Chapter 3 — Fair Value Hedges

3.1 Overview

As indicated in the ASC master glossary and discussed briefly in Section 1.3.1, a fair value hedge is a “hedge of the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk.” Variability in that risk has the potential to affect reported earnings.

ASC 815-25

35-1 Gains and losses on a qualifying fair value hedge shall be accounted for as follows:

The gain or loss on the hedging instrument shall be recognized currently in earnings, except for amounts excluded from the assessment of effectiveness that are recognized in earnings through an amortization approach in accordance with paragraph 815-20-25-83A. All amounts recognized in earnings shall be presented in the same income statement line item as the earnings effect of the hedged item.
The gain or loss (that is, the change in fair value) on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized currently in earnings.

Pending Content (Transition Guidance: ASC 815-20-65-6)

35-1 [See Section 9.7.]

An entity with a fair value hedge that meets all of the hedging criteria in ASC 815 (see Chapter 2) would (1) record the change in the hedging instrument’s fair value in current-period earnings, except for amounts that are excluded from the hedge effectiveness analysis (see Section 3.4), and (2) adjust the hedged item’s carrying amount for the change in the hedged item’s fair value that is attributable to the risk being hedged. The adjustment to the carrying amount of the hedged item would also be recognized in current-period earnings. For qualifying fair value hedges, all amounts recognized in earnings that are related to both the hedging instrument and the hedged item are presented in the same income statement line item and should be related to the risk being hedged.

Common examples of fair value hedging strategies include the following:

Hedged Item	Derivative
Fixed-rate debt (liability)	A receive-fixed, pay-variable interest rate swap
Fixed-rate loans (assets)	A receive-variable, pay-fixed interest rate swap
Commodity inventory	Fixed-price forward or option to sell a commodity
Foreign-currency-denominated fixed-rate debt	Pay-variable, receive-fixed cross-currency interest rate swap
Nonderivative fixed-price commitment to sell a commodity	Fixed-price forward to purchase a commodity

This chapter discusses the accounting for fair value hedges from start to finish, including how to account for the hedged item throughout the hedging relationship and beyond. The discussion is broken down into the two major categories of fair value hedging relationships — hedges of financial instruments and hedges of nonfinancial assets. Foreign currency hedges (both fair value and cash flow hedges) is discussed separately in Chapter 5.

3.1.1 Hedging Firm Commitments

Although fair value hedging typically involves hedges of recognized assets or liabilities, an entity is also permitted to hedge changes in the fair value of an unrecognized firm commitment. Such a commitment to purchase or sell an asset at a fixed price exposes an entity to fluctuations in the asset’s fair value because the market price of the asset can change before the commitment is fulfilled. If an entity has entered into a firm commitment to deliver a commodity but does not already have the commodity in inventory, it may enter into a derivative contract to purchase the commodity at a fixed price to hedge that exposure.

The ASC master glossary defines a firm commitment, in part, as an agreement between unrelated parties that (1) is “binding on both parties and usually legally enforceable,” (2) “specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction,” and (3) “includes a disincentive for nonperformance that is sufficiently large to make performance probable.” (See the ASC master glossary for the complete definition of a firm commitment.)

Disincentives include both monetary penalties and nonmonetary consequences, such as exposure to costly litigation in the event of nonperformance (see ASC 815-25-55-84). In evaluating whether a monetary penalty is significant, an entity should consider market volatility and the price risk of the asset underlying the firm commitment.

Intercompany commitments do not meet the definition of a firm commitment because they are not made with a third party. However, intercompany commitments that have foreign currency exposure can be hedged as a forecasted transaction in a foreign currency cash flow hedge (see Section 5.3.1.1.1).

In addition, a contract with an equity method investee does not satisfy the criteria of a firm commitment because such a commitment must be made with an unrelated party. Since the definition of “related parties” in ASC 850-10-20 includes an equity method investee, a contract does not qualify as a firm commitment if it is between (1) an investor and its equity method investee or (2) a subsidiary and an equity method investee of the subsidiary’s parent. As discussed in Section 2.2.1.5, an entity is permitted to hedge exposures related to forecasted transactions with an equity method investee that are not eliminated through equity method accounting in a cash flow hedge. However, if an entity has a fixed-price firm commitment with an equity method investee, any transactions related to that firm commitment will no longer have exposure to changes in cash flows related to any component of the transaction with fixed terms.

