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
|
---|---|---|
|
|
|
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 LIBOR). 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 LIBOR. 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 LIBOR with a tenor that matches how often the swap is
repriced or settled (e.g., three-month LIBOR if the swap is repriced on a
quarterly basis) and (2) a term that matches the term of the hedged item (10
years).
In most hedging relationships involving an at-market interest rate swap, we would
expect 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, if the hedging instrument is not a swap, an
entity may construct a hypothetical at-market interest rate swap to determine
the benchmark rate component of the contractual coupons. 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-six-month LIBOR + 200 basis points (i.e., current
LIBOR 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 LIBOR 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, LIBOR is the designated benchmark rate for interest rate risk. In
assessing hedge effectiveness, the entity will have to consider the basis
difference between LIBOR 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., LIBOR) and not changes in the rate referenced in the swap
(i.e., the prime rate). If it is later determined that the hedge of LIBOR
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 as selected contractual cash flows 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 when the
last hedged cash flow is due and payable. 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 on the date in which the last hedged cash
flow is due and payable. 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).
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-13B [See Section 9.7.]
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 when the last hedged cash flow is due and payable.”2 By using an assumed term that ends when the last hedged cash flow is
due and payable, 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 (LIBOR)
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 (LIBOR),
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 LIBOR 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 when the last hedged cash flow is due and
payable.”3
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 five-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 six-month LIBOR 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.
However, to apply the accounting guidance in ASC 815-20-25-6B and ASC
815-25-25-13A and actually designate the prepayable asset in a
last-of-layer hedging relationship (see Section 3.2.1.4), an entity must determine that the
instrument’s features could allow it to become prepayable during the
life the designated hedging relationship. For example, if an entity
holds an instrument with a conversion option that becomes exercisable
five years after its issuance, the entity would be unable to designate
the convertible instrument as a hedged item in either (1) a hedging
relationship in which it applies the guidance in ASC 815-20-25-6B and
ASC 815-25-25-13A or (2) a last-of-layer hedging relationship unless the
hedging relationship’s designated duration includes the period in which
the conversion option becomes effective (i.e., the term of the hedging
relationship extends beyond the five-year anniversary of the
instrument’s issuance). When an entity assesses whether an instrument
that contains multiple prepayment features can be the designated hedged
item in one of these hedging relationships, the entity may make its
determination on the basis of the prepayment feature that could be
triggered the soonest.
At the February 14, 2018, FASB meeting, the staff also clarified that
contingent acceleration clauses that permit an acceleration of
contractual maturity should not be considered prepayment features if the
contingent event is related to the debtor’s credit deterioration or
other changes in the debtor’s credit risk. However, if the credit
contingency is accompanied by other features that would otherwise make
the instrument eligible to be considered prepayable, the existence of
the contingent acceleration clause related to credit would not preclude
an entity from considering the instrument to be prepayable.
Changing Lanes
In November 2019, the FASB issued a
proposed ASU of Codification improvements
to hedge accounting. One of the proposed improvements was to
replace the term “prepayable” with “early settlement feature” in
the guidance on the application of the shortcut method; however,
at the October 11, 2023, FASB meeting, the Board decided not to
affirm its proposed amendment.
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 Last-of-Layer Method/Portfolio Layer Method
ASC 815-20
25-12A For a closed
portfolio of prepayable financial assets or one or
more beneficial interests secured by a portfolio of
prepayable financial instruments, an entity may
designate as the hedged item a stated amount of the
asset or assets that are not expected to be affected
by prepayments, defaults, and other factors
affecting the timing and amount of cash flows if the
designation is made in conjunction with the
partial-term hedging election in paragraph
815-20-25-12(b)(2)(ii) (this designation is referred
to throughout Topic 815 as the “last-of-layer
method”).
-
As part of the initial hedge documentation, an analysis shall be completed and documented to support the entity’s expectation that the hedged item (that is, the designated last of layer) is anticipated to be outstanding as of the hedged item’s assumed maturity date in accordance with the entity’s partial-term hedge election. That analysis shall incorporate the entity’s current expectations of prepayments, defaults, and other events affecting the timing and amount of cash flows associated with the closed portfolio of prepayable financial assets or beneficial interest(s) secured by a portfolio of prepayable financial instruments.
