance with paragraph 815-20-25-83A. All amounts recognized in earnings shall be presented in the same income statement line item as the earnings effect of the hedged item.
- The gain or loss (that is, the change in fair value) on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized currently in earnings except as described in (c).
- For one or more existing hedged layer or layers that are designated under the portfolio layer method in accordance with paragraph 815-20-25-12A, the gain or loss (that is, the change in fair value) on the hedged item attributable to the hedged risk shall not adjust the carrying value of the individual beneficial interest or individual assets in or removed from the closed portfolio. Instead, that amount shall be maintained on a closed portfolio basis and recognized currently in earnings.
An entity with a fair value hedge that meets all of the hedging
criteria in ASC 815 (see Chapter 2) would (1)
record the change in the hedging instrument’s fair value in current-period earnings,
except for amounts that are excluded from the hedge effectiveness analysis (see
Section 3.4), and (2) adjust the hedged
item’s carrying amount for the change in the hedged item’s fair value that is
attributable to the risk being hedged. The adjustment to the carrying amount of the
hedged item would also be recognized in current-period earnings. For qualifying fair
value hedges, all amounts recognized in earnings that are related to both the
hedging instrument and the hedged item are presented in the same income statement
line item and should be related to the risk being hedged.
Common examples of fair value
hedging strategies include the following:
|
Hedged Item
|
Derivative
|
|---|---|
|
Fixed-rate debt (liability)
|
A receive-fixed, pay-variable interest rate swap
|
|
Fixed-rate loans (assets)
|
A receive-variable, pay-fixed interest rate swap
|
|
Commodity inventory
|
Fixed-price forward or option to sell a commodity
|
|
Foreign-currency-denominated fixed-rate debt
|
Pay-variable, receive-fixed cross-currency interest rate
swap
|
|
Nonderivative fixed-price commitment to sell a commodity
|
Fixed-price forward to purchase a commodity
|
This chapter discusses the accounting for fair value hedges from
start to finish, including how to account for the hedged item throughout the hedging
relationship and beyond. The discussion is broken down into the two major categories
of fair value hedging relationships — hedges of financial instruments and hedges of
nonfinancial assets. Foreign currency hedges (both fair value and cash flow hedges)
are discussed separately in Chapter 5.
3.1.1 Hedging Firm Commitments
Although fair value hedging typically involves hedges of recognized assets or
liabilities, an entity is also permitted to hedge changes in the fair value of
an unrecognized firm commitment. Such a commitment to purchase or sell an asset
at a fixed price exposes an entity to fluctuations in the asset’s fair value
because the market price of the asset can change before the commitment is
fulfilled. If an entity has entered into a firm commitment to deliver a
commodity but does not already have the commodity in inventory, it may enter
into a derivative contract to purchase the commodity at a fixed price to hedge
that exposure.
The ASC master glossary defines a firm commitment, in part, as
an agreement between unrelated parties that (1) is “binding on both parties and
usually legally enforceable;” (2) “specifies all significant terms, including
the quantity to be exchanged, the fixed price, and the timing of the
transaction;” and (3) “includes a disincentive for nonperformance that is
sufficiently large to make performance probable.” (See the ASC master glossary
for the complete definition of a firm commitment.)
Disincentives include both monetary penalties and nonmonetary consequences, such
as exposure to costly litigation in the event of nonperformance (see ASC
815-25-55-84). In evaluating whether a monetary penalty is significant, an
entity should consider market volatility and the price risk of the asset
underlying the firm commitment.
Intercompany commitments do not meet the definition of a firm commitment because
they are not made with a third party. However, intercompany commitments that
have foreign currency exposure can be hedged as a forecasted transaction in a
foreign currency cash flow hedge (see Section
5.3.1.1.1).
In addition, a contract with an equity method investee does not
satisfy the criteria of a firm commitment because such a commitment must be made
with an unrelated party. Since the definition of “related parties” in ASC
850-10-20 includes an equity method investee, a contract does not qualify as a
firm commitment if it is between (1) an investor and its equity method investee
or (2) a subsidiary and an equity method investee of the subsidiary’s parent. As
discussed in Section 2.2.1.5, an entity is
permitted to hedge exposures related to forecasted transactions with an equity
method investee that are not eliminated through equity method accounting in a
cash flow hedge. However, if an entity has a fixed-price firm commitment with an
equity method investee, any transactions related to that firm commitment will no
longer have exposure to changes in cash flows related to any component of the
transaction with fixed terms.