3.2 Financial Instruments and Mortgage Servicing Rights

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

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

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

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

3.2.1 Interest Rate Risk Hedging

Interest rate risk is the most common hedged risk related to financial instruments and mortgage servicing rights. Entities often hedge mortgage servicing rights, fixed-rate assets, or fixed-rate liabilities with derivatives that have an underlying that is based on a benchmark interest rate (e.g., derivatives based on U.S. Treasury rates or 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: The remaining cash flows of the hedged item as of the end of the period, discounted at a rate equal to the market interest rate as of the beginning of the hedging relationship adjusted for changes in the benchmark rate from the inception of the hedging relationship to the beginning of the period. The remaining cash flows of the hedged item as of the end of the period, discounted at a rate equal to the market interest rate as of the beginning of the hedging relationship adjusted for changes in the benchmark rate from the inception of the hedging relationship to the end of the period.	Yes. Because the impact of the passage of time is excluded from the calculation, the entity will need to make cumulative basis adjustments to the hedged item at the end of the hedging term unless it elects to amortize basis adjustments over the life of the hedging relationship (see Section 3.2.5.1). In a partial-term hedge, the remaining basis adjustment is amortized over the remaining life of the debt in a manner consistent with the treatment of premiums and discounts on the debt. In a full-term hedge, the remaining basis adjustment is recognized as part of the derecognition of underlying debt (e.g., extinguishment gain or loss).
Example 9 — benchmark component of contractual coupon cash flows (see Section 3.2.1.5.1.2)	The difference between (1) and (2) below: The remaining assumed (benchmark component) cash flows of the hedged item as of the end of the period, discounted at the benchmark rate at the beginning of the period. The remaining assumed (benchmark component) cash flows of the hedged item as of the end of the period, discounted at the benchmark rate at the end of the period.	Yes. Because the impact of the passage of time is excluded from the calculation, the entity will need to make cumulative basis adjustments to the hedged item at the end of hedging term unless it elects to amortize basis adjustments over the life of the hedging relationship (see Section 3.2.5.1). In a partial-term hedge, the remaining basis adjustment is amortized over the remaining life of the debt in a manner consistent with the treatment of premiums and discounts on debt. In a full-term hedge, the remaining basis adjustment is recognized as part of the derecognition of underlying debt (e.g., extinguishment gain or loss).
Example 11/16 — full contractual coupon cash flows (see Section 3.2.1.5.2.1)	The difference between (1) and (2) below: The remaining cash flows of the hedged item as of the beginning of the period, discounted at a rate equal to the market interest rate as of the beginning of the hedging relationship adjusted for changes in the benchmark rate from the inception of the hedging relationship to the beginning of the period. The remaining cash flows of the hedged item as of the end of the period, discounted at a rate equal to the market interest rate as of the beginning of the hedging relationship adjusted for changes in the benchmark rate from the inception of the hedging relationship to the end of the period.	If fair value of debt is equal to par at hedge inception — No. The entity will make cumulative basis adjustments that should equal zero. An entity may still elect to amortize basis adjustments over the life of the hedging relationship, but there is no reason to do so. If fair value of debt is not equal to par at hedge inception — Yes. The entity will make cumulative basis adjustments on the debt instrument that will equal and offset the difference between the debt’s fair value at hedge inception and the par amount of the debt unless the entity elects to amortize basis adjustments over the life of the hedging relationship (see Section 3.2.5.1). In a partial-term hedge, the remaining basis adjustment is amortized over the debt’s remaining life in a manner consistent with the treatment of premiums and discounts on debt. In a full-term hedge, the remaining basis adjustment is recognized as part of the derecognition of underlying debt (e.g., extinguishment gain or loss).
Example 11/16 — benchmark component of contractual coupon cash flows (see Section 3.2.1.5.2.2)	The difference between (1) and (2) below: The remaining assumed (benchmark component) cash flows of the hedged item as of the beginning of the period, discounted at the benchmark rate at the beginning of the period. The remaining assumed (benchmark component) cash flows of the hedged item as of the end of the period, discounted at the benchmark rate at the end of the period.	No. The entity will make cumulative basis adjustments that should equal zero. An entity may still elect to amortize basis adjustments over the life of the hedging relationship.

