3.2 Financial Instruments and Mortgage Servicing Rights

As discussed in Chapter 2, in a fair value hedge that involves existing financial assets and liabilities, an entity can designate a derivative instrument to hedge one or more specific risks of a hedged item. The table below summarizes the potential hedged items and risks in a fair value hedge of a financial asset, mortgage servicing right,1 or financial liability.

Underlying Asset or Liability	Hedgeable Portion	Risks That May Be Hedged
Fixed-rate asset or liability Mortgage servicing rights Net investment in lease (lessor) Portfolio of similar above items (see Section 2.2.2.2.1)	A proportion of a hedged item (see Section 2.2.2.1.1.1) Selected contractual cash flows (see Section 2.2.2.1.1.2) Embedded options (see Section 2.2.2.1.1.3) Unguaranteed residual value in a direct financing or sales-type lease (see Section 2.2.2.1.1.4) Entire asset or liability (or the entire portfolio)	Interest rate risk (see Section 2.3.1.1) Credit risk (see Section 2.3.1.2) Foreign currency risk (see Section 2.3.1.3) Overall risk (see Section 2.3.1.4)

Although in many fair value hedges the hedging derivative does not provide a perfectly effective offset to the total changes in fair value that are related to the hedged item, the ability to designate (1) select portions of the hedged item and (2) specific hedged risks may affect both the hedge effectiveness assessment discussed in Section 2.5 and how the hedged item is remeasured. In fact, thoughtful designation of such items can make the difference between a hedging relationship that qualifies for hedge accounting and a relationship that does not, which will also affect earnings.

For example, the hedged item in a qualifying fair value hedging relationship is remeasured for changes in its fair value that are attributable to the risk being hedged, not necessarily for all changes in its fair value during the period. By designating a component risk (or risks) that more closely aligns with the underlying risk (or risks) of the hedging instrument, an entity can significantly improve the amount of offset achieved in the income statement and, in some cases, achieve a perfectly effective hedging relationship. Further, in the assessment of hedge effectiveness, the change in the hedged item’s fair value that is attributable to the designated risk is also the amount that is compared with the change in the derivative’s fair value. Therefore, proper risk designation also increases an entity’s chances of having a highly effective hedging relationship that would qualify for hedge accounting.

3.2.1 Interest Rate Risk Hedging

Interest rate risk is the most common hedged risk related to financial instruments and mortgage servicing rights. Entities often hedge mortgage servicing rights, fixed-rate assets, or fixed-rate liabilities with derivatives that have an underlying that is based on a benchmark interest rate (e.g., derivatives based on U.S. Treasury rates or SOFR). As discussed in Section 2.3.1.1, the selection of interest rate risk as the hedged risk removes from the hedging relationship the changes in the hedged item’s fair value that are attributable to changes in credit spreads. As a reminder, an entity is prohibited from hedging HTM debt securities and embedded prepayment options in debt instruments for interest rate risk (see Sections 2.3.1.1.1 and 2.3.1.1.2).

ASC 815-25

35-13 In calculating the change in the hedged item’s fair value attributable to changes in the benchmark interest rate (see paragraph 815-20-25-12(f)(2)), the estimated coupon cash flows used in calculating fair value shall be based on either the full contractual coupon cash flows or the benchmark rate component of the contractual coupon cash flows of the hedged item determined at hedge inception.

If an entity selects interest rate risk as its designated risk in a fair value hedging relationship, it has two alternatives regarding how it defines the hedged interest cash flows when calculating the changes in the hedged item’s fair value that are attributable to the changes in the benchmark interest rate; the entity may look to either (1) the full contractual coupon cash flows or (2) the benchmark rate component of those contractual coupon cash flows. The alternative chosen will affect both the cash flows that will be the foundation of the present value calculation and the discount rate used for that calculation. If the entity looks to the full contractual coupon cash flows, the discount rate used in the measurement should incorporate the credit spread at inception. If the entity looks to the benchmark rate component of the contractual coupon cash flows, the discount rate should not incorporate a credit spread. In either case, the discount rate used at the end of each reporting period should reflect the rate used at the beginning of the hedging relationship, adjusted for changes in the benchmark interest rate. See Section 3.2.1.5 for further discussion of how to measure the changes in the hedged item that are attributable to changes in the benchmark interest rate under both alternatives. One way to determine the benchmark rate component of contractual coupons is by reference to the interest rate on the fixed leg of an interest rate swap that has the following terms:

The variable leg is based on the designated benchmark rate and has no spread.
The term of the swap matches the term of the hedged item (i.e., matches the portion of the debt being hedged).
Any prepayment terms in the debt during the term of the hedge are mirrored in the swap.
The swap has a fair value of zero at the inception of the hedging relationship.

For example, assume that an entity is hedging a 10-year fixed-rate debt instrument with no prepayment features for changes in the instrument’s fair value that are attributable to changes in the SOFR OIS rate. To determine the benchmark rate component of the contractual coupons, the entity would reference the rate on the fixed leg of an at-market interest rate swap that has (1) a variable leg that is repriced on the basis of the daily SOFR and (2) a term that matches the term of the hedged item (10 years).

Before the transition from LIBOR to SOFR, in most hedging relationships involving an at-market interest rate swap, we would have expected the benchmark rate component of the contractual coupons to match the rate on the fixed leg of the actual swap used (adjusted to remove any fixed spread that exists on the variable leg). Note that the swap does not necessarily need to qualify for the shortcut method (e.g., it does not need to be repriced at least every six months). However, as discussed in Section 2.3.1.1, ASU 2018-16 established the SOFR OIS rate as an acceptable benchmark rate; that rate is the overnight indexed swap rate and does not include swaps that use SOFR term rates for the variable leg. Therefore, an entity may construct a hypothetical at-market interest rate swap to determine the benchmark rate component of the contractual coupons if the hedging instrument is one of the following: (1) a swap that is not based on a benchmark interest rate (e.g., a term SOFR swap), (2) an off-market swap, or (3) not a swap. The example below, which is derived from Example 16 in ASC 815-25-55-100 through 55-108, illustrates this approach.

Example 3-1

Measurement of Hedged Item — Full Contractual Coupon Cash Flows Versus Benchmark Component of Contractual Coupon Cash Flows

On July 2, 20X0, Entity XYZ issues, at par, $100 million of A1-quality five-year fixed-rate debt with an annual 8 percent interest coupon payable semiannually. On that same date, XYZ also enters into a $100 million notional five-year receive-8 percent, pay-180-day Average SOFR + 200 basis points (i.e., current SOFR swap rate is 6 percent) interest rate swap that settles semiannually. Entity XYZ designates the swap as the hedging instrument in a fair value hedge of the interest rate risk of the $100 million liability. Assume that the SOFR swap rate increased by 100 basis points to 7 percent on December 31, 20X0.

The table below highlights the reduced impact on earnings that results from using the benchmark interest rate component of the contractual coupon cash flows to calculate the change in the hedged item’s fair value that is attributable to interest rate risk.

Note that the example above contains a few important simplifying assumptions that may affect the degree of hedge effectiveness, which in turn has an impact on the net effect on the income statement during the hedging relationship. Those simplifying assumptions are:

Fair value of derivative not impacted by changes in credit — In the example, it is assumed that there are no changes in the counterparty’s creditworthiness, credit, or funding spreads that would change the effectiveness of the hedging relationship. As noted in Section 2.5.2.1.2.6, the fair value of a derivative is affected by changes in the creditworthiness of both counterparties to the derivative. However, changes in creditworthiness that affect the derivative’s fair value during the life of the hedging relationship will not have an impact on the determination of changes in the hedged item’s fair value unless the shortcut method is applied.
The yield curve is flat — While, for simplicity, it is typically assumed in the examples in ASC 815 (including the example above) that there is a flat yield curve throughout the term of the hedging relationships, such a yield curve is actually quite rare. Therefore, any calculations of fair value should be consistent with the concepts in ASC 820, even though the hedged item will generally not be recognized at its full fair value because it is remeasured only (1) for changes in fair value that are attributable to the designated risk and (2) during the period in which it is in a qualifying fair value hedging relationship. If the yield curve is not flat, the actual discount rate that an entity uses in determining the fair value of each individual cash flow will depend on the timing of that specific cash flow.

An entity is permitted to designate a swap whose variable leg is an index other than the entity’s designated benchmark rate as a hedge of the interest rate risk related to the benchmark rate in fixed-rate debt. Accordingly, if an entity has fixed-rate debt outstanding and it designates a benchmark rate in a hedge of interest rate risk, the index on which the variable leg of the hedging interest rate swap is based does not have to be the benchmark rate. However, the hedging relationship would not qualify for the shortcut method in ASC 815-20-25-102 through 25-111 unless the index of the variable leg is the designated benchmark rate (see ASC 815-20-25-105(f)).

For example, assume that an entity has entered into an interest rate swap whose variable leg is based on the prime rate and, under the entity’s risk management policy, SOFR OIS is the designated benchmark rate for interest rate risk. In assessing hedge effectiveness, the entity will have to consider the basis difference between SOFR OIS and the prime rate. If the results of the entity’s assessment indicate that the hedging relationship is highly effective, hedge accounting would be appropriate. However, when the entity is measuring the change in the hedged item’s fair value that is due to changes in the designated benchmark interest rate, it should consider changes in the designated benchmark interest rate (i.e., SOFR OIS) and not changes in the rate referenced in the swap (i.e., the prime rate). If it is later determined that the hedge of SOFR interest rate risk with a swap whose variable leg is based on the prime rate is not highly effective, hedge accounting would be discontinued.

3.2.1.1 Partial-Term Hedging

ASC 815-25

35-13B For a fair value hedge of interest rate risk in which the hedged item is designated for a partial term in accordance with paragraph 815-20-25-12(b)(2)(ii), an entity may measure the change in the fair value of the hedged item attributable to interest rate risk using an assumed term that begins when the first hedged cash flow begins to accrue and ends at the end of the designated hedge period. The assumed issuance of the hedged item occurs on the date that the first hedged cash flow begins to accrue. The assumed maturity of the hedged item occurs at the end of the designated hedge period. An entity may measure the change in fair value of the hedged item attributable to interest rate risk in accordance with this paragraph when the entity is designating the hedged item in a hedge of both interest rate risk and foreign exchange risk. In that hedging relationship, the change in carrying value of the hedged item attributable to foreign exchange risk shall be measured on the basis of changes in the foreign currency spot rate in accordance with paragraph 815-25-35-18. Additionally, an entity may have one or more separately designated partial-term hedging relationships outstanding at the same time for the same debt instrument (for example, 2 outstanding hedging relationships for consecutive interest cash flows in Years 1‒3 and consecutive interest cash flows in Years 5‒7 of a 10-year debt instrument).

As discussed in Section 2.2.2.1.1.2, an entity may hedge one or more selected contractual cash flows of an item (or a portfolio of items) in a fair value hedging relationship. A hedge of some, but not all, of the contractual cash flows of a debt instrument is commonly referred to as a partial-term hedge. Before the issuance of ASU 2017-12, it was difficult for an entity to qualify for hedge accounting when designating a partial-term hedge, but ASU 2017-12 and ASU 2019-04 changed how an entity measures changes in a hedged item’s fair value that are attributable to changes in the designated risk for partial-term hedges, which in turn affects the hedge effectiveness assessment. In addition, ASU 2017-12 amended the shortcut method criteria to allow partial-term hedges to qualify for the shortcut method.

ASC 815-25-35-13B states that in a fair value hedge of interest rate risk, an entity may measure the change in the hedged item’s fair value that is attributable to changes in the benchmark interest rate by “using an assumed term that begins when the first hedged cash flow begins to accrue and ends at the end of the designated hedge period.” By using an assumed term that ends at the end of the designated hedge period, the entity assumes that the remaining principal payment will occur at the end of the specified partial term.

Example 3-2

Partial-Term Hedge

TreyCo issues $100 million of five-year noncallable fixed-rate debt. It enters into an at-market two-year receive-fixed, pay-variable (SOFR overnight) interest rate swap with a notional amount of $100 million and designates the swap as a fair value hedge of the interest rate risk for the first two years of the debt’s term. When TreyCo calculates the change in the debt’s fair value that is attributable to changes in the benchmark interest rate (SOFR OIS), it may assume for calculation purposes that (1) the term of the hedged debt is two years and (2) repayment of the outstanding debt occurs at the end of the second year. If TreyCo also elects to measure the changes in the debt’s fair value that are attributable to changes in SOFR OIS on the basis of the benchmark rate component of the contractual coupon cash flows, it may assume the benchmark rate component of the coupons would be equal to the fixed rate on the swap.