-
For purposes of its analysis, the entity may assume that as prepayments, defaults, and other events affecting the timing and amount of cash flows occur, they first will be applied to the portion of the closed portfolio of prepayable financial assets or one or more beneficial interests that is not part of the hedged item (that is, the designated last of layer).
Pending Content (Transition Guidance: ASC
815-20-65-6)
25-12A
[See Section 9.7.]
ASC 815-25
35-7A When the hedged item
is designated and accounted for under the
last-of-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 item (that is, the designated last of layer)
is still anticipated to be outstanding as of the
hedged item’s assumed maturity date. That analysis
shall incorporate the entity’s current expectations
of prepayments, defaults, and other events affecting
the timing and amount of cash flows using a method
consistent with the method used to perform the
analysis in paragraph 815-20-25-12A(a).
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-7A [See Section 9.7.]
ASU 2017-12 also added the “last-of-layer” method to ASC 815, which enables
an entity to apply fair value hedging to closed portfolios of prepayable
financial assets without having to consider prepayment risk or credit risk
when measuring those assets. An entity can also apply the method to one or
more beneficial interests secured by a portfolio of prepayable financial
instruments (e.g., an MBS). The last-of-layer method cannot be applied to
liabilities, so the issuer of an MBS could not hedge the issued security
under the last-of-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 last-of-layer method cannot be
applied to cash flow hedging relationships.
In accordance with ASC 815-20-25-12A, an entity that uses the last-of-layer
method would designate a stated amount of the asset or assets that it does
not expect “to be affected by prepayments, defaults, and other factors
affecting the timing and amount of cash flows” (the “last of layer”) as the
hedged item in a fair value hedge of interest rate risk. This designation
would occur in conjunction with the partial-term hedging election discussed
in Section 3.2.1.1.
Changing Lanes
Because the last-of-layer method was a late addition
to ASU 2017-12, it was not in the exposure draft and, therefore,
never subject to public comment. After its issuance, several
questions were raised related to the last-of-layer method. In March
2022, the FASB issued ASU 2022-01, which clarifies the guidance in
ASC 815 on fair value hedge accounting of interest rate risk for
portfolios of financial assets. ASU 2022-01 renames the
“last-of-layer” method the “portfolio layer” method and addresses
feedback from stakeholders regarding its application. See Chapter 9 for
a discussion of the main provisions, effective dates, and transition
requirements of ASU 2022-01.
To support the designation, the entity should include evidence that it
performed an analysis that reinforced its expectation that the hedged item
(i.e., the last of layer) would be outstanding as of the item’s assumed
maturity date 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 and defaults); however,
the entity may assume that the effects of any events, such as prepayments or
defaults, would first apply to the portion of the closed portfolio or
beneficial interest(s) that is not part of the designated hedged item (last
of layer).
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 last of layer) will be outstanding on the assumed maturity
date. 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.
Connecting the Dots
ASU 2017-12 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
last-of-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). Paragraph
BC112 of ASU 2017-12 states, in part:
Using the benchmark rate component of the
contractual coupon cash flows when (a) all assets have the
same assumed maturity and (b) prepayment risk does not
affect the measurement of the hedged item results in all
hedged items having the same benchmark rate coupon. When
those elections are made, and because the portfolio is
closed, a similar assets test needs to be performed only at
hedge inception. Additionally, all assets in the portfolio
for hedge accounting purposes are considered nonamortizing
and nonprepayable with the same maturity and coupon,
resulting in the similar assets test being performed on a
qualitative basis.
When an entity accounts for a hedging relationship that is
designated under the last-of-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 last-of-layer hedge, the hedged item is a closed portfolio of
prepayable assets, so the basis adjustment is a portfolio-level basis
adjustment. As discussed below, an entity must, by using a systematic and
rational method, allocate the basis adjustment (or portion thereof) to the
individual assets within the portfolio upon a full or partial discontinuance
of the last-of-layer hedge. The shortcut method may not be applied to a
last-of-layer hedge.