Connecting the Dots

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

3.2.2 Foreign Currency Risk Hedging

ASC 815-25

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

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

3.2.3 Credit Risk Hedging

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

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

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

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

3.2.4 Overall Fair Value Hedging

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

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

3.2.5 Accounting for Basis Adjustments

ASC 815-25

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

35-9 An adjustment of the carrying amount of a hedged interest-bearing financial instrument 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

September 30, 20X4

December 31, 20X4

March 31, 20X5

June 30, 20X5

September 30, 20X5

December 31, 20X5

March 31, 20X6

June 30, 20X6

September 30, 20X6

December 31, 20X6

March 31, 20X7

June 30, 20X7

September 30, 20X7

December 31, 20X7

March 31, 20X8

June 30, 20X8

September 30, 20X8

December 31, 20X8

The table below shows (1) the 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.

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 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

December 31, 20X6

March 31, 20X7

June 30, 20X7

September 30, 20X7

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

June 30, 20X8

September 30, 20X8

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.

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

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

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

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

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

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

ASU 2022-01 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).

See footnote 2.

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

3.5 Discontinuing a Fair Value Hedge

In certain circumstances, an entity may be required to discontinue hedge accounting because of a change in circumstances. In other cases, an entity may elect to do so. Section 3.5.1 discusses possible reasons why hedge accounting might be discontinued for a fair value hedging relationship, and Section 3.5.2 walks through the accounting for the hedged item after such a discontinuation, including a discussion of amounts in AOCI related to components that were excluded from the hedge effectiveness assessment.

3.5.1 Reasons for Discontinuing a Fair Value Hedge

ASC 815-25

40-1 An entity shall discontinue prospectively the accounting specified in paragraphs 815-25-35-1 through 35-6 for an existing hedge if any one of the following occurs:

Any criterion in Section 815-20-25 is no longer met.
The derivative instrument expires or is sold, terminated, or exercised.
The entity removes the designation of the fair value hedge.

3.5.1.1 Derivative or Hedged Item No Longer Held

ASC 815-25-40-1(b) requires an entity to discontinue hedge accounting for a fair value hedging relationship if the hedging derivative “expires or is sold, terminated, or exercised.” In such a case, hedge accounting should be applied through the date of the of expiration, sale, termination, or exercise if the hedging relationship met the criteria to qualify for hedge accounting until then. After that date, there will no longer be a derivative measured at fair value on the balance sheet, so the hedged item should no longer be remeasured for changes in its fair value that are attributable to the hedged risk unless it is designated as the hedged item in a new qualifying fair value hedging relationship.

ASC 815-20-40-1 does not specifically mention the sale, termination, or exercise of the hedged item. However, if the item is no longer recognized on the balance sheet, there is no longer a hedged item with exposure to changes in fair value that are attributable to the hedged risk that could affect earnings. Therefore, the hedging relationship would no longer meet the general hedging requirements of ASC 815-20-25 because there would not be an eligible hedged item. Accordingly, the entity would need to discontinue hedge accounting for the hedging relationship in accordance with ASC 815-20-40-1(a).

3.5.1.1.1 Derivative Modifications

ASC 815 does not contain explicit guidance on how to determine whether the modification of an existing derivative instrument results in the “termination” of the original derivative and replacement with a new one. If the premodified derivative was a hedging instrument in a qualified hedging relationship and the modification is considered a termination of the derivative, the hedging relationship would be discontinued under ASC 815-25-40-1(b) (for a fair value hedge) or ASC 815-30-40-1(b) (for a cash flow hedge). In addition, ASC 815-20-55-56 states, in part, that “[i]f an entity wishes to change any of the critical terms of the hedging relationship (including the method designated for use in assessing hedge effectiveness), as documented at inception, the mechanism provided in this Subtopic to accomplish that change is the dedesignation of the original hedging relationship and the designation of a new hedging relationship that incorporates the desired changes.” As discussed in Sections 3.5.1.3, 4.1.5.1.3, and 5.4.3, a hedging relationship must be discontinued upon its dedesignation regardless of the type of hedging relationship (i.e., fair value hedge, cash flow hedge, or net investment hedge).

As noted above, ASC 815 does not provide specific guidance on determining whether a modification of a derivative’s terms is significant enough to be viewed as the termination of the original derivative and replacement with a new one. One reason for this lack of guidance could be that there is no need for such a distinction. A derivative within the scope of ASC 815 must be recognized on the balance sheet at fair value. If the modification of a derivative’s terms results in a change in its fair value and the counterparties do not exchange consideration for that change, the entity would generally recognize the change in earnings. If the derivative is not in a qualifying hedging relationship, all changes in fair value must be recognized in earnings. If the derivative is in a qualifying hedging relationship and the change is viewed as a change in a critical term of the derivative, the entity is required to dedesignate the hedging relationship under ASC 815-20-55-56. Accordingly, any change in the derivative’s value that results from the modification of terms would (1) not be attributed to the preexisting hedging relationship and (2) then be recognized in earnings.