When an entity designates a partial-term fair value hedge, it may, in accordance with ASC 815-20-25-12(b)(2)(ii), designate any single interest payment or any consecutive interest payments associated with the debt instrument as the hedged partial term. The entity is not required to designate the first scheduled contractual interest payment as the first payment in the hedged partial term; therefore, partial-term hedging also applies to hedging strategies that involve forward-starting swaps (see Example 2-2). As noted above, under ASC 815-25-35-13B, the entity would measure the change in the debt’s fair value that is attributable to interest rate risk by “using an assumed term that begins when the first hedged cash flow begins to accrue and ends at the end of the designated hedge period.”

Furthermore, for prepayable instruments, if the designated hedged partial term ends on or before the date on which the instrument may be prepaid, the designated hedged item is essentially not prepayable. Therefore, the entity does not need to consider prepayment risk for such a hedging relationship when determining hedge effectiveness or measuring changes in the hedged item’s fair value that are attributable to interest rate risk (which aligns with how an entity would consider prepayment risk in a partial-term cash flow hedge of a callable instrument).

An entity should account for any basis adjustments made to the hedged item’s carrying value in a partial-term hedging relationship in accordance with its hedging policies. Under ASC 815, any method of amortization must result in amortization of the basis adjustments over the life of the hedging relationship, not the life of the debt instrument. Accordingly, if an entity elects to amortize the basis adjustments during the hedging relationship (see Section 3.2.5), the period of amortization would match the term of the hedge (i.e., amortization would occur up to the assumed maturity date). Upon an early termination of the hedging relationship, the entity should amortize any remaining carrying amount adjustments in a manner consistent with how it amortizes any other premiums or discounts for the hedged item (generally over the remaining life of the debt instrument).

3.2.1.1.1 Multiple Concurrent Partial-Term Hedges of Same Hedged Item

An entity can have multiple partial-term hedging relationships involving the same hedged item outstanding at the same time. However, the same hedged cash flows may not be designated as the hedged item in more than one outstanding hedging relationship at the same time. ASU 2019-04 added the following to ASC 815-25-35-13B:

[A]n entity may have one or more separately designated partial-term hedging relationships outstanding at the same time for the same debt instrument (for example, 2 outstanding hedging relationships for consecutive interest cash flows in Years 1–3 and consecutive interest cash flows in Years 5–7 of a 10-year debt instrument).

3.2.1.1.2 Partial-Term Hedging for Risks Other Than Interest Rate Risk

After the issuance of ASU 2017-12, questions arose about whether the ability to measure the change in the fair value of the hedged item in a partial-term fair value hedge by using the item’s assumed term only applies to hedges of interest rate risk or whether the change in the fair value of the hedged item in a partial-term fair value hedge of both interest rate risk and foreign exchange risk also can be measured by using the instrument’s assumed term. In response, ASU 2019-04 added the following to ASC 815-25-35-13B:

An entity may measure the change in fair value of the hedged item attributable to interest rate risk in accordance with this paragraph when the entity is designating the hedged item in a hedge of both interest rate risk and foreign exchange risk. In that hedging relationship, the change in carrying value of the hedged item attributable to foreign exchange risk shall be measured on the basis of changes in the foreign currency spot rate in accordance with paragraph 815-25-35-18.

As a result of this clarification, partial-term hedging is allowed for interest rate risk, foreign currency risk, or a combination of those risks, but ASC 815-25-35-18 already requires any asset or liability that is denominated in a foreign currency to be remeasured for changes in foreign currency exchange rates in accordance with ASC 830 (i.e., on the basis of the spot exchange rate as of the balance sheet date). For example, ASC 830 already requires a foreign-currency-denominated debt instrument to be translated on the basis of the spot exchange rate as of the balance sheet date. Accordingly, the maturity date of a debt instrument (actual or assumed) is irrelevant when the instrument is remeasured for changes in its fair value that are attributable to changes in foreign currency exchange rates.

3.2.1.2 Prepayable Debt

ASC 815-20

Fair Value Hedges of Interest Rate Risk in Which the Hedged Item Can Be Settled Before Its Scheduled Maturity

25-6B An entity may designate a fair value hedge of interest rate risk in which the hedged item is a prepayable instrument in accordance with paragraph 815-20-25-6. The entity may consider only how changes in the benchmark interest rate affect the decision to settle the hedged item before its scheduled maturity (for example, an entity may consider only how changes in the benchmark interest rate affect an obligor’s decision to call a debt instrument when it has the right to do so). The entity need not consider other factors that would affect this decision (for example, credit risk) when assessing hedge effectiveness. Paragraph 815-25-35-13A discusses the measurement of the hedged item.

ASC 815-25

35-13A In a hedge of interest rate risk in which the hedged item is a prepayable instrument in accordance with paragraph 815-20-25-6, the factors incorporated for the purpose of adjusting the carrying amount of the hedged item shall be the same factors that the entity incorporated for the purpose of assessing hedge effectiveness in accordance with paragraph 815-20-25-6B. For example, if an entity considers only how changes in the benchmark interest rate affect an obligor’s decision to prepay a debt instrument when assessing hedge effectiveness, it shall consider only that factor when adjusting the carrying amount of the hedged item. The election to consider only how changes in the benchmark interest rate affect an obligor’s decision to prepay a debt instrument does not affect an entity’s election to use either the full contractual coupon cash flows or the benchmark rate component of the contractual coupon cash flows determined at hedge inception for purposes of measuring the change in fair value of the hedged item in accordance with paragraph 815-25-35-13.

ASU 2017-12 also significantly changed how, under ASC 815, an entity may evaluate the impact of prepayment features when measuring the change in the hedged item’s fair value that is attributable to changes in the designated benchmark interest rate. As noted in paragraph BC99 of ASU 2017-12, the FASB was responding to concerns that “estimating the fair value of the prepayment option to the level of precision required in the current reporting and regulatory environment is virtually impossible because an entity is required to incorporate credit and all other idiosyncratic factors that would affect the prepayment option.” If we assume that entities act on the basis of available market information and in a timely manner, an issuer of a callable debt instrument will exercise its right to prepay the debt on the basis of changes in its market borrowing rate, which include both changes in the benchmark interest rate and changes in credit spreads. Even if a prepayment option is “mirrored” in an interest rate swap, the decision to terminate an interest rate swap would only be based on changes in the underlying rate of the swap, which would not include changes in credit spreads. In addition, as noted in paragraph BC99 of ASU 2017-12, borrowers do not always exercise prepayment options when it makes sense to do so since there may be idiosyncratic factors at play. For example, borrowers are required to prepay residential mortgage loans upon the sale of the underlying property, which is often driven by non-market-based factors (e.g., death, relocation).

In addition, ASU 2017-12 added ASC 815-20-25-6B, which allows an entity that is assessing hedge effectiveness to elect to “consider only how changes in the benchmark interest rate affect the decision to settle the hedged item before its scheduled maturity.” This decision also affects the measurement of the change in the hedged item’s fair value that is attributable to changes in the designated benchmark interest rate; ASC 815-25-35-13A states that “the factors incorporated for the purpose of adjusting the carrying amount of the hedged item shall be the same factors that the entity incorporated for the purpose of assessing hedge effectiveness in accordance with paragraph 815-20-25-6B.” An entity may also elect to consider all factors that would affect its decision to settle the hedged item before its scheduled maturity when (1) assessing hedge effectiveness and (2) measuring the change in the hedged item’s fair value that is attributable to changes in the designated benchmark interest rate. However, we do not expect many entities to do so since considering all factors would increase the sources of ineffectiveness in most cases. In fact, the sources of ineffectiveness might be great enough to prevent many hedging relationships from being considered highly effective.

So, what happens when an entity only considers how changes in the benchmark interest rate affect the decision to settle the hedged item before its scheduled maturity? One impact is that an investor in a callable debt instrument can consider only how changes in the benchmark interest rate will affect an obligor’s decision to call the debt instrument. The investor is not required to consider all factors that will affect the decision to settle the financial instrument before its scheduled maturity when assessing hedge effectiveness and measuring the change in the debt’s fair value that is attributable to changes in the benchmark interest rate.

If an entity designates interest rate risk as the hedged risk in a fair value hedge of a prepayable financial instrument and elects to consider only how changes in the benchmark interest rate affect the decision to settle the hedged item before its scheduled maturity, one acceptable way to determine the change in the instrument’s fair value attributable to interest rate risk is to assume that the credit spread of the issuer remains fixed over the life of the hedging relationship.

Example 3-3

Determining Change in Fair Value of Prepayable Debt Attributable to Benchmark Interest Rate

InvestorCo holds a $1 million 10-year debt instrument issued by DebtCo, which can call the debt at par any time after the 5-year anniversary of the debt issuance. The debt pays interest semiannually at 6 percent per annum. Also assume that InvestorCo enters into an at-market pay-fixed, receive-variable interest rate swap with a notional amount of $1 million and a term of 10 years. InvestorCo will receive daily SOFR and pay 4 percent per annum semiannually. It can terminate the swap at any time after five years. When determining the fair value of the debt in periods after the issuance, InvestorCo would assume that the market rate on the debt is 200 basis points (6% – 4%) above the swap rate for an interest rate swap that (1) has a life that matches the remaining life of the debt and (2) can be terminated by InvestorCo at any time after the five-year anniversary of the debt’s issuance. The swap rate is the rate on the fixed leg of a swap that has a fair value of zero.

Note that if the hedged item is convertible debt and the hedged risk is interest rate risk, the analysis would not take into account any early conversions or exercises of call options that would be triggered by the value of the underlying equity instruments. This is because such events, which would qualify as prepayments, do not result from changes in the benchmark interest rate.

Also, as noted in Section 3.2.1.1, if an entity designates a partial-term fair value hedge and the designated partial term ends on or before the date on which the instrument may be prepaid, the designated hedged item is essentially not prepayable. Therefore, the entity does not need to consider prepayment risk for such hedging relationships when it determines hedge effectiveness or measures changes in the fair value of the hedged item. Note that all other references to “scheduled maturity” in ASC 815-20-25-6B and in the discussion above should be interpreted as referring to the assumed maturity in a partial-term fair value hedging relationship.

3.2.1.2.1 Contingent Prepayment Terms

The ASC master glossary defines prepayable as “[a]ble to be settled by either party before its scheduled maturity.” At its February 14, 2018, meeting, the FASB staff indicated, and the Board agreed, that in most circumstances, an entity should look to this broad definition when determining whether an instrument is prepayable.

Therefore, an instrument with noncontingent prepayment features that are exercisable at any time is considered prepayable. In addition, an instrument with features that make it prepayable upon the passage of a specified amount of time, or conversion features (with or without a call option) that could require the issuer to convert debt into equity, would also be prepayable if, under the contractual terms of the instrument, those features could be triggered before its maturity date. An instrument with a prepayment feature in which the timing of exercisability is unknown (e.g., an event-based contingency or a contingency that is triggered by specified interest rate movements) also would qualify as being prepayable because the contingency could be resolved at any time during the instrument’s life.

If an entity designates an instrument that is considered prepayable as the hedged item in a fair value hedge of interest rate risk, it will generally elect to only take into account how those features are affected by changes in the benchmark interest rate when analyzing the prepayment features for its (1) assessment of hedge effectiveness under ASC 815-20-25-6B and (2) measurement of the change in the hedged item’s fair value that is attributable to changes in the benchmark interest rate under ASC 815-25-35-13A. ASC 815-20-25-6B states, in part, that an entity “may consider only how changes in the benchmark interest rate affect the decision to settle the hedged item before its scheduled maturity,” and ASC 815-25-35-13A requires “the factors incorporated for the purpose of adjusting the carrying amount of the hedged item [to] be the same factors that the entity incorporated for the purpose of assessing hedge effectiveness.”

Below are examples of instruments that are considered prepayable. If such an instrument is designated as the hedged item in a fair value hedge of interest rate risk, an entity should consider the effects of the prepayment features as follows:

An instrument in which the entity’s ability to prepay is triggered by the occurrence of a specified event that is unrelated to changes in the benchmark rate — If the entity considers only how changes in the benchmark interest rate affect the decision to settle the hedged item before its maturity, its assessment of hedge effectiveness and measurement of the hedged item should ignore the contingent feature until the specified event occurs because changes in the benchmark interest rate do not affect the timing of the event. After the contingency is resolved (i.e., after the event that triggers the prepayment feature occurs), the entity would consider the effect of the prepayment feature in its assessment of hedge effectiveness and measurement of the hedged item only to the extent that changes in the benchmark interest rate would affect the entity’s decision to prepay.
An instrument with an interest-rate–related contingency — When the entity assesses hedge effectiveness and measures the change in hedged item’s fair value that is attributable to interest rate risk, it must consider both (1) interest rate fluctuations that could trigger the contingency and (2) “the probability of exercise given the interest rate scenario (only considering the effects of the benchmark interest rate),” as indicated in the FASB’s “Staff Interpretations of Update 2017-12 for Prepayable Financial Instruments.” However, if the contingency is related to movements in a nonbenchmark interest rate, the entity may ignore the effects of any movements in the actual referenced rate that differ from movements in the benchmark interest rate. In essence, the entity is allowed to assume that there is a fixed spread between the benchmark interest rate and the interest rate linked to the contingency.
A debt instrument with a conversion feature — As stated in “Staff Interpretations of Update 2017-12 for Prepayable Financial Instruments,” when an entity assesses hedge effectiveness or measures the changes in the hedged item’s fair value that are attributable to changes in the benchmark interest rate, it should “consider only how changes in benchmark interest rates affect the decision to prepay,” even though changes in equity prices and equity volatility and dividend considerations historically have been much more significant factors in such decisions. Note that the occurrence of a conversion before the instrument’s contractual maturity is considered a “prepayment” in this context since the instrument would be settled before its scheduled maturity.