In accordance with ASC 815-25-40-8(a), an entity that concludes on any hedge
effectiveness assessment date that it no longer expects the entire hedged
last of layer to be outstanding on its assumed maturity date must, at a
minimum, discontinue hedge accounting for that portion of the hedged last of
layer that is not expected to be outstanding. Moreover, in accordance with
ASC 815-20-40-8(b), the entity must discontinue the entire hedging
relationship on any assessment date on which it determines that the hedged
last of layer currently exceeds the outstanding balance of (1) the closed
portfolio of prepayable assets or (2) one or more beneficial interests in
the prepayable assets. If an entity discontinues a full or partial hedge, it
must allocate, in a systematic and rational manner, the outstanding basis
adjustment (or portion thereof) that resulted from the previous hedge
accounting for this hedging relationship 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.” We believe
that if an entity is required to discontinue the entire hedging relationship
because the outstanding balance of the hedged item is less than the hedged
last of layer, a proportion of the portfolio basis adjustment should be
reversed through earnings for the portion of the hedged last of layer that
no longer exists. See Section 3.5 for further
discussion of dedesignating and discontinuing fair value hedges.
Connecting the Dots
The last-of-layer method does not specifically incorporate a tainting
threshold; therefore, an entity that is required to discontinue a
last-of-layer hedging relationship is not precluded from designating
similar hedging relationships in the future. However, we believe
that an entity that needs to dedesignate a last-of-layer hedging
relationship, partially or fully, should consider the reasons for
the dedesignation when performing similar analyses for future
last-of-layer hedges.
Example 3-4
Last-of-Layer
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
five years. On the basis of its current expectations
about the level 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 $160 million at the end of the five-year
period. With that in mind, it executes a five-year,
receive-variable (one-month LIBOR), pay-fixed
interest rate swap with a notional amount of $160
million to hedge the interest rate risk.
Last-of-Layer
Method — Application at Inception
-
Weekapaug designates as the hedged item interest receipts on the last $160 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., $160 million last of layer) by using the benchmark rate component (LIBOR) of the contractual coupon cash flows.
-
In accordance with ASC 815, Weekapaug (1) performs an analysis that supports its expectation that the hedged item will be outstanding as of the item’s assumed maturity date and (2) documents its conclusion that the $300 million of mortgages in Portfolio X are similar.
-
Because the designated $160 million of unpaid principal balance (the last of layer) is expected to be outstanding at the end of the specified hedge term, Weekapaug can ignore prepayment risk and default risk when assessing whether the hedging relationship is expected to be highly effective.
Last-of-Layer
Method — Application in Subsequent Reporting
Periods
- Because of the combined effect of Weekapaug’s (1) elections related to the partial-term hedge, (2) use of the benchmark rate component of the coupon, and (3) last-of-layer designation, the hedged last of layer is essentially transformed into a homogeneous group 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 relationship will pass the quarterly hedge effectiveness assessment given that the key terms of the hedging relationship match (although the shortcut method may not be applied).
-
Weekapaug will account for the hedge accounting basis adjustments that arise during the hedging relationship at the Portfolio X level (i.e., the level of the designated hedged item).
-
As of each effectiveness testing date, Weekapaug will perform an analysis to support its expectation that the unpaid principal balance at the end of the hedged term will be no less than $160 million (i.e., the designated hedged exposure).
-
If Weekapaug concludes on any assessment date that it expects the outstanding balance of Portfolio X to be less than $160 million on the assumed maturity date, it would be required to (1) discontinue hedge accounting for at least the portion of the designated last of layer that it no longer expects to be outstanding on the assumed maturity date and (2) allocate the related portion of the outstanding basis adjustment to individual assets in the closed portfolio by using a systematic and rational method.
-
If the outstanding balance of loans in Portfolio X is less than $160 million on any assessment date, Weekapaug must discontinue the entire hedging relationship and allocate the portfolio-level basis adjustment to the individual assets by using a systematic and rational method. A proportion of the portfolio basis adjustment should be reversed through earnings for the portion of the hedged last of layer that no longer exists. For example, if the outstanding balance of the loans in Portfolio X is $144 million on an assessment date, Weekapaug should (1) reverse 10 percent, or ($160 million – $144 million) ÷ $160 million, of the portfolio-level basis adjustment through earnings and (2) allocate the remaining 90 percent of the basis adjustment to the remaining individual assets.
-
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 we discuss 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?4
|
---|---|---|
Example 9 — full contractual coupon cash flows
(see Section 3.2.1.5.1.1)
|
The difference between (1) and (2) below:
|
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).
|
Example 9 — benchmark component of contractual
coupon cash flows (see Section 3.2.1.5.1.2)
|
The difference between (1) and (2) below:
|
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).
|
Example 11/16 — full contractual
coupon cash flows (see Section 3.2.1.5.2.1)
|
The difference between (1) and (2) below:
|
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).
|
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:
|
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 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.