The guidance does not explicitly address a modification of terms that is not deemed to be a change in a critical term of the derivative or hedging relationship. If the derivative is designated in a qualifying fair value hedging relationship, the hedged item would not have a corresponding change in fair value (or payment, if a payment was required to execute the modification), so the mechanics of fair value hedging would result in no offset for any change in the derivative’s fair value that must be recognized in earnings. If the derivative is designated in a qualifying cash flow hedge or net investment hedge and the entity determines that the hedging relationship was still highly effective (by considering the change in the derivative’s fair value or cash flows that is not offset by any change in the hedged cash flows or net investment in foreign operations), any change in fair value that was not offset by a payment for the modification would be recognized in OCI.

Connecting the Dots

Some believe that any modification of a derivative’s terms that affects its fair value is a change of a critical term of the derivative, which would result in the automatic dedesignation of any hedging relationship. Others believe that modifications that would affect the fair value of the derivative but do not result in changes in any of its settlement terms are not changes in the critical terms of the derivative or the hedging relationship; therefore, such modifications would not result in an automatic hedge dedesignation event. Examples of such modifications could be changes in collateral requirements or novations.

ASU 2016-05 added ASC 815-20-55-56A to clarify that derivative novations would not be considered a change in the critical terms of a hedging relationship (see the next section). We believe that an entity should carefully evaluate any other modifications (e.g., changes in collateral requirements) that would affect the fair value of the derivative but do not result in changes in any of its settlement terms before concluding that a change in the critical terms of the hedging relationship has not occurred. For example, if the modification resulted in a significant change in the derivative’s fair value, it would be difficult for the entity to conclude that the critical terms of the hedging relationship were not changed.

In addition, the FASB issued ASU 2021-01 in January 2021 to address the accounting for changes in interest rates used for discounting and for variation margin settlements and price alignment interest (PAI). See Section 8.3 for further discussion of ASU 2021-01.

3.5.1.1.2 Derivative Novations

ASC 815-20

55-56A For the purposes of applying the guidance in paragraph 815-20-55-56, a change in the counterparty to a derivative instrument that has been designated as the hedging instrument in an existing hedging relationship would not, in and of itself, be considered a change in a critical term of the hedging relationship.

ASC 815-25

40-1A For the purposes of applying the guidance in paragraph 815-25-40-1, a change in the counterparty to a derivative instrument that has been designated as the hedging instrument in an existing hedging relationship would not, in and of itself, be considered a termination of the derivative instrument.

ASC 815-30

40-1A For the purposes of applying the guidance in paragraph 815-30-40-1, a change in the counterparty to a derivative instrument that has been designated as the hedging instrument in an existing hedging relationship would not, in and of itself, be considered a termination of the derivative instrument.

A novation of a derivative occurs when one of the counterparties to the derivative is replaced with another counterparty.

Example 3-14

TreyCo has an outstanding interest rate swap with Weekapaug Regional Bank, which assigns its rights and obligations under the swap to Makisupa Regional Bank. In this case, the interest rate swap was novated. Weekapaug would no longer recognize the interest rate swap on its balance sheet; the swap would instead be recognized on Makisupa’s balance sheet. However, TreyCo would continue to recognize the swap on its balance sheet.

Novations were not very common until the enactment of Dodd-Frank,5 which includes certain provisions that require entities to novate derivatives. If a novated derivative had previously been designated in a hedging relationship, it was not clear whether such a change in counterparties to the derivative would be deemed a change in the critical terms of the hedging relationship that would give rise to a requirement to dedesignate the relationship in accordance with ASC 815-20-55-56. As a result, the International Swaps and Derivatives Association (ISDA) consulted with the SEC’s Office of the Chief Accountant (OCA) about whether novations made in response to Dodd-Frank would result in a requirement to dedesignate hedging relationships that involve novated derivatives. In response, in a May 2012 letter to the ISDA, the OCA indicated that a required novation of a bilateral OTC derivative contract on the same financial terms would not have to be deemed a termination of the old derivative or a change in the critical terms of the hedging relationship. As long as other terms of the derivative were not changed, the existing hedging relationships could be continued.