3.2.1.3 Shortcut Method

As discussed in Section 2.5.2.2.1, the shortcut method is used to account for certain hedging relationships in which interest rate swaps hedge interest rate risk in existing debt instruments. The shortcut method cannot be applied to hedges of mortgage servicing rights since such rights do not meet the definition of a debt instrument because of the performance obligation required by the servicer. If a hedging relationship qualifies for the shortcut method, it is assumed to be a “perfect” hedging relationship, so the entity does not need to perform quantitative assessments at any time during the hedging relationship. Section 2.5.2.2.1 primarily focuses on the conditions that need to be met for a hedging relationship to qualify for the shortcut method.

When the shortcut method is applied to a fair value hedging relationship, the hedged item is a fixed-rate debt instrument (asset or liability) and the hedging instrument is an interest rate swap that effectively converts the fixed cash flows on the debt instrument into a variable rate based on the designated benchmark interest rate. The application of the shortcut method combines synthetic instrument accounting with the recognition of derivative instruments at fair value on the balance sheet 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. In a fair value hedge, an entity adjusts the carrying amount of the hedged debt in an amount equal to and offsetting the change in the derivative’s fair value. The shortcut method may be applied to either a full-term or partial-term fair value hedging relationship, but it may not be applied to a partial-term hedging relationship that involves a forward-starting swap (see Example 2-32).

As noted in Section 2.5.2.2.1.8, an entity needs to monitor the nonperformance risk of both parties to the interest rate swap because if it is no longer probable that both parties will perform under the swap, the continued application of the shortcut method is no longer appropriate.

In addition, as noted in Section 2.5.2.2.1.9, if the application of the shortcut method is no longer appropriate (for any reason) but the entity has documented a backup quantitative hedge effectiveness assessment method, it may still be appropriate for the entity to apply hedge accounting if the hedging relationship is still highly effective.

Section 3.2.7 includes detailed illustrations of the application of the shortcut method to a full-term fair value hedging relationship (see Example 3-6) and a partial-term fair value hedging relationship (see Example 3-8).

3.2.1.4 Portfolio Layer Method

ASC 815 — Glossary

Hedged Layer

The hedged item designated in a portfolio layer method hedging relationship, representing a stated amount or stated amounts of a closed portfolio of financial assets or one or more beneficial interests secured by a portfolio of financial instruments that is not expected to be affected by prepayments, defaults, or other factors affecting the timing and amount of cash flows for the designated hedge period.

ASC 815-20

25-12A For a closed portfolio of financial assets or one or more beneficial interests secured by a portfolio of financial instruments, an entity may designate as the hedged item or items a hedged layer or layers if the following criteria are met (this designation is referred to throughout Topic 815 as the “portfolio layer method”):

As part of the initial hedge documentation, an analysis is completed and documented to support the entity’s expectation that the hedged item or items (that is, the hedged layer or layers in aggregate) is anticipated to be outstanding for the designated hedge period. That analysis shall incorporate the entity’s current expectations of prepayments, defaults, and other factors affecting the timing and amount of cash flows associated with the closed portfolio.
For purposes of its analysis in (a), the entity assumes that as prepayments, defaults, and other factors affecting the timing and amount of cash flows occur, they first will be applied to the portion of the closed portfolio that is not hedged.
The entity applies the partial-term hedging guidance in paragraph 815-20-25-12(b)(2)(ii) to the assets or beneficial interest used to support the entity’s expectation in (a). An asset that matures on a hedged layer’s assumed maturity date meets this requirement.

See paragraphs 815-25-55-1A through 55-1E for implementation guidance related to a closed portfolio with multiple hedged layers.

25-12B After a closed portfolio is established in accordance with paragraph 815-20-25-12A, an entity may designate new hedging relationships associated with the closed portfolio without dedesignating any existing hedging relationships associated with the closed portfolio if the criteria in paragraph 815-20-25-12A are met for those newly designated hedging relationships.

Consideration of Prepayment Risk Using the Portfolio Layer Method

25-118A In a fair value hedge of interest rate risk designated under the portfolio layer method in accordance with paragraph 815-20-25-12A, an entity may exclude prepayment risk (if applicable) when measuring the change in fair value of the hedged item attributable to interest rate risk.

ASC 815-25

Existing Portfolio Layer Method Hedges

35-7A For each closed portfolio with one or more hedging relationships designated and accounted for under the portfolio layer method in accordance with paragraph 815-20-25-12A, an entity shall perform and document at each effectiveness assessment date an analysis that supports the entity’s expectation that the hedged layer or layers in aggregate is still anticipated to be outstanding for the designated hedge period. That analysis shall incorporate the entity’s current expectations of prepayments, defaults, and other factors affecting the timing and amount of cash flows associated with the closed portfolio using a method consistent with the method used to perform the analysis in paragraph 815-20-25-12A(a) and (b).

Hedged Item Is Designated Under the Portfolio Layer Method

Voluntary Dedesignations

40-7A An entity may elect to discontinue (or partially discontinue) hedge accounting prospectively for all or a portion of the hedged layer for one or more hedging relationships associated with the closed portfolio at any time if a breach has not occurred in accordance with paragraph 815-25-40-8(b) and a breach is not anticipated in accordance with paragraph 815-25-40-8(a). If multiple hedged layers are associated with the closed portfolio, the entity may voluntarily elect to dedesignate (or partially dedesignate) any hedges associated with that closed portfolio.

In March 2022, the FASB issued ASU 2022-01, which clarified the guidance in ASC 815 on fair value hedge accounting of interest rate risk for portfolios of financial assets. The ASU amended the guidance in ASU 2017-12 that, among other things, established the “last-of-layer” method for making the fair value hedge accounting for these portfolios more accessible. ASU 2022-01 renamed that method the “portfolio layer” method and addressed feedback from stakeholders regarding its application.

The portfolio layer method permits entities to designate, as the hedged item in a fair value hedge of interest rate risk, a stated amount or stated amounts (each a “layer”) of a closed portfolio2 of financial assets or beneficial interests (or both) that is not expected to be affected by prepayments, defaults, or other factors influencing the timing or amount of cash flows. This designation would occur in conjunction with the partial-term hedging election discussed in Section 3.2.1.1. By isolating the hedged item(s) in this manner, entities eliminate the need to consider prepayment risk or credit risk when measuring those assets. The portfolio layer method cannot be applied to liabilities, so the issuer of an MBS could not hedge the issued security under the portfolio layer method. In addition, the method is not available for hedges of mortgage servicing rights because such rights do not meet the definition of a financial asset. Finally, the portfolio layer method cannot be applied to cash flow hedging relationships.

To support designation of a portfolio layer method hedging relationship, the entity should include evidence that it performed an analysis that reinforced its expectation that the hedged item or items (i.e., the hedged layer or layers in aggregate) would be outstanding for the designated hedge period in the initial hedge designation. That analysis should reflect the entity’s current expectations about factors that can affect the timing and amount of the closed portfolio’s (or, for beneficial interests, the underlying assets’) cash flows (e.g., prepayments or defaults); however, the entity should assume that the effects of any events, such as prepayments or defaults, would first apply to the portion of the closed portfolio that is not hedged.

As of each subsequent hedge effectiveness assessment date, the entity must continue to update its analysis supporting the expectation that the hedged item (i.e., the layer) will be outstanding for the designated hedge period. The updated analysis should reflect the entity’s current expectations about the level of prepayments, defaults, or other factors that could affect the timing and amount of cash flows. When updating its analysis, the entity should use the same methods as those used at hedge inception.

With respect to hedging instruments designated in a portfolio layer method hedge, ASU 2022-01 clarified that an entity has the flexibility to use any type of derivative or combination of derivatives (e.g., spot-starting constant-notional swaps with different term lengths, a combination of spot-starting and forward-starting constant-notional swaps, amortizing-notional swaps) by applying the multiple-layer model that aligns with its risk management strategy. Further, at any time after the initial hedge designation, new hedging relationships associated with the closed portfolio may be designated in accordance with ASC 815-20-25-12B, and existing hedging relationships associated with the portfolio may be dedesignated to align with an entity’s evolving strategy for managing interest rate risk.

Connecting the Dots

ASU 2022-01 did not change the requirement that a hedged portfolio in a single fair value hedge must consist only of “similar” assets that share the risk exposure for which they are designated as being hedged. However, an entity that applies the portfolio layer method may qualitatively satisfy this criterion if it combines the partial-term fair value hedge election (see Section 3.2.1.1) and the election to measure changes in the hedged item’s fair value by using the benchmark rate component of the contractual coupon cash flows (see Section 3.2.1).

When an entity accounts for a hedging relationship that is designated under the portfolio layer method, it may exclude prepayment risk and credit risk when measuring the change in the hedged item’s fair value that is attributable to changes in interest rate risk. Also, on each reporting date, the entity should adjust the basis of the hedged item for the gain or loss that is attributable to changes in the hedged risk (i.e., interest rate risk), as it would do for any other fair value hedge. However, in a portfolio layer method hedge, the hedged item is a closed portfolio of financial assets, so the basis adjustment is a portfolio-level basis adjustment. In accordance with ASC 815-25-35-1(c), such a portfolio-level basis adjustment “shall not adjust the carrying value of the individual beneficial interest or individual assets in or removed from the closed portfolio.” As discussed below, by using a systematic and rational method, an entity must allocate the basis adjustment associated with the designated amount to the remaining individual assets within the portfolio upon a full or partial discontinuance (including as a result of a breach) of the portfolio layer method hedge. The shortcut method may not be applied to a portfolio layer method hedge.

In accordance with ASC 815-25-40-8(a), if an entity concludes on any hedge effectiveness assessment date that it no longer anticipates that the hedged layer or layers will be outstanding for the designated hedge period, it must “discontinue (or partially discontinue) hedge accounting for [that] portion of the hedged [layer] that is no longer anticipated to be outstanding for the designated hedge period.” Similarly, in accordance with ASC 815-25-40-8(b), if an entity concludes on any assessment date that “the outstanding amount of the closed portfolio of financial assets or one or more beneficial interests [in the financial assets] is less than the hedged layer or layers . . . , the entity shall discontinue (or partially discontinue) hedge accounting” for the portion of the hedged layer that is breached. If an anticipated breach under ASC 815-25-40-8(a) or an actual breach under ASC 815-25-40-8(b) has not occurred, the entity may voluntarily elect to discontinue or partially discontinue hedge accounting on a prospective basis for all or a portion of a hedged layer at any time in accordance with ASC 815-25-40-7A. In these cases, if there are multiple hedged layers in the closed portfolio, an entity may fully discontinue or partially discontinue any hedge associated with that portfolio.

Alternatively, if an entity determines that a breach is either anticipated or has occurred and there are multiple hedged layers associated with the closed portfolio, it must determine which hedge or hedges to discontinue or partially discontinue by using a systematic and rational approach in accordance with its accounting policy. As indicated in ASC 815-25-40-8A, an entity should “establish its accounting policy no later than when it first anticipates a breach or when a breach has occurred (whichever comes first)” and “consistently apply its accounting policy to all portfolio layer method breaches (anticipated and occurred).” If an entity discontinues a full or partial hedge in a voluntary dedesignation or in anticipation of a breach, it must allocate, in a systematic and rational manner, the outstanding basis adjustment (or portion thereof) that resulted from the discontinued portion of the hedging relationship(s) to the individual assets in the closed portfolio. Under ASC 815-25-40-9, such allocated amounts must be amortized over a period “that is consistent with the amortization of other discounts or premiums associated with the respective assets.” However, if an entity is required to discontinue a portion of a portfolio layer method hedging relationship because the outstanding balance of the hedged item is less than the hedged layer (i.e., a breach has occurred), the entity should (1) reverse a portion of the portfolio basis adjustment by using a systematic and rational method through interest income for the portion of the hedged layer that no longer exists and (2) disclose the specific amount and cause of the breach, in accordance with ASC 815-25-40-9A. See Section 3.5 for further discussion of dedesignating and discontinuing fair value hedges.