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-9 [See Section 9.7.]
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 outstanding partial-term hedge of an
interest-bearing financial instrument, 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).
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-9A [See Section 9.7.]
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 five-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).
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.
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-10 [See Section 9.7.]
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.
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-11 [See Section 9.7.]
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.
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-12 [See Section 9.7.]
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 last-of-layer 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. See Chapter 9 for further
discussion of ASU 2022-01.
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.
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-6 [See Section 9.7.]
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.
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.
Changing Lanes
In March 2022, the FASB issued ASU 2022-01, which
clarifies the guidance in ASC 815 on fair value hedge accounting of
interest rate risk for portfolios of financial assets. ASU 2022-01
renames the “last-of-layer” method the “portfolio layer” method and
addresses feedback from stakeholders regarding its application. In
addition, ASU 2022-01 amends ASC 815-25-35-6 to clarify that if the
hedged closed portfolio includes AFS debt securities, some or all of the
change in the hedged item’s fair value attributable to the hedged risk
should be recognized in earnings rather than in OCI to offset the gain
or loss on the hedging instrument. See Chapter 9 for a more thorough
discussion of ASU 2022-01.
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
|
Three-month LIBOR
|
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:
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
three-month LIBOR 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
The table below shows (1) the
three-month LIBOR 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.
September 30,
20X4
The table below shows (1) the
three-month LIBOR 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.
December 31,
20X4
The table below shows (1) the
three-month LIBOR 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.
March 31,
20X5
The table below shows (1) the
three-month LIBOR 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,
20X5
The table below shows (1) the
three-month LIBOR 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.
September 30,
20X5
The table below shows (1) the
three-month LIBOR 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.
December 31,
20X5
The table below shows (1) the
three-month LIBOR 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.
March 31,
20X6
The table below shows (1) the
three-month LIBOR 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,
20X6
The table below shows (1) the
three-month LIBOR 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.
September 30,
20X6
The table below shows (1) the
three-month LIBOR 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.
December 31,
20X6
The table below shows (1) the
three-month LIBOR 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.
March 31,
20X7
The table below shows (1) the
three-month LIBOR 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,
20X7
The table below shows (1) the
three-month LIBOR 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.
September 30,
20X7
The table below shows (1) the
three-month LIBOR 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.
December 31,
20X7
The table below shows (1) the
three-month LIBOR 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.
March 31,
20X8
The table below shows (1) the
three-month LIBOR 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,
20X8
The table below shows (1) the
three-month LIBOR 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.
September 30,
20X8
The table below shows (1) the
three-month LIBOR 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.
December 31,
20X8
The table below shows (1) the
three-month LIBOR 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 (three-month LIBOR) 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.
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.
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:
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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
three-month LIBOR 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
|
Six-month LIBOR
|
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 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:
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 six-month LIBOR 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 six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (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
The table below shows (1) the six-month LIBOR 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 swap’s fair value for the period.
December 31, 20X6
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (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, 20X7
The table below shows (1) the six-month LIBOR 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, 20X7
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (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, 20X7
The table below shows (1) the six-month LIBOR 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.
December 31, 20X7
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (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
The table below shows (1) the six-month LIBOR 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, 20X8
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (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, 20X8
The table below shows (1) the six-month LIBOR 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.
December 31, 20X8
The table below shows (1) the six-month LIBOR 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 (six-month LIBOR) 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.
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.
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:
March 31,
20X6
The table below shows (1) the six-month LIBOR 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 six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (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
The table below shows (1) the six-month LIBOR 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.
December 31, 20X6
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (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
The table below shows (1) the six-month LIBOR 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, 20X7
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (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 six-month LIBOR 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 six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (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
The table below shows (1) the six-month LIBOR 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, 20X8
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (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
The table below shows (1) the six-month LIBOR 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.
December 31, 20X8
The table below shows (1) the six-month LIBOR 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
1
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).
2
ASU 2022-01 modifies this language in ASC
815-25-35-13B to “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” (emphasis
added).
3
See footnote 2.
4
For simplicity, we assume that
the hedging relationship is not discontinued
before the end of the hedging relationship.