Even after the OCA addressed novations resulting from the Dodd-Frank Act, it continued to receive questions related to the novation of a derivative in the following scenarios:

The reporting entity’s derivative counterparty merges with and into a surviving entity that assumes the same rights and obligations that existed under a preexisting derivative instrument of the merged entities.
The reporting entity’s derivative counterparty novates a derivative instrument to an entity under common control with the derivative counterparty.
At the inception of the hedging relationship, the reporting entity knows and contemporaneously documents that all or part of the derivative will be novated to a new counterparty during the hedging relationship.

At the 2014 AICPA Conference on Current SEC and PCAOB Developments, the OCA indicated that in any of the circumstances described above, it would not object if an entity continues its existing hedging relationship despite the derivative instrument’s novation provided that (1) no other critical terms of the derivative are changed and (2) the hedging relationship continues to be highly effective.

As a result of discussions by the EITF in 2015, the FASB issued ASU 2016-05 in March 2016. The ASU added ASC 815-20-55-56A, ASC 815-25-40-1A, and ASC 815-30-40-1A, which indicate that a change in the counterparty to a derivative instrument that has been designated in an existing hedging relationship would not, in and of itself, be considered either a termination of the derivative instrument or a change in a critical term of the hedging relationship.

3.5.1.2 Relationship No Longer Qualifies for Hedge Accounting

3.5.1.2.1 Hedging Relationship Not Highly Effective

ASC 815-25

Noncompliance With Effectiveness Criterion

40-3 In general, if a periodic assessment indicates noncompliance with the effectiveness criterion in paragraphs 815-20-25-75 through 25-80, an entity shall not recognize the adjustment of the carrying amount of the hedged item described in paragraphs 815-25-35-1 through 35-6 after the last date on which compliance with the effectiveness criterion was established.

40-4 However, if the event or change in circumstances that caused the hedging relationship to fail the effectiveness criterion can be identified, the entity shall recognize in earnings the changes in the hedged item’s fair value attributable to the risk being hedged that occurred before that event or change in circumstances.

As noted in ASC 815-25-40-1(a), hedge accounting should be discontinued for a fair value hedging relationship if any of the qualifying criteria for a fair value hedge are no longer met. The most common reason for needing to discontinue such a relationship under ASC 815-25-40-1(a) is that the hedge effectiveness assessment no longer supports an assertion that the hedging relationship is or is expected to be highly effective. However, while ASC 815-25-40-1(a) requires hedge accounting to be discontinued, as discussed in Section 2.5.1, we do not believe that a hedging relationship must be dedesignated upon a failed hedge effectiveness assessment because the effect of discontinuing hedge accounting is that it is not applied during the period in which the hedging relationship does not qualify for it. ASC 815-25-40-3 states, in part, that “an entity shall not recognize the adjustment of the carrying amount of the hedged item [in a fair value hedging relationship] after the last date on which compliance with the effectiveness criterion was established.”

If an entity’s retrospective hedge effectiveness assessment shows that a hedging relationship was not highly effective in the period just completed, the entity should consider whether there was a specific event or change in circumstances that caused the relationship to fail the effectiveness assessment. ASC 815-25-40-4 states, in part, that “if the event or change in circumstances that caused the hedging relationship to fail the effectiveness criterion can be identified, the entity shall recognize in earnings the changes in the hedged item’s fair value attributable to the risk being hedged that occurred before that event or change in circumstances.” In other words, if the hedging relationship was highly effective for a portion of the period before the specific event or change in circumstances occurred, it would be appropriate to apply hedge accounting to that portion.

If the hedging relationship is not dedesignated, hedge accounting may be applied in any subsequent period in which the entity can show that (1) it expects the hedging relationship to be highly effective at the beginning of the period (the prospective hedge effectiveness assessment) and (2) the hedge was highly effective during the period (the retrospective hedge effectiveness assessment). However, as noted in Section 2.5.1, if there are repeated failed hedge effectiveness assessments, the entity may want to consider whether a different hedging strategy would qualify for hedge accounting. Example 3-11 illustrates a fair value hedge of inventory that is discontinued but not dedesignated.

3.5.1.2.2 Hedged Item No Longer Meets Definition of Firm Commitment

ASC 815-25

Hedged Item No Longer Meets Definition of Firm Commitment

40-5 If a fair value hedge of a firm commitment is discontinued because the hedged item no longer meets the definition of a firm commitment, the entity shall do both of the following:

Derecognize any asset or liability previously recognized pursuant to paragraph 815-25-35-1(b) (because of an adjustment to the carrying amount for the firm commitment)
Recognize a corresponding loss or gain currently in earnings.