Connecting the Dots

The portfolio layer method does not specifically incorporate a tainting threshold; therefore, an entity that is required to discontinue a portfolio layer method hedging relationship is not precluded from designating similar hedging relationships in the future. However, we believe that an entity that needs to dedesignate a portfolio layer method hedging relationship, partially or fully, should consider the reasons for the dedesignation when performing similar analyses for future portfolio method layer hedges.

3.2.1.4.1 Illustrative Examples

ASC 815-20

Hedged Item in a Portfolio Layer Method Hedge

55-15A This implementation guidance describes the hedged item in a portfolio layer method hedge in several scenarios.

Scenario A

55-15B For a closed portfolio of financial assets of $100 million, Entity A designates a single hedged item of $10 million of the assets that is expected to be outstanding for the hedge period of Years 1–5. Entity A designates as the hedging instrument a spot-starting constant-notional pay-fixed, receive-variable interest rate swap with a notional amount of $10 million and a term of 5 years. In this single-layer hedge, the hedged layer represents $10 million of assets in the closed portfolio that is not expected to be affected by prepayments, defaults, or other factors affecting the timing or amount of cash flows for the hedge period of Years 1–5.

Scenario B

55-15C For a closed portfolio of financial assets of $100 million, Entity A designates a hedged item of $20 million of assets that is expected to be outstanding for the hedge period of Years 1–3. It also designates a hedged item of $10 million of the assets in the closed portfolio that is expected to be outstanding for the hedge period of Years 1–5. For the $20 million hedged item, Entity A designates as the hedging instrument a spot-starting constant-notional pay-fixed, receive-variable interest rate swap with a notional amount of $20 million and a term of 3 years. For the $10 million hedged item, Entity A designates as the hedging instrument a spot-starting constant-notional pay-fixed, receive-variable interest rate swap with a notional amount of $10 million and a term of 5 years. In this scenario, there are two hedged layers:

A hedged layer representing $20 million of assets in the closed portfolio that is not expected to be affected by prepayments, defaults, or other factors affecting the timing or amount of cash flows for the hedge period of Years 1–3
A hedged layer representing $10 million of assets in the closed portfolio that is not expected to be affected by prepayments, defaults, or other factors affecting the timing or amount of cash flows for the hedge period of Years 1–5.

Although the $10 million and $20 million hedged layers are separately designated, Entity A should consider the aggregate hedged amount of $30 million in Years 1–3 when assessing whether the hedged layers are anticipated to be outstanding in accordance with paragraphs 815-20-25-12A(a) and 815-25-35-7A.

Scenario C

55-15D For a closed portfolio of financial assets of $100 million, Entity A designates a single hedged item of $30 million for Year 1 that decreases to an amount of $20 million for Year 2 and $10 million for Year 3. Entity A designates a single amortizing-notional swap as the hedging instrument. In this single-layer hedge, the hedged layer represents a $30 million stated amount for Year 1, a $20 million stated amount for Year 2, and a $10 million stated amount for Year 3, which reflects the amortizing-notional swap’s features.

ASC 815-25

Implementation Guidance

Portfolio Layer Method Hedges — Multiple Hedged Layers

55-1A This implementation guidance demonstrates how an entity should apply the following aspects of the portfolio layer method if it elects to designate multiple hedged layers of a single closed portfolio:

Performing the similar-asset assessment upon initial designation of a portfolio layer method hedge
Evaluating whether the entity may continue to apply the guidance for a portfolio layer method hedge after initial designation.

55-1B For the purposes of illustrating the guidance in paragraph 815-25-55-1A, the implementation guidance in paragraphs 815-25-55-1C through 55-1D assumes that Entity A designates multiple hedged layers of a closed portfolio of 5-year and 10-year prepayable loans originated on the hedge inception date.

Similar-Asset Assessment at Hedge Designation

55-1C Entity A designates hedged layers with assumed maturity dates of three years and seven years, respectively. When applying the similar-asset assessment for a portfolio hedge in accordance with paragraph 815-20-25-12(b)(1), Entity A should consider all assets in the closed portfolio for the 3-year hedged layer but consider only the 10-year assets for the 7-year hedged layer. That is, an entity should consider the assets that support the hedged layer.

Subsequent Assessment

55-1D After initial hedge designation, Entity A should continue to assess whether the individual three-year and seven-year hedged layers meet the requirements in paragraph 815-25-35-7A on the basis of the same assets used to perform the similar-asset assessments in accordance with paragraph 815-25-55-1C. For Years 1–3, the entity should consider whether the hedged layers in aggregate are anticipated to be outstanding.

Example 3-4

Portfolio Layer Method Hedge

Weekapaug Regional Bank has a portfolio (“Portfolio X”) of fixed-rate prepayable residential mortgages with stated maturities of up to 30 years. The fixed rates and maturity dates of the mortgages vary. The current outstanding principal balance of the pool of mortgages is $300 million.

Weekapaug wants to hedge its exposure to changes in the fair value of the mortgages in Portfolio X that are attributable to changes in the benchmark interest rate over the next 5- and 10-year periods. On the basis of its current expectations about the levels of prepayments, defaults, and other factors that could affect the timing and amount of cash flows in Portfolio X, Weekapaug believes that the outstanding unpaid principal balance will not fall below $200 million at the end of the 5-year period and $50 million at the end of the 10-year period. With that in mind, it executes (1) a 10-year, receive-variable (daily SOFR), pay-fixed interest rate swap with a notional amount of $50 million and (2) a 5-year, receive-variable (daily SOFR), pay-fixed interest rate swap with a notional amount of $150 million to hedge the interest rate risk of each layer.

Portfolio Layer Method — Application at Inception

Weekapaug designates as the first hedged item interest receipts on the last $50 million of unpaid principal balance within Portfolio X over the next 10 years (i.e., a partial-term hedge election) and elects to measure the hedged item (i.e., $50 million layer) by using the benchmark rate component (SOFR OIS) of the contractual coupon cash flows.
Weekapaug designates as the second hedged item interest receipts on the last previously unhedged $150 million of unpaid principal balance within Portfolio X over the next five years (i.e., a partial-term hedge election) and elects to measure the hedged item (i.e., $150 million layer) by using the benchmark rate component (SOFR OIS) of the contractual coupon cash flows.
In accordance with ASC 815, Weekapaug (1) performs an analysis that supports its expectation that the hedged items will be outstanding as of the designated hedge periods and (2) documents its conclusion that the $300 million of mortgages in Portfolio X are similar.
Because both the designated $50 million of unpaid principal balance (the first layer) and the designated $150 million of unpaid principal balance (the second layer) are expected to be outstanding at the end of the specified hedge terms, Weekapaug can ignore prepayment risk and default risk when assessing whether the hedging relationships are expected to be highly effective.

Portfolio Layer Method — Application in Subsequent Reporting Periods

Because of the combined effect of Weekapaug’s (1) elections related to the partial-term hedges, (2) use of the benchmark rate component of the coupons, and (3) portfolio layer method designation, the hedged layers are essentially transformed into homogeneous groups of loans and cash flows within Portfolio X. As a result, Weekapaug can ignore contractual principal payments, prepayments, and defaults for measurement purposes and avoid having to assess after hedge inception whether the assets in Portfolio X are still similar.
The designated hedging relationships will pass the quarterly hedge effectiveness assessment because the key terms of the hedging relationships match (although the shortcut method may not be applied).
Weekapaug will account for the hedge accounting basis adjustments that arise during the hedging relationships at the Portfolio X level (i.e., the level of the designated hedged items).
As of each effectiveness testing date, Weekapaug will perform an analysis to support its expectation that the unpaid principal balance will be no less than (1) $50 million at the end of the 10-year hedge period and (2) $200 million ($50 million + $150 million; i.e., the designated hedged exposures) at the end of the 5-year hedge period:
- Anticipated breach — If Weekapaug concludes on any assessment date that it expects the outstanding balance of Portfolio X to be less than $50 million or $200 million at the end of the 10-year or 5-year designated hedge period, respectively, it would be required to (1) discontinue hedge accounting for at least the portion of the designated layer that it no longer expects to be outstanding for the designated hedge period in accordance with its accounting policy3 and (2) allocate the related portion of the outstanding basis adjustment to the remaining individual assets in the closed portfolio by using a systematic and rational method.
- Actual breach — If the outstanding balance of loans in Portfolio X is less than $200 million on any assessment date from hedge inception through year 5 or $50 million on any assessment date from years 6 through year 10, Weekapaug must discontinue (or partially discontinue) hedge accounting for the portion of the hedged item (or items) that is no longer outstanding in accordance with its accounting policy.4 A proportion of the portfolio basis adjustment should be recognized in interest income for the portion of the hedged layer that no longer exists. In addition, Weekapaug should disclose the specific amount that was reversed through interest income and the cause of the breach. For example, if the outstanding balance of the loans in Portfolio X is $185 million on an assessment date within years 1 through 5, Weekapaug should (1) partially discontinue the second hedged layer (i.e., the $150 million layer) in accordance with its accounting policy and (2) recognize 10 percent [$15 million ÷ $150 million) of the second hedged layer’s portfolio-level basis adjustment through interest income. In addition, Weekapaug should assess whether it continues to expect the outstanding balance of Portfolio X to equal or exceed the designated hedged layers throughout each respective, designated hedge period.

3.2.1.5 Methods of Measuring Changes in Fair Value That Are Due to Changes in Benchmark Interest Rates

ASC 815 does not prescribe a single method for determining the change in the hedged item’s fair value that is attributable to changes in the benchmark interest rate. Rather, it provides illustrative examples, such as those shown below.

3.2.1.5.1 Example 9 Method

ASC 815-25

Example 9: Fair Value Hedge of the LIBOR Swap Rate in a $100,000 BBB-Quality 5-Year Fixed-Rate Noncallable Note

55-53 This Example illustrates one method that could be used pursuant to paragraph 815-20-25-12(f)(2) in determining the hedged item’s change in fair value attributable to changes in the benchmark interest rate. Other methods could be used in determining the hedged item’s change in fair value attributable to changes in the benchmark interest rate as long as those methods meet the criteria in that paragraph. For simplicity, commissions and most other transaction costs, initial margin, and income taxes are ignored unless otherwise stated. Assume that there are no changes in creditworthiness that would alter the effectiveness of the hedging relationship.

55-54 On January 1, 20X0, Entity GHI issues at par a $100,000 BBB-quality 5-year fixed-rate noncallable debt instrument with an annual 10 percent interest coupon. On that date, Entity GHI enters into a 5-year interest rate swap based on the LIBOR swap rate and designates it as the hedging instrument in a fair value hedge of the $100,000 liability. Under the terms of the interest rate swap, Entity GHI will receive fixed interest at 7 percent and pay variable interest at LIBOR. The variable leg of the interest rate swap resets each year on December 31 for the payments due the following year. This Example has been simplified by assuming that the interest rate applicable to a payment due at any future date is the same as the rate for a payment at any other date (that is, the yield curve is flat). During the hedge period, the gain or loss on the interest rate swap will be recorded in earnings. The Example assumes that immediately before the interest rate on the variable leg resets on December 31, 20X0, the LIBOR swap rate increased by 50 basis points to 7.50 percent, and the change in fair value of the interest rate swap for the period from January 1 to December 31, 20X0, is a loss in value of $1,675.

55-55 Under this method, the change in a hedged item’s fair value attributable to changes in the benchmark interest rate for a specific period is determined as the difference between two present value calculations that use the remaining cash flows as of the end of the period and reflect in the discount rate the effect of the changes in the benchmark interest rate during the period.

Subparagraph superseded by Accounting Standards Update No. 2017-12.
Subparagraph superseded by Accounting Standards Update No. 2017-12.

55-56 Both present value calculations are computed using the estimated future cash flows for the hedged item, which would be either its remaining contractual coupon cash flows or the LIBOR benchmark rate component of the remaining contractual coupon cash flows determined at hedge inception as illustrated by the following Cases:

Using the full contractual coupon cash flows (Case A)
Using the LIBOR benchmark rate component of the contractual coupon cash flows (Case B).

55-56A This Example illustrates two approaches for computing the change in fair value of the hedged item attributable to changes in the benchmark interest rate. This Subtopic does not specify the discount rate that must be used to calculate the change in fair value of the hedged item.

55-56B In Cases A and B in this Example, Entity GHI presents the total change in the fair value of the hedging instrument (that is, the interest accruals and all other changes in fair value) in the same income statement line item (in this case, interest expense) that is used by Entity GHI to present the earnings effect of the hedged item before applying hedge accounting in accordance with paragraph 815-20-45-1A.