40-6 A pattern of discontinuing hedge accounting and derecognizing firm commitments would call into question the firmness of future hedged firm commitments and the entity’s accounting for future hedges of firm commitments.

The guidance in ASC 815-25-40-1(a) would also apply if the hedged item in a fair value hedge no longer qualifies to be the hedged item. This would be the case if the hedged item is an unrecognized firm commitment that no longer meets the definition of a firm commitment. In that case, as indicated by ASC 815-25-40-5, an entity must not only discontinue the application of hedge accounting but also derecognize in earnings the asset or liability that was recognized as an adjustment to the carrying amount of a previously qualifying fair value hedging relationship. In addition, a pattern of hedged firm commitments that no longer meet the definition of a firm commitment would call into question whether an entity could assert that the commitments it wanted to hedge would meet the definition of a firm commitment. Note that a commitment that was settled according to its terms is not considered a firm commitment that no longer meets the definition of a firm commitment.

3.5.1.2.3 Last-of-Layer Breach

ASC 815-25

40-8 For a hedging relationship designated under the last-of-layer method in accordance with paragraph 815-20-25-12A, an entity shall discontinue (or partially discontinue) hedge accounting in either of the following circumstances:

If the entity cannot support on a subsequent testing date that the hedged item (that is, the designated last of layer) is anticipated to be outstanding in accordance with paragraph 815-25-35-7A, it shall at a minimum discontinue hedge accounting for the portion of the hedged item no longer expected to be outstanding at the hedged item’s assumed maturity date.

b. If on a subsequent testing date the outstanding amount of the closed portfolio of prepayable financial assets or one or more beneficial interests is less than the hedged item, the entity shall discontinue hedge accounting.

Pending Content (Transition Guidance: ASC 815-20-65-6)

40-8 [See Section 9.7.]

40-9 If a last-of-layer method hedging relationship is discontinued (or partially discontinued), the outstanding basis adjustment (or portion thereof) as of the discontinuation date shall be allocated to the individual assets in the closed portfolio using a systematic and rational method. An entity shall amortize those amounts over a period that is consistent with the amortization of other discounts or premiums associated with the respective assets 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)

40-9 [See Section 9.7.]

Last-of-layer hedging involves a partial-term fair value hedge of a portfolio of prepayable financial assets for changes in fair value that are attributable to changes in the designated benchmark interest rate, as discussed in Section 3.2.1.4. At each hedge effectiveness assessment date throughout the life of a last-of-layer hedge, an entity is required to support the expectation that the designated last of layer will be outstanding on the assumed maturity date. If the entity cannot support that assertion, in accordance with ASC 815-25-40-8(a), it is required to dedesignate the proportion of the hedge related to the portion of the last of layer that is not expected to be outstanding on the assumed maturity date. Proportional dedesignations are discussed in Section 3.5.1.3.1.

However, if, on an assessment date, the outstanding amount of the closed portfolio of a last-of-layer hedge is less than the designated last of layer (commonly referred to as a “breach” of the last of layer), the entity must dedesignate and discontinue the entire last-of-layer hedging relationship in accordance with ASC 815-25-40-8(b).

According to ASC 815-25-40-9, at the time of a partial or full discontinuance of a last-of-layer hedge, the outstanding portfolio-level basis adjustment “shall be allocated to the individual assets in the closed portfolio using a systematic and rational method.” As noted in Example 3-4, we believe that in the case of a breach of the last of layer, the portion of the basis adjustment related to the breached portion should be reversed through earnings since it is related to assets that no longer exist (e.g., sales, prepayments, or defaults). The basis adjustment that is allocated to the assets that still remain in the pool on the date of discontinuance would be amortized over “a period that is consistent with the amortization of other discounts or premiums associated with the respective assets.”

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. ASU 2022-01 amends ASC 815-25-35-6 to clarify that in the event of an anticipated or actual breach of a hedged layer, an entity should discontinue hedge accounting for all or part of one or more hedging relationships related to the portfolio layer method hedge. In addition, in the event a breach has occurred, the portion of the basis adjustment related to the breached portion of the portfolio should be reclassified into interest income. See Chapter 9 for a more thorough discussion of ASU 2022-01.

3.5.1.3 Dedesignations

ASC 815-25-40-1(c) notes that fair value hedge accounting should be discontinued if an entity “removes the designation of the fair value hedge.” An entity may discontinue a hedging relationship at any time, even if the hedging instrument and the hedged item remain unchanged and are not sold, terminated, expired, or exercised. In some cases, an entity may dedesignate a hedging relationship to change its method of assessing hedge effectiveness (see Section 2.5.4), but in other cases, it may want to change the hedging relationship itself, such as in a dynamic hedging strategy (see Section 2.5.2.1.3). For example, the entity may want to deploy the hedging instrument in a different hedging relationship or simply may no longer want to apply hedge accounting to the relationship. The voluntary discontinuance of a hedging relationship is accomplished by (1) formally documenting the dedesignation of the relationship and then (2) discontinuing the application of hedge accounting to the dedesignated relationship on the date of the documentation.

Connecting the Dots

The concept of voluntarily dedesignating an existing hedging relationship has been a topic of deliberation by both the FASB and the International Accounting Standards Board (IASB®). While we further examine some of the differences between U.S. GAAP and IFRS Accounting Standards in Appendix A, this is one subject in which the standards are not converged. Under IFRS 9, an entity is not allowed to dedesignate a hedging relationship without either terminating the hedging derivative or entering into an offsetting derivative. When the FASB issued its June 2008 and May 2010 exposure drafts to amend hedge accounting, it proposed a model similar to IFRS 9. However, on the basis of comments received and further deliberations, the Board did not include such a requirement in its September 2016 exposure draft on targeted improvements to accounting for hedging activities, which was ultimately issued as ASU 2017-12. Instead, the ASU maintains an entity’s ability to voluntarily dedesignate a hedging relationship through documentation.

3.5.1.3.1 Proportional Dedesignations

If an entity wants to dedesignate part of a hedging relationship, rather than the entire relationship, it must make a proportional dedesignation in which it dedesignates the same proportion of both the hedging instrument and the hedged item. For example, if an entity is using a forward contract to sell 100 ounces of gold to hedge 100 ounces of gold inventory and decides to dedesignate 10 percent of the hedging relationship, it would dedesignate 10 percent of the forward contract (the notional amount related to 10 ounces) and 10 percent of the gold inventory (10 ounces) from the hedging relationship. After the dedesignation, the remaining hedging relationship would involve 90 percent of the outstanding forward contract hedging 90 ounces of gold inventory.

ASC 815-30-55-67 through 55-76 provide an example of a hedge of foreign currency risk related to forecasted royalty payments. In the example, the overall foreign currency exposure is related to the ultimate settlement of a quarterly payable that results from three different monthly royalty expenses. When each monthly royalty is incurred and the forecasted transaction becomes a recognized payable, the entity dedesignates a proportion of the derivative from the existing overall cash flow hedge and then can redesignate that proportion in a fair value hedge of the recognized payable. In Section 5.3.1.1.2, we discuss a foreign currency hedging strategy in which a forecasted transaction (e.g., the royalty expense) is hedged through the settlement date (e.g., the settlement of the payable) as a combination of a cash flow hedge (i.e., the forecasted transaction) followed by a fair value hedge (i.e., the recognized payable).

Another example of a required proportional dedesignation event is when an entity has an existing last-of-layer hedging relationship (see Section 3.2.1.4) and it no longer believes that the outstanding balance of the closed portfolio of assets will equal or exceed the designated last of layer through the assumed maturity date. Accordingly, under ASC 815-25-40-8(a), the entity should “at a minimum discontinue hedge accounting for the portion of the hedged item no longer expected to be outstanding at the hedged item’s assumed maturity date.”

An entity may not dedesignate a proportion of a derivative from the hedging relationship without also dedesignating the same proportion of the hedged item. In addition, an entity may not dedesignate a portion of a derivative and hedged item that is not expressed as a proportion of the original hedging relationship without a full dedesignation of the original hedging relationship and redesignation of a new hedging relationship. For example, if an entity wants to dedesignate the last two years of a hedging relationship that involves a five-year interest rate swap hedging a five-year fixed-rate debt instrument, it must dedesignate the entire five-year relationship and redesignate the new three-year relationship. Note that a portion of a derivative does not qualify as the hedging instrument in a hedging relationship, as discussed in Section 2.4.1.2.

Any dedesignation should be accomplished through contemporaneous documentation. A proportional dedesignation maintains the remaining proportion of the original hedging relationship (i.e., the proportion that has not been dedesignated) for the remainder of its term. If the hedging relationship met the conditions to apply hedge accounting up to the date of proportional dedesignation, hedge accounting would be applied to the entire hedging relationship up until that date.