In accordance with Example 9 in ASC 815-25-55-53 through 55-61C, the entity calculates the change in the hedged item’s fair value that is attributable to changes in the benchmark interest rate by using the remaining cash flows of the hedged item as of the end of the reporting period in the present value calculations. The Example 9 method isolates changes in interest rates during the period but excludes changes in fair value that are due to the passage of time. The mechanics of the calculation depend on whether a company elects to use the full contractual coupons or the benchmark component of the contractual coupons, which is discussed further below.

Because the Example 9 method excludes changes in fair value that are attributable to the passage of time, the cumulative basis adjustments to the hedged item will not reverse themselves out. In other words, the strict application of the Example 9 method will almost certainly result in a cumulative adjustment to the basis of the hedged item that still remains at the end of the hedging relationship. If the term of the hedging relationship covers the full term of the debt instrument and the debt is then extinguished, any remaining basis adjustment would result in a gain or loss upon extinguishment if the entity does not elect to amortize basis adjustments before the end of the hedging relationship (see Section 3.2.5.1 for a discussion on the amortization of basis adjustments).

Note that the Example 9 method includes some very important simplifying assumptions. First, it is assumed that the yield curve is flat in all scenarios, which makes the discounting of cash flows very simplistic because the same discount rate is applied to every cash flow. Second, it is assumed that the discount rates used for the swaps are also appropriate for discounting the hedged item’s cash flows. That assumption ignores the fact that derivatives typically use a discount rate that (1) reflects the credit of both parties to the derivative and (2) is influenced by credit enhancements (e.g., master netting arrangements or collateral).

3.2.1.5.1.1 Full Contractual Coupons

ASC 815-25

Case A: Using the Full Contractual Coupon Cash Flows

55-57 In this Case, assume Entity GHI elected to calculate the change in the fair value of the hedged item attributable to interest rate risk on the basis of the full contractual coupon cash flows of the hedged item. Accordingly, both present value calculations in accordance with paragraph 815-25-55-55 are computed using the remaining contractual coupon cash flows as of the end of the period and the discount rate that reflects the change in the designated benchmark interest rate during the period. The method chosen by Entity GHI in this Case requires that the discount rate be based on the market interest rate for the hedged item at the inception of the hedging relationship. The discount rates used for those present value calculations would be, respectively:

The discount rate equal to the market interest rate for that hedged item at the inception of the hedge adjusted (up or down) for changes in the benchmark rate (designated as the interest rate risk being hedged) from the inception of the hedge to the beginning date of the period for which the change in fair value is being calculated
The discount rate equal to the market interest rate for that hedged item at the inception of the hedge adjusted (up or down) for changes in the designated benchmark rate from the inception of the hedge to the ending date of the period for which the change in fair value is being calculated.

55-58 Entity GHI elected to subsequently assess hedge effectiveness on a quantitative basis. In Entity GHI’s quarterly assessments of hedge effectiveness for each of the first three quarters of year 20X0 in this Example, there was zero change in the hedged item’s fair value attributable to changes in the benchmark interest rate because there was no change in the LIBOR swap rate. However, in the assessment for the fourth quarter 20X0, the discount rate for the beginning of the period is 10 percent (the hedged item’s original market interest rate with an adjustment of zero), and the discount rate for the end of the period is 10.50 percent (the hedged item’s original market interest rate adjusted for the change during the period in the LIBOR swap rate [+ 0.50 percent]).

55-59 Calculate the present value using the end-of-period discount rate of 10.50 percent (that is, the beginning-of-period discount rate adjusted for the change during the period in the LIBOR swap rate of 50 basis points).

55-60 The change in fair value of the hedged item attributable to the change in the benchmark interest rate is $100,000 – $98,432 = $1,568 (the fair value decrease in the liability is a gain on debt).

55-61 When the change in fair value of the hedged item ($1,568 gain) attributable to the risk being hedged is compared with the change in fair value of the hedging instrument ($1,675 loss), a mismatch of $107 results that will be reported in earnings, because both changes in fair value are recorded in earnings. The change in the fair value of the hedging instrument will be presented in the same income statement line item as the earnings effect of the hedged item in accordance with paragraph 815-20-45-1A.

If an entity that is applying the Example 9 method elects to use the full contractual coupon cash flows to calculate the changes in the hedged item’s fair value that are attributable to changes in the benchmark interest rate, it should use discount rates that are based on the market interest rate at the inception of the hedge (including the credit spread) adjusted for changes in the benchmark rate (either positive or negative) since the beginning of the hedging relationship. The change in fair value that is attributable to changes in the benchmark interest rate should be calculated as the difference between (1) and (2) below:

The remaining cash flows of the hedged item as of the end of the period, discounted at a rate equal to the market interest rate as of the beginning of the hedging relationship adjusted for changes in the benchmark rate from the inception of the hedging relationship to the beginning of the period.
The remaining cash flows of the hedged item as of the end of the period, discounted at a rate equal to the market interest rate as of the beginning of the hedging relationship adjusted for changes in the benchmark rate from the inception of the hedging relationship to the end of the period.

3.2.1.5.1.2 Benchmark Component of Contractual Coupons

ASC 815-25

Case B: Using the LIBOR Benchmark Rate Component of the Contractual Coupon Cash Flows

55-61A In this Case, assume Entity GHI elected to calculate the change in the fair value of the hedged item attributable to interest rate risk on the basis of the benchmark rate component of the contractual coupon cash flows determined at hedge inception. Accordingly, both present value calculations in accordance with paragraph 815-25-55-55 are computed using the remaining benchmark rate component of contractual coupon cash flows as of the end period and the discount rate that reflects the change in the designated benchmark rate during the period. The discount rates used by Entity GHI in this Case would be, respectively:

The benchmark rate (designated as the interest rate risk being hedged) as of the beginning date of the period for which the change in fair value is being calculated
The designated benchmark rate as of the ending date of the period for which the change in fair value is being calculated.

55-61B Entity GHI elected to subsequently assess hedge effectiveness on a quantitative basis. In Entity GHI’s quarterly assessments of hedge effectiveness for each of the first three quarters of year 20X0, there was no change in the hedged item’s fair value attributable to changes in the benchmark interest rate because there was no change in the LIBOR swap rate. However, in the assessment for the fourth quarter 20X0, the discount rate for the beginning of the period is 7 percent, and the discount rate for the end of the period is 7.50 percent reflecting the change during the period in the LIBOR swap rate. The change in fair value of the hedged item attributable to the change in the benchmark interest risk for the period January 1, 20X0, to December 31, 20X0, is a gain of $1,675, calculated as follows.

55-61C Because the change in fair value of the hedged item ($1,675 gain) attributable to the risk being hedged is the same as the change in fair value of the hedging instrument ($1,675 loss), there is perfect offset and, therefore, a zero net earnings effect.

If an entity that is applying the Example 9 method elects to use the benchmark component of the contractual coupon cash flows to calculate the changes in the hedged item’s fair value that are attributable to changes in the benchmark interest rate, it should use discount rates that are based on the benchmark interest rate at the beginning and end of the period. The change in fair value that is attributable to changes in the benchmark interest rate should be calculated as the difference between (1) and (2) below:

The remaining assumed (benchmark component) cash flows of the hedged item as of the end of the period, discounted at the benchmark rate at the beginning of the period.
The remaining assumed (benchmark component) cash flows of the hedged item as of the end of the period, discounted at the benchmark rate at the end of the period.

3.2.1.5.2 Example 11/16 Method

ASC 815-25

Example 16: Fair Value Hedge of the LIBOR Swap Rate in a $100 Million A1-Quality 5-Year Fixed-Rate Noncallable Debt

55-100 The following Cases illustrate application of the guidance in Sections 815-20-25, 815-20-35, and 815-25-35 to a fair value hedge of the LIBOR swap rate in a $100 million A1-quality 5-year fixed-rate noncallable debt:

Using the full contractual coupon cash flows (Case A)
Using the benchmark rate component of the contractual coupon cash flows (Case B).

55-101 On July 2, 20X0, Entity XYZ issues at par a $100 million A1-quality 5-year fixed-rate noncallable debt instrument with an annual 8 percent interest coupon payable semiannually. On that date, Entity XYZ enters into a 5-year interest rate swap based on the LIBOR swap rate and designates it as the hedging instrument in a fair value hedge of interest rate risk of the $100 million liability. Under the terms of the interest rate swap, Entity XYZ will receive a fixed interest rate at 8 percent and pay variable interest at LIBOR plus 200 basis points (current LIBOR 6 percent) on a notional amount of $100 million (semiannual settlement and interest reset dates). For simplicity, commissions and most other transaction costs, initial margin, and income taxes are ignored unless otherwise stated. Assume that there are no changes in creditworthiness that would alter the effectiveness of the hedging relationship. The Example also assumes that the yield curve is flat and that the LIBOR swap rate increased 100 basis points to 7 percent on December 31, 20X0. The change in fair value of the interest rate swap for the period from July 2, 20X0, to December 31, 20X0, is a loss of $3,803,843.

55-102 In both Cases A and B in this Example, Entity XYZ presents the total change in the fair value of the hedging instrument (that is, the interest accruals and all other changes in fair value) in the same income statement line item (in this case, interest expense) that is used by Entity XYZ to present the earnings effect of the hedged item before applying hedge accounting in accordance with paragraph 815-20-45-1A.

Example 11 in ASC 815-25-55-72 through 55-77 and Example 16 in ASC 815-25-55-100 through 55-108 use the same approach, which is referred to herein as the “Example 11/16 method.” However, Example 11 only reflects an entity that elects to use the full contractual coupon cash flows as the basis for measuring the changes in the hedged item’s fair value that are attributable to changes in the benchmark interest rate, while Example 16 applies to both entities that elect to use the full contractual coupon cash flows and entities that elect to use benchmark component of the contractual coupon cash flows. Accordingly, we will focus on Example 16.

In a manner similar to the Example 9 method discussed in Section 3.2.1.5.1, under the Example 11/16 method, the entity calculates the change in the hedged item’s fair value that is attributable to changes in the benchmark interest rate by performing two present value calculations. However, unlike the Example 9 method, the Example 11/16 method does not exclude changes in fair value that are due to the passage of time. The present value calculation related to the beginning of the period is based on the remaining cash flows as of the beginning of the period, and the present value calculation related to the end of the period is based on the remaining cash flows as of the end of the period. The mechanics of the present value calculation depend on whether a company elects to use the full contractual coupon cash flows or the benchmark component of the contractual coupon cash flows.

Under Example 9 in ASC 815-25-55-53 through 55-61C, changes in fair value that are attributable to the passage of time are excluded. However, under Example 11 in ASC 815-25-55-72 through 55-77, the cumulative basis adjustments to the hedged item will reverse themselves out unless all the following conditions are met:

The entity designates a hedging relationship when the debt’s current fair value does not equal its par amount because either (1) the debt is issued at a premium or discount or (2) the designated relationship is a late-term hedge (see Example 2-30 for a discussion of the availability of the shortcut method for late-term hedges).
The term of the hedging relationship matches the remaining life of the hedged item (i.e., it is not a partial-term fair value hedge).
The entity elects to use the full contractual coupon cash flows when measuring changes in the hedged item’s fair value that are attributable to changes in the benchmark interest rate.

In other words, under the Example 11/16 method, there will generally not be a basis adjustment to the hedged item at the end of the hedging relationship unless the entity (1) enters into a late-term hedge and (2) elects to use the full contractual coupon cash flows when measuring changes in the hedged item’s fair value that are attributable to changes in the benchmark interest rate. Accordingly, an entity would not need to amortize basis adjustments before the end of the hedging relationship if any of the following are true:

The entity designates the hedging relationship on (1) the issuance date (or the trade date) of debt that is issued without a premium or discount or (2) another date on which the debt’s fair value equals its par amount.
The entity elects to use the benchmark component of the contractual coupon cash flows when measuring changes in the hedged item’s fair value that are attributable to changes in the benchmark interest rate.
The entity enters into a partial-term fair value hedging relationship.

While an entity may not be required to amortize basis adjustments to the hedged item during the term of the hedging relationship, it still may elect to do so. See Section 3.2.5.1 for a discussion of the amortization of basis adjustments.

Note that Example 11 in ASC 815-25-55-72 through 55-77 and Example 16 in ASC 815-25-55-100 through 55-108 include some very important simplifying assumptions. First, it is assumed that the yield curve is flat in all scenarios, which makes the discounting of cash flows very simplistic because the same discount rate is applied to every cash flow. Second, it is assumed that the discount rates used for the swaps are also appropriate for discounting the hedged item’s cash flows. That assumption ignores the fact that derivatives typically use a discount rate that reflects the credit of both parties to the derivative and is also influenced by credit enhancements (e.g., master netting arrangements or collateral).

3.2.1.5.2.1 Full Contractual Coupons

ASC 815-25

Case A: Using the Full Contractual Coupon Cash Flows

55-103 In this Case, assume that Entity XYZ elected to calculate fair value changes in the hedged item attributable to interest rate risk using the full contractual coupon cash flows of the hedged item. The change in fair value of the debt attributable to changes in the benchmark interest rate for the period July 2, 20X0, to December 31, 20X0, is a gain of $3,634,395, calculated as follows.

55-104 As of December 31, 20X0, the fair value of the debt attributable to interest rate risk is calculated by discounting the full contractual coupon cash flows at the debt’s original market rate with a 100 basis point adjustment related to the increase in the LIBOR swap rate (50 basis point adjustment on a semiannual basis). The following journal entries illustrate the interest rate swap and debt fair value changes attributable to changes in the LIBOR swap rate.

55-105 The net earnings effect of the hedge is $169,448 due to the mismatch between the changes in fair value of the hedging instrument and the hedged item attributable to the changes in the benchmark interest rate.

If an entity that is applying the Example 11/16 method elects to use the full contractual coupon cash flows to calculate the changes in the hedged item’s fair value that are attributable to changes in the benchmark interest rate, it should use discount rates that are based on the market interest rate at the inception of the hedge (including the credit spread), adjusted for the changes in the benchmark rate (either positive or negative) since the beginning of the hedging relationship. The change in fair value that is attributable to changes in the benchmark interest rate should be calculated as the difference between (1) and (2) below:

The remaining cash flows of the hedged item as of the beginning of the period, discounted at a rate equal to the market interest rate as of the beginning of the hedging relationship adjusted for changes in the benchmark rate from the inception of the hedging relationship to the beginning of the period.
The remaining cash flows of the hedged item as of the end of the period, discounted at a rate equal to the market interest rate as of the beginning of the hedging relationship adjusted for changes in the benchmark rate from the inception of the hedging relationship to the end of the period.

3.2.1.5.2.2 Benchmark Component of Contractual Coupons

ASC 815-25

Case B: Using the Benchmark Rate Component of the Contractual Coupon Cash Flows

55-106 In this Case, assume that Entity XYZ elected to calculate fair value changes in the hedged item attributable to interest rate risk using the benchmark rate component of the contractual coupon cash flows of the hedged item determined at hedge inception. The change in fair value of the debt attributable to changes in the benchmark interest rate for the period July 2, 20X0, to December 31, 20X0, is a gain of $3,803,843, calculated as follows.

55-107 As of December 31, 20X0, the fair value of the debt attributable to interest rate risk is calculated by discounting the benchmark rate component of the contractual coupon cash flows using the benchmark interest rate at December 31, 20X0 (7 percent annual rate; 3.5 percent for each semiannual period). The following journal entries illustrate the interest rate swap and debt fair value changes attributable to changes in the LIBOR swap rate.

55-108 The net earnings effect of the hedge is zero due to the perfect offset in fair value changes between the hedging instrument and the hedged item attributable to the changes in the benchmark interest rate.

If an entity that is applying the Example 11/16 method elects to use the benchmark component of the contractual coupon cash flows to calculate the changes in the hedged item’s fair value that are attributable to changes in the benchmark interest rate, it should use discount rates that are based on the benchmark interest rate at the beginning and end of the period. The change in fair value that is attributable to changes in the benchmark interest rate would be calculated as the difference between:

The remaining assumed (benchmark component) cash flows of the hedged item as of the beginning of the period, discounted at the benchmark rate at the beginning of the period.
The remaining assumed (benchmark component) cash flows of the hedged item as of the end of the period, discounted at the benchmark rate at the end of the period.

3.2.1.5.3 Comparison of Methods

The following table summarizes the Example 9 and Example 11/16 methods for calculating the change in the hedged item’s fair value that is attributable to changes in the designated benchmark interest rate, with use of (1) the full contractual coupon cash flows and (2) the benchmark component of the contractual coupon cash flows:

Method	Calculation of the Change in the Hedged Item’s Fair Value That Is Attributable to Changes in the Designated Benchmark Interest Rate	Will Unamortized Basis Adjustments to Hedged Item Exist at End of Hedging Relationship?5
Example 9 — full contractual coupon cash flows (see Section 3.2.1.5.1.1)	The difference between (1) and (2) below: The remaining cash flows of the hedged item as of the end of the period, discounted at a rate equal to the market interest rate as of the beginning of the hedging relationship adjusted for changes in the benchmark rate from the inception of the hedging relationship to the beginning of the period. The remaining cash flows of the hedged item as of the end of the period, discounted at a rate equal to the market interest rate as of the beginning of the hedging relationship adjusted for changes in the benchmark rate from the inception of the hedging relationship to the end of the period.	Yes. Because the impact of the passage of time is excluded from the calculation, the entity will need to make cumulative basis adjustments to the hedged item at the end of the hedging term unless it elects to amortize basis adjustments over the life of the hedging relationship (see Section 3.2.5.1). In a partial-term hedge, the remaining basis adjustment is amortized over the remaining life of the debt in a manner consistent with the treatment of premiums and discounts on the debt. In a full-term hedge, the remaining basis adjustment is recognized as part of the derecognition of underlying debt (e.g., extinguishment gain or loss).
Example 9 — benchmark component of contractual coupon cash flows (see Section 3.2.1.5.1.2)	The difference between (1) and (2) below: The remaining assumed (benchmark component) cash flows of the hedged item as of the end of the period, discounted at the benchmark rate at the beginning of the period. The remaining assumed (benchmark component) cash flows of the hedged item as of the end of the period, discounted at the benchmark rate at the end of the period.	Yes. Because the impact of the passage of time is excluded from the calculation, the entity will need to make cumulative basis adjustments to the hedged item at the end of hedging term unless it elects to amortize basis adjustments over the life of the hedging relationship (see Section 3.2.5.1). In a partial-term hedge, the remaining basis adjustment is amortized over the remaining life of the debt in a manner consistent with the treatment of premiums and discounts on debt. In a full-term hedge, the remaining basis adjustment is recognized as part of the derecognition of underlying debt (e.g., extinguishment gain or loss).
Example 11/16 — full contractual coupon cash flows (see Section 3.2.1.5.2.1)	The difference between (1) and (2) below: The remaining cash flows of the hedged item as of the beginning of the period, discounted at a rate equal to the market interest rate as of the beginning of the hedging relationship adjusted for changes in the benchmark rate from the inception of the hedging relationship to the beginning of the period. The remaining cash flows of the hedged item as of the end of the period, discounted at a rate equal to the market interest rate as of the beginning of the hedging relationship adjusted for changes in the benchmark rate from the inception of the hedging relationship to the end of the period.	If fair value of debt is equal to par at hedge inception — No. The entity will make cumulative basis adjustments that should equal zero. An entity may still elect to amortize basis adjustments over the life of the hedging relationship, but there is no reason to do so. If fair value of debt is not equal to par at hedge inception — Yes. The entity will make cumulative basis adjustments on the debt instrument that will equal and offset the difference between the debt’s fair value at hedge inception and the par amount of the debt unless the entity elects to amortize basis adjustments over the life of the hedging relationship (see Section 3.2.5.1). In a partial-term hedge, the remaining basis adjustment is amortized over the debt’s remaining life in a manner consistent with the treatment of premiums and discounts on debt. In a full-term hedge, the remaining basis adjustment is recognized as part of the derecognition of underlying debt (e.g., extinguishment gain or loss).
Example 11/16 — benchmark component of contractual coupon cash flows (see Section 3.2.1.5.2.2)	The difference between (1) and (2) below: The remaining assumed (benchmark component) cash flows of the hedged item as of the beginning of the period, discounted at the benchmark rate at the beginning of the period. The remaining assumed (benchmark component) cash flows of the hedged item as of the end of the period, discounted at the benchmark rate at the end of the period.	No. The entity will make cumulative basis adjustments that should equal zero. An entity may still elect to amortize basis adjustments over the life of the hedging relationship.

Connecting the Dots

After reviewing the differences between the methods for calculating the change in the hedged item’s fair value that is attributable to changes in the designated benchmark interest rate, along with the differences that result from use of the full contractual coupon cash flows or use of the benchmark component of the contractual coupon cash flows, we believe that most entities will elect to apply the Example 11/16 method and use the benchmark component of the contractual coupon cash flows when the shortcut method is not applied. Such a combination of elections will allow an entity to avoid having to amortize the basis adjustments to the hedged item during the hedging relationship regardless of when the relationship is established (i.e., even in the case of late-term hedges). We also expect entities to make these elections when identifying a backup quantitative assessment method for fair value hedging relationships for which the shortcut method is applied (see Section 2.5.2.2.1.9).

3.2.2 Foreign Currency Risk Hedging

ASC 815-25

35-18 Remeasurement of hedged foreign-currency-denominated assets and liabilities is based on the guidance in Subtopic 830-20, which requires remeasurement based on spot exchange rates, regardless of whether a fair value hedging relationship exists.

Foreign currency hedging is discussed in detail in Chapter 5. As noted in ASC 815-25-35-18, if the hedged item is a recognized foreign-currency-denominated asset or liability, hedge accounting does not override the ASC 830 model for translating foreign-currency-denominated assets or liabilities. Such assets and liabilities must still be remeasured on the basis of the spot exchange rate on the balance sheet date. While this may seem to obviate the need for hedge accounting, an entity may still achieve some benefits from applying the fair value hedging model to a hedge of foreign currency risk related to financial assets or liabilities. One reason for doing so would be to exclude components of the change in the hedging instrument’s fair value from the assessment of hedge effectiveness, which would allow the entity to recognize the initial time value or cross-currency basis spread, or both, in a systematic and rational basis over the life of the hedge. In addition, an entity may want to apply fair value hedge accounting to a strategy in which it hedges foreign currency risk in combination with interest rate risk (e.g., hedging a fixed-rate foreign-currency-denominated debt instrument).

3.2.3 Credit Risk Hedging

It is fairly uncommon for an entity to hedge only the credit risk of a mortgage servicing right, a financial asset, or a financial liability, largely because there are few derivatives that are based on the credit of one or more specific obligors. If a derivative only pays out on the basis of the default of a debt instrument, it is not likely to be accounted for as a derivative under the financial guarantee scope exception in ASC 815-10-15-58 (see Section 2.3.4 of Deloitte’s Roadmap Derivatives for further detail on the financial guarantee scope exception). Sometimes, an entity will enter into a credit default swap to hedge a debt instrument’s credit risk. However, the entity’s ability to achieve a highly effective hedging relationship may depend on the types of triggering events that would result in a payout under the credit default swap because such events may not align with all of the factors that would affect the issuer’s credit spread. As previously discussed, credit risk for a fair value hedging relationship is defined in ASC 815-20-25-12(f)(4) as:

The risk of changes in its fair value attributable to both of the following (referred to as credit risk):

Changes in the obligor’s creditworthiness
Changes in the spread over the benchmark interest rate with respect to the hedged item’s credit sector at inception of the hedge.

If an entity enters into a derivative that is highly effective against all changes in credit risk and the hedging relationship meets all of the other conditions for fair value hedge accounting, the entity would remeasure the hedged item for changes in fair value that are attributable to changes in credit risk.

3.2.4 Overall Fair Value Hedging

If an entity elects to hedge a mortgage servicing right, a financial asset, or a financial liability for overall changes in fair value in a qualifying fair value hedging relationship, it will remeasure the hedged asset or liability for all changes in fair value during the period. Note that such remeasurement does not result in recognition of the hedged item at fair value unless the item was recognized at fair value as of the beginning of the hedging relationship. For example, assume that an entity is hedging debt for overall changes in fair value and, at the inception of the hedge, the debt has an amortized cost basis of $1 million and a fair value of $1.1 million. If the debt’s fair value at the end of the reporting period increases to $1.18 million, the debt would be remeasured to $1.08 million since its fair value increased by $80,000 during the period.

In addition, as discussed in Section 2.3.1.1.2, an entity may hedge the prepayment option embedded in a debt instrument, but if it does so, it may only hedge the prepayment option for overall changes in fair value. Accordingly, the guidance in Section 3.2.1.2 about ignoring the impact of anything other than changes in the benchmark rate when measuring the change in the hedged item’s fair value that is attributable to the hedged risk does not apply if the hedged item is the prepayment option in a debt instrument that is hedged for changes in its overall fair value.

3.2.5 Accounting for Basis Adjustments

ASC 815-25

35-8 The adjustment of the carrying amount of a hedged asset or liability required by paragraph 815-25-35-1(b) shall be accounted for in the same manner as other components of the carrying amount of that asset or liability. For example, an adjustment of the carrying amount of a hedged asset held for sale (such as inventory) would remain part of the carrying amount of that asset until the asset is sold, at which point the entire carrying amount of the hedged asset would be recognized as the cost of the item sold in determining earnings.