After a dedesignation, an entity would only assess the remaining proportion of the hedging relationship to determine whether it qualifies for hedge accounting. In other words, the entity would compare only (1) the proportion of the changes in the derivative’s fair value that are related to the proportion that is still designated as the hedging instrument and included in the assessment of hedge effectiveness with (2) the changes in the fair value of the newly designated proportion of the hedged item that are attributable to changes in the designated risk. The proportion of the derivative that was dedesignated from the hedging relationship may be used as the designated hedging instrument in another qualifying hedging relationship.

The table below summarizes the treatment of the derivative and hedged item both before and after a proportional dedesignation of a fair value hedging relationship. It is assumed that the proportion of the derivative that was dedesignated is not designated in a new qualifying hedging relationship.

	Before Date of Dedesignation		After Date of Dedesignation
	Hedge Is Highly Effective	Hedge Is Not Highly Effective	Hedge Is Highly Effective	Hedge Is Not Highly Effective
Derivative	Remeasured at fair value through earnings6
Proportion of hedged item still designated	Carrying amount adjusted for changes in fair value attributable to hedged risk.	Carrying amount not adjusted.	Carrying amount adjusted for changes in fair value attributable to hedged risk.	Carrying amount not adjusted. See Sections 3.2.5 (financial) and 3.3.1 (nonfinancial) for treatment of basis adjustments.
Proportion of hedged item dedesignated			Carrying amount not adjusted. See Sections 3.2.5 (financial) and 3.3.1 (nonfinancial) for treatment of prior basis adjustments.

An entity could accomplish the same objective of a proportional dedesignation by dedesignating the entire hedging relationship and redesignating the portion of the hedging relationship that it intends to apply hedge accounting to; however, redesignating an existing derivative into a new hedging relationship would most likely involve an off-market derivative, which would affect the assessment of hedge effectiveness (see Section 2.5.2.1.4).

3.5.2 Accounting for a Discontinued Fair Value Hedge

Upon the discontinuation of hedge accounting for a fair value hedging relationship, the treatment of any remaining basis adjustments to the hedged item from the application of fair value hedge accounting until its discontinuation depends on the hedged item’s nature. If the hedged item is an interest-bearing financial instrument, cumulative adjustments to the carrying amount should be amortized to earnings “over a period that is consistent with the amortization of other discounts or premiums associated with the hedged item” in accordance with ASC 815-25-35-9A (see Section 3.2.5). If the hedged item is a nonfinancial asset or liability, the entity should account for the basis adjustments in the same manner as other components of the carrying amount of that asset or liability (see Section 3.3.1).

ASC 815-25

40-7 When applying the guidance in paragraph 815-20-25-83A, any amounts remaining in accumulated other comprehensive income associated with amounts excluded from the assessment of effectiveness shall be recorded in earnings in the current period if the hedged item is derecognized. For all other discontinued fair value hedges, any amounts associated with the excluded component remaining in accumulated other comprehensive income shall be recorded in earnings in the same manner as other components of the carrying amount of the hedged asset or liability in accordance with paragraphs 815-25-35-8 through 35-9A.

If a fair value hedge is discontinued early, any amounts associated with remaining components in AOCI that were excluded from the hedge effectiveness assessment should be reclassified into earnings in the same manner as other components of the hedged item’s carrying amount. For example, if an entity had designated a purchased put option in a fair value hedge of inventory for changes in overall price risk and had been excluding the option’s time value from the assessment of hedge effectiveness, any amounts in AOCI related to changes in the fair value of the time value that had not already been recognized in earnings would remain in AOCI until the inventory affected earnings (i.e., those amounts in AOCI would be reclassified into cost of sales when the inventory was sold or reclassified into impairment expense if the inventory was subsequently impaired).

Footnotes

Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

If any component of the derivative is excluded from the assessment of hedge effectiveness and the difference between the changes in that component’s in fair value and the amount recognized in earnings under a systematic and rational method are recorded in OCI as permitted by ASC 815-20-25-83A, only the proportion of the derivative that is still in a hedging relationship qualifies for this treatment after the date of the proportional dedesignation. Amounts related to the proportion of the derivative that was dedesignated should remain in AOCI and be reclassified in earnings in a manner similar to the related basis adjustments on the hedged item, as discussed in this table (see Section 3.5.2).

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Expires	December 31, 20X9
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