35-9 An adjustment of the carrying amount of a hedged interest-bearing financial instrument that is required by paragraph 815-25-35-1(b) and an adjustment that is maintained on a closed portfolio basis in a portfolio layer method hedge in accordance with paragraph 815-25-35-1(c) shall be amortized to earnings. Amortization shall begin no later than when the hedged item ceases to be adjusted for changes in its fair value attributable to the risk being hedged.

35-9A If, as permitted by paragraph 815-25-35-9, an entity amortizes the adjustment to the carrying amount of the hedged item during an existing partial-term hedge of an interest-bearing financial instrument or amortizes the basis adjustment in an existing portfolio layer method hedge, the entity shall fully amortize that adjustment by the hedged item’s assumed maturity date in accordance with paragraph 815-25-35-13B. For a discontinued hedging relationship, all remaining adjustments to the carrying amount of the hedged item shall be amortized over a period that is consistent with the amortization of other discounts or premiums associated with the hedged item in accordance with other Topics (for example, Subtopic 310-20 on receivables — nonrefundable fees and other costs). See paragraphs 815-25-40-9 through 40-9A for further guidance on accounting for a basis adjustment attributable to a discontinued portfolio layer method hedge.

The hedged item in a qualifying fair value hedge of a financial asset or liability is remeasured for changes in its fair value that are attributable to changes in the designated risk. Adjustments to the carrying amount are then treated in the same manner as any other basis adjustment that applies to the asset or liability. For example, if a debt instrument is adjusted for an increase in its fair value that is attributable to changes in the designated risk, the increase creates a premium on the debt instrument.

3.2.5.1 Amortization of Basis Adjustments

As long as a hedging relationship continues to qualify for hedge accounting, an entity has the option to either (1) immediately begin amortization of basis adjustments to an interest-bearing hedged item or (2) wait until the hedging relationship has been discontinued. If the entity elects to begin amortizing a basis adjustment while the hedging relationship is still outstanding, the period of amortization should coincide with the remaining life of the hedging relationship in a manner consistent with the guidance in ASC 815-25-35-9A.

For example, assume that CactusCo has 10-year fixed-rate debt that it hedges with a 5-year interest rate swap in a partial-term fair value hedging relationship. If CactusCo begins amortizing the basis adjustments as they occur, the amortization period should match the period of the hedging relationship (i.e., five years) as long as that relationship qualifies for hedge accounting and continues. When hedge accounting is discontinued, any remaining basis adjustment should be amortized over the remaining life of the debt (i.e., to the 10-year maturity date).

An entity’s decision about whether to amortize basis adjustments may be driven by the method the entity is using to determine the changes in the hedged item’s fair value that are attributable to changes in the designated risk. For example, if an entity enters into an interest rate swap to hedge a debt instrument for changes in fair value that are attributable to changes in the designated benchmark interest rate and is using a method that will result in no cumulative basis adjustments at the end of the hedging relationship, the entity is not likely to elect to amortize the basis adjustments before the end of the hedging relationship. This would be the case if an entity applies any of the following methods to determine the change in the hedged item’s fair value that is attributable to changes in the designated benchmark interest rate:

The shortcut method (see Section 3.2.1.3).
The Example 11/16 method in combination with an election to use the benchmark component of the contractual coupon cash flows (see Section 3.2.1.5.2.2).
The Example 11/16 method in combination with an election to use the full contractual coupon cash flows (see Section 3.2.1.5.2.1) when the fair value of the hedged debt instrument is equal to par at hedge inception.

See Section 3.2.1.5 for a discussion of the methods for determining the change in the hedged item’s fair value that is attributable to changes in the designated benchmark interest rate. Section 3.2.1.5.3 includes a table summarizing the various methods.

3.2.5.2 Interaction With Impairment Guidance

ASC 815-25

35-10 An asset or liability that has been designated as being hedged and accounted for pursuant to this Section remains subject to the applicable requirements in generally accepted accounting principles (GAAP) for assessing impairment or credit losses for that type of asset or for recognizing an increased obligation for that type of liability. Those impairment or credit loss requirements shall be applied after hedge accounting has been applied for the period and the carrying amount of the hedged asset or liability has been adjusted pursuant to paragraph 815-25-35-1(b). A portfolio layer method basis adjustment that is maintained on a closed portfolio basis for an existing hedge in accordance with paragraph 815-25-35-1(c) shall not be considered when assessing the individual assets or individual beneficial interest included in the closed portfolio for impairment or when assessing a portfolio of assets for impairment. An entity may not apply this guidance by analogy to other components of amortized cost basis. Because the hedging instrument is recognized separately as an asset or liability, its fair value or expected cash flows shall not be considered in applying those impairment or credit loss requirements to the hedged asset or liability.

Interaction With Measurement of Credit Losses

35-11 This Subtopic implicitly affects the measurement of credit losses under Subtopic 326-20 on financial instruments measured at amortized cost by requiring the present value of expected future cash flows to be discounted by the new effective rate based on the adjusted amortized cost basis in a hedged loan. Paragraph 326-20-55-9 requires that, when the amortized cost basis of a loan has been adjusted under fair value hedge accounting, the effective rate is the discount rate that equates the present value of the loan’s future cash flows with that adjusted amortized cost basis. That paragraph states that the adjustment under fair value hedge accounting for changes in fair value attributable to the hedged risk under this Subtopic shall be considered to be an adjustment of the loan’s amortized cost basis. As discussed in that paragraph, the loan’s original effective interest rate becomes irrelevant once the recorded amount of the loan is adjusted for any changes in its fair value. Because paragraph 815-25-35-10 requires that the loan’s amortized cost basis be adjusted for hedge accounting before the requirements of Subtopic 326-20 are applied, this Subtopic implicitly supports using the new effective rate and the adjusted amortized cost basis. A portfolio layer method basis adjustment that is maintained on a closed portfolio basis for an existing hedge in accordance with paragraph 815-25-35-1(c) shall not adjust the amortized cost basis of the individual assets or individual beneficial interest included in the closed portfolio. An entity may not apply this guidance by analogy to other components of amortized cost basis.

35-12 This guidance applies to all entities applying Subtopic 326-20 to financial assets that are hedged items in a fair value hedge, regardless of whether those entities have delayed amortizing to earnings the adjustments of the loan’s amortized cost basis arising from fair value hedge accounting until the hedging relationship is dedesignated. The guidance on recalculating the effective rate is not intended to be applied to all other circumstances that result in an adjustment of a loan’s amortized cost basis and is not intended to be applied to the individual assets or individual beneficial interest in an existing portfolio layer method hedge closed portfolio.

As noted in Section 3.2.5, basis adjustments to a hedged asset or liability in a qualifying fair value hedging relationship are accounted for in the same manner as other components of the asset’s carrying amount. Accordingly, in the evaluation of a financial asset or an unrecognized loan commitment for impairment or credit losses, the relevant starting point is the carrying amount of the asset or loan commitment after the hedge accounting adjustments. In addition, if an entity is determining impairment on the basis of a discounted cash flow model, the discount rate should be the relevant effective interest rate after the basis adjustments.

Changing Lanes

As discussed in Section 3.2.1.4, basis adjustments for a portfolio layer method hedge are done at a portfolio level unless the hedge is discontinued in part or in full. In March 2022, the FASB issued ASU 2022-01, which addresses the interaction of the portfolio-level basis adjustments with impairment and credit losses standards. Under the ASU, portfolio-level basis adjustments from an existing hedging relationship would be ignored in the evaluation of assets for impairment.

If the hedged item is a recognized mortgage servicing right, the impairment guidance in ASC 860-50-35-9 through 35-14 is applicable. For impairment analysis purposes, the carrying amount of a mortgage servicing right should be determined after any fair value hedging basis adjustments. Mortgage servicing rights may be either an asset or a liability, and the impairment guidance applies to both. An impairment of a mortgage servicing asset would result in an allowance, and an impairment of a mortgage servicing liability would result in an increased liability.

If the hedged item is an existing financial liability, no additional considerations related to impairment apply.

3.2.6 Hedged Item Measured at Fair Value, With Changes in Fair Value Recognized in OCI

ASC 815-25

35-6 If a hedged item is otherwise measured at fair value with changes in fair value reported in other comprehensive income (such as an available-for-sale debt security), the adjustment of the hedged item’s carrying amount discussed in paragraph 815-25-35-1(b) shall be recognized in earnings rather than in other comprehensive income to offset the gain or loss on the hedging instrument. If the hedged item is a hedged layer designated in a portfolio layer method hedge on a closed portfolio in accordance with paragraph 815-20-25-12A and the closed portfolio includes only available-for-sale debt securities, the entire gain or loss (that is, the change in fair value) on the hedged item attributable to the hedged risk shall be recognized in earnings rather than in other comprehensive income to offset the gain or loss on the hedging instrument. If the closed portfolio includes available-for-sale debt securities and assets that are not available-for-sale debt securities, an entity shall determine the portion of the change in fair value on the hedged item attributable to the hedged risk associated with the available-for-sale debt securities using a systematic and rational method. That amount shall be recognized in earnings rather than in other comprehensive income. However, an entity shall not adjust the carrying amount of the individual available-for-sale debt securities included in the closed portfolio in accordance with paragraph 815-25-35-1(c).

If the hedged item in a qualifying fair value hedge has already been measured at fair value, with changes in fair value reported in OCI, no additional remeasurement of the hedged item is required. However, the portion of the change in fair value that is attributable to changes in the designated risk is recognized in earnings instead of OCI. When applying this guidance to portfolio layer method hedging relationships in which the closed portfolio includes both AFS debt securities and assets that are not AFS debt securities, entities should use a systematic and rational method to determine the aforementioned “portion” to be recognized in earnings on the basis of the composition of the underlying closed portfolio.

Example 3-5

Hedged Item Is an AFS Debt Security

SimpleBand acquires a fixed-rate AFS debt security for $100,000. It designates an interest rate swap to hedge the interest rate risk in the security, and the hedging relationship qualifies for the shortcut method. At the end of the reporting period, the security’s fair value is $110,000 and the interest rate swap’s fair value is negative $8,000 (it is a liability). SimpleBand recognizes the $8,000 decrease in the swap’s fair value in the income statement. To account for the $10,000 increase in the fair value of the debt security, SimpleBand recognizes $8,000 in the income statement and $2,000 in OCI.

If an AFS debt security has an unrealized loss in OCI, in a manner consistent with the discussion in Section 3.2.5.2, an entity should still evaluate the asset for impairment in accordance with ASC 326-30. Generally speaking, a credit-related impairment would result in a reclassification of at least a portion of the unrealized loss out of AOCI into earnings. If the AFS debt security was hedged for changes in its fair value that are attributable to changes in the designated benchmark interest rate, the basis adjustments previously recognized in earnings were not related to credit risk.

3.2.7 Illustrative Examples

Example 3-6

Shortcut Method — Interest Rate Swap Hedging Fixed-Rate Debt (Full-Term Hedge)

On January 2, 20X4, Reprise issues $100 million of fixed-rate debt, with interest payable quarterly at a rate of 3 percent per year. Principal is payable at maturity, which is on December 31, 20X8, and the debt is not prepayable. To maintain compliance with its policy of having at least half of its outstanding borrowings in the form of variable-rate debt (either directly or indirectly by using swaps), Reprise enters into an interest rate swap on January 2, 20X4, to effectively convert the debt from fixed- to variable-rate debt. The interest rate swap has the following terms:

Notional	$100 million
Effective date	January 2, 20X4
Maturity date	December 31, 20X8
Fixed-leg payer	Counterparty
Fixed-leg rate	1.7346%
Variable-leg payer	Reprise
Variable rate	90-day Average SOFR
Reset/settlement frequency	Quarterly: March 31, June 30, September 30, December 31

Reprise designates the swap as a hedge of changes in the debt’s fair value that are attributable to changes in benchmark interest rates. As part of the hedge designation documentation, Reprise notes that the hedging relationship qualifies for the shortcut method and that the shortcut method will be applied.

For this example, assume that neither the creditworthiness of Reprise nor the creditworthiness of the counterparty to the interest rate swap calls into question whether it is probable that both parties will perform under the interest rate swap over its life.

Reprise recognizes (1) the accruals of the settlements of the interest rate swap directly in the same income statement line item in which the hedged item affects earnings (interest expense) and (2) the change in the fair value of the swap on the basis of the change in its “clean” fair value each period. The swap’s clean fair value does not include any accrued settlements.

Reprise records the following journal entries throughout the term of the hedge:

January 2, 20X4

No entry is required for entering into the interest rate swap because the swap has a fair value of zero at inception.

March 31, 20X4

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the swap’s fair values at the beginning and end of the period, and (4) the change in the swap’s fair value for the period.

June 30, 20X4

September 30, 20X4

December 31, 20X4

March 31, 20X5

June 30, 20X5

September 30, 20X5

December 31, 20X5

March 31, 20X6

June 30, 20X6

September 30, 20X6

December 31, 20X6

March 31, 20X7

June 30, 20X7

September 30, 20X7

December 31, 20X7

March 31, 20X8

June 30, 20X8

September 30, 20X8

December 31, 20X8

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement), (2) the current period’s swap settlement, (3) the swap’s fair values at the beginning and end of the period, and (4) the change in the swap’s fair value for the period.

Example 3-7

Long-Haul Method — Interest Rate Swap Hedging Fixed-Rate Debt for Interest Rate Risk (Full-Term Hedge)

Assume the same facts as in Example 3-6, except that Reprise does not elect to apply the shortcut method. As a result, as long as the hedge remains highly effective and continues to meet the conditions for applying hedge accounting, Reprise determines (1) the changes in the debt’s fair value that are attributable to changes in the benchmark interest rate and (2) the fair value of the interest rate swap.

To calculate the change in fair value that is attributable to changes in the benchmark interest rate, Reprise elects to apply the Example 11/16 method by using estimated cash flows based on the benchmark interest rate component of the contractual coupon cash flows, as allowed under ASC 815-25-35-13 (see Section 3.2.1.5.2.2). Reprise determines that the benchmark component of the contractual coupon cash flows is equal to the interest rate on the fixed leg of the interest rate swap (i.e., 1.7346 percent) because:

The swap has a variable leg that is based on the designated benchmark rate (SOFR OIS) and has no spread.
The term of the swap matches the term of the hedged item (matches the portion of debt being hedged).
There are no prepayment terms in the debt that need to be mirrored in the swap.
The swap has a fair value of zero at the inception of the hedging relationship.

In addition, for each period, Reprise determines the “fair value” of a theoretical debt instrument that has been remeasured for changes in fair value that are attributable to changes in the designated benchmark interest rate. The terms of the theoretical debt instrument are consistent with the actual debt, except for a coupon of 1.7346 percent per year (the benchmark component of the contractual coupons).

As in Example 3-6, assume that neither the creditworthiness of Reprise nor the creditworthiness of the counterparty to the interest rate swap calls into question whether it is probable that both parties will perform under the interest rate swap over its life. However, their creditworthiness does affect the swap’s fair value. Accordingly, even though the assumed coupons on the debt are the same as those on the fixed leg of the swap, the fair values of the swap and the assumed debt do not react to changes in the benchmark interest rate in the same manner.

The hedge effectiveness assessments performed throughout the life of the hedging relationship indicate that the hedging relationship is highly effective.

Reprise records the following journal entries throughout the term of the hedge:

January 2, 20X4

No entry is required for entering into the interest rate swap because the swap has a fair value of zero at inception.

March 31, 20X4

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

June 30, 20X4

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, (4) the changes in the fair values of the swap and the theoretical debt for the period.

September 30, 20X4

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

December 31, 20X4

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

March 31, 20X5

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

June 30, 20X5

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

September 30, 20X5

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

December 31, 20X5

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

March 31, 20X6

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

June 30, 20X6

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

September 30, 20X6

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

December 31, 20X6

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

March 31, 20X7

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

June 30, 20X7

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

September 30, 20X7

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

December 31, 20X7

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

March 31, 20X8

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

June 30, 20X8

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

September 30, 20X8

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

December 31, 20X8

The table below shows (1) the 90-day Average SOFR at the beginning of the period (which affects the current period’s swap settlement), (2) the current period’s swap settlement, (3) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (4) the changes in the fair values of the swap and the theoretical debt for the period.

Example 3-8

Shortcut Method — Interest Rate Swap Hedging Fixed-Rate Debt (Partial-Term Hedge)

On January 2, 20X6, Reprise issues $100 million of 10-year fixed-rate debt, with interest payable quarterly at a rate of 3 percent per year. Principal is payable at maturity, which is in 10 years; the debt is not prepayable. Reprise believes that interest rates will decline over the next three years and only wants to hedge interest rate risk for that period. Accordingly, it enters into an interest rate swap on January 2, 20X6, with the following terms:

Notional	$100 million
Effective date	January 2, 20X6
Maturity date	December 31, 20X8
Fixed-leg payer	Counterparty
Fixed-leg rate	1.5173%
Variable-leg payer	Reprise
Variable rate	180-day Average SOFR
Reset/settlement frequency	Semiannually: June 30, December 31

Reprise designates the swap as a hedge of the changes in the debt’s fair value that are attributable to changes in the designated benchmark interest rate. The hedged debt’s assumed maturity is December 31, 20X8 (the maturity date of the interest rate swap). As part of its hedge designation documentation, Reprise states that the hedging relationship qualifies for the shortcut method and that the shortcut method will be applied. Note that even though the reset and settlement frequency of the interest rate swap (i.e., semiannually) does not match the frequency of interest payments on the debt (i.e., quarterly), the fair value hedging relationship still qualifies for the shortcut method (see Section 2.5.2.2.1.6).

As in the previous examples, assume that neither the creditworthiness of Reprise nor the creditworthiness of the counterparty to the interest rate swap call into question whether it is probable that both parties will perform under the swap over its life.

Reprise records the following journal entries throughout the term of the hedge:

January 2, 20X6

No entry is required for entering into the interest rate swap because the swap has a fair value of zero at inception.

March 31, 20X6

The table below shows (1) the 180-day Average SOFR as of the last reset date (which affects the current period’s accrual of the next swap settlement), (2) the swap’s fair values at the beginning and end of the period, and (3) the change in the swap’s fair value for the period.

June 30, 20X6

The table below shows (1) the 180-day Average SOFR as of the last reset date (which affects the current period’s accrual of the swap settlement) and the current 180-day Average SOFR, (2) the current period’s swap settlement, (3) the accrued interest on the swap for the prior and current periods (both components of the current period’s swap settlement), (4) the swap’s fair values at the beginning and end of the period, and (5) the change in the swap’s fair value for the period.

September 30, 20X6

December 31, 20X6

March 31, 20X7

June 30, 20X7

September 30, 20X7

December 31, 20X7

The table below shows (1) the 180-day Average SOFR as of the last reset date (which affects the current period’s accrual of the swap settlement) and the current 180-day Average SOFR, (2) the current period’s swap settlement, (3) the accrued interest on the swap for the prior and current periods (both components of the current period’s swap settlement), (4) the swap’s fair values at the beginning and end of the period and (5) the change in the swap’s fair value for the period.

March 31, 20X8

June 30, 20X8

September 30, 20X8

December 31, 20X8

The table below shows (1) the 180-day Average SOFR as of the last reset date (which affects the current period’s accrual of the swap settlement), (2) the current period’s swap settlement, (3) the accrued interest on the swap for the prior and current periods (both components of the current period’s swap settlement), (4) the swap’s fair values at the beginning and end of the period, and (5) the change in the swap’s fair value for the period.

Example 3-9

Long-Haul Method — Interest Rate Swap Hedging Fixed-Rate Debt for Interest Rate Risk (Partial-Term Hedge)

Assume the same facts as in Example 3-8, except that Reprise does not elect to apply the shortcut method. As a result, as long as the hedge remains highly effective and continues to meet the conditions for applying hedge accounting, Reprise determines (1) the changes in the debt’s fair value that are attributable to changes in the benchmark interest rate and (2) the fair value of the interest rate swap.

To calculate the changes in the debt’s fair value that are attributable to changes in the benchmark interest rate, Reprise elects to apply the Example 11/16 method by using estimated cash flows based on the benchmark interest rate component of the contractual coupon cash flows, as allowed under ASC 815-25-35-13 (see Section 3.2.1.5.2.2). Reprise determines that the benchmark rate component of the contractual coupon cash flows is equal to the interest rate on the fixed leg of the interest rate swap (i.e., 1.5173) because:

The swap has a variable leg that is based on the designated benchmark rate (180-day Average SOFR) and has no spread.
The term of the swap matches that of the hedged item (i.e., it is a partial-term hedge in which the swap matches the portion of the debt being hedged).
There are no prepayment terms in the debt that need to be mirrored in the swap.
The swap has a fair value of zero at the inception of the hedging relationship.

As in the previous examples, assume that neither the creditworthiness of Reprise nor the creditworthiness of the counterparty to the interest rate swap calls into question whether it is probable that both parties will perform under the swap over its life. However, their creditworthiness does affect the swap’s fair value. Accordingly, even though the assumed interest rate on the debt is the same as that on the fixed leg of the swap, the fair values of the swap and the assumed debt do not react to changes in the benchmark interest rate in the same manner. In addition, the swap only has settlements on a semiannual basis, while the debt has interest payments on a quarterly basis.

The hedge effectiveness assessments performed throughout the life of the hedging relationship indicate that the hedging relationship is highly effective.

Reprise records the following journal entries throughout the term of the hedge:

January 2, 20X6

No entry is required for entering into the interest rate swap because the swap has a fair value of zero at inception.

March 31, 20X6

The table below shows (1) the 180-day Average SOFR as of the last reset date (which affects the current period’s accrual of the next swap settlement), (2) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (3) the changes in the fair values of the swap and the theoretical debt for the period.

June 30, 20X6

The table below shows (1) the 180-day Average SOFR as of the last reset date (which affects the current period’s accrual of the swap settlement) and the current 180-day Average SOFR, (2) the current period’s swap settlement, (3) the accrued interest on the swap for the prior and current periods (both components of the current period’s swap settlement), (4) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (5) the changes in the fair values of the swap and the theoretical debt for the period.

September 30, 20X6

December 31, 20X6

The table below shows (1) the 180-day Average SOFR as of the last reset date (which affects the current period’s accrual of the swap settlement) and the current 180-day Average SOFR, (2) the current period’s swap settlement, (3) the accrued interest on the swap for the prior and current periods (both components of the current period’s swap settlement), (4) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (5) the changes in fair values of the swap and the theoretical debt for the period.

March 31, 20X7

June 30, 20X7

The table below shows (1) the 180-day Average SOFR as of the last reset date (which affects the current period’s accrual of the swap settlement) and the current 180-day Average SOFR, (2) the current period’s swap settlement, (3) the accrued interest on the swap for the prior and current periods (both components of the current period’s swap settlement), (4) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (5) the changes in the fair values of the swap and the theoretical debt for the period.

September 30, 20X7

The table below shows (1) the 180-day Average SOFR as of the last reset date (which affects the current period’s accrual of the next swap settlement), (2) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (3) the changes in fair values of the swap and the theoretical debt for the period.

December 31, 20X7

The table below shows (1) the 180-day Average SOFR as of the last reset date (which affects the current period’s accrual of the swap settlement) and the current 180-day Average SOFR, (2) the current period’s swap settlement, (3) the accrued interest on the swap for the prior and current periods (both components of the current period’s swap settlement), (4) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (5) the changes in the fair values of the swap and the theoretical debt for the period.

March 31, 20X8

June 30, 20X8

The table below shows (1) the 180-day Average SOFR as of the last reset date (which affects the current period’s accrual of the swap settlement) and the current 180-day Average SOFR, (2) the current period’s swap settlement, (3) the accrued interest on the swap for the prior and current periods (both components of the current period’s swap settlement), (4) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (5) the changes in fair values of the swap and the theoretical debt for the period.

September 30, 20X8

December 31, 20X8

The table below shows (1) the 180-day Average SOFR as of the last reset date (which affects the current period’s accrual of the swap settlement), (2) the current period’s swap settlement, (3) the accrued interest on the swap for the prior and current periods (both components of the current period’s swap settlement), (4) the fair values of the swap and the theoretical debt at the beginning and end of the period, and (5) the changes in the fair values of the swap and the theoretical debt for the period.

Footnotes

Although a mortgage servicing right is not a financial asset because the servicer is obligated to perform to receive the servicing fee, it is included in this section because certain aspects of the model for fair value hedges of financial assets also apply to hedges of mortgage servicing rights (e.g., the types of risks that may be hedged and the amortization of basis adjustments).

ASU 2022-01 clarified that the closed portfolio may include both prepayable and nonprepayable financial assets. Further, once a closed portfolio is established and designated in a portfolio layer method hedge, the addition of new assets to the portfolio is prohibited.

In the event of either an anticipated or actual breach (i.e., if the unpaid principal balance is expected to be less than or is less than $200 million in the closed portfolio within the first five years), Weekapaug must determine which hedge to discontinue or partially discontinue by using a systematic and rational approach in accordance with its accounting policy election.

See footnote 3.

For simplicity, we assume that the hedging relationship is not discontinued before the end of the hedging relationship.

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