4.2 Financial Instruments

As discussed in Chapter 2, in a cash flow hedge of financial instruments, a derivative instrument hedges one or more specific risks of a hedged item. The table below summarizes the potential hedged items and risks in a cash flow hedge involving a financial asset or liability.

Underlying Asset/Liability	Hedgeable Portion	Risks That May Be Hedged
Variable-rate asset or liability Forecasted issuance of debt Forecasted origination of a loan Forecasted purchase or sale of a debt instrument Portfolio of similar above items (see Section 2.2.2.2.2)	Any specified cash flows	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)

In many cases, the hedging derivative is not perfectly effective at offsetting the total changes in cash flows related to the hedged item in a cash flow hedge involving financial instruments. However, as discussed in Section 2.5, an entity has the ability to (1) select portions (specific cash flows) of the hedged item and (2) designate specific hedged risks, both of which affect the hedge effectiveness assessment. Thoughtful designation of those items can make the difference between a hedging relationship that qualifies for hedge accounting and one that does not. As long as a qualifying cash flow hedging relationship is highly effective, all components of the change in the derivative’s fair value that are included in the hedge effectiveness assessment are recorded in OCI (see Section 2.5 for a discussion of hedge effectiveness assessments). Unlike a qualifying fair value hedge, ineffectiveness is not recognized currently in the income statement.

4.2.1 Interest Rate Risk Hedging

In hedges of financial instruments, the most commonly hedged risk is interest rate risk. Entities often hedge the forecasted origination, acquisition, or issuance of fixed-rate debt instruments with derivatives that are based on a benchmark rate (e.g., derivatives based on U.S. Treasury rates or SOFR OIS). However, while most variable-rate debt instruments have interest payments that vary on the basis of changes in a benchmark rate, there are still many such instruments that have interest payments that vary on the basis of a nonbenchmark rate (e.g., a bank’s designated prime rate). When the FASB issued ASU 2017-12, it amended the permitted interest rate risk hedging strategies to differentiate between transactions involving fixed-rate debt and transactions involving variable-rate debt. ASU 2017-12 introduced the “contractually specified interest rate” as an acceptable designated risk related to variable-rate debt instruments, both existing and forecasted.

The table below summarizes (1) the different types of debt instruments that give rise to interest rate risk and (2) the items and interest rate risks that may be hedged in a qualifying cash flow hedging relationship.

Type of Debt Instrument	Hedged Item — Interest Rate Risk
Existing fixed-rate debt	N/A. No exposure to changes in cash flows. Fair value hedging may apply (see Section 3.2.1).
Existing variable-rate debt	Interest payments — contractually specified interest rate.
Forecasted issuance/acquisition of fixed-rate debt	Proceeds/price or interest payments — benchmark interest rate.
Forecasted issuance/acquisition of variable-rate debt	Interest payments — forecasted contractually specified interest rate.

4.2.1.1 Hedging Existing Variable-Rate Debt Instruments

As discussed in Section 2.3.1.1, an entity that has a variable-rate debt instrument is exposed to changes in cash flows as a result of changes in the contractually specified interest rate. The debtor is exposed to increased interest expense if the interest rate increases, and the creditor is exposed to decreased interest income if the interest rate decreases.

If an entity wants to hedge changes in its interest payments on a variable-rate debt instrument for changes that are attributable to interest rate risk, it would designate as the hedged risk the contractually specified interest rate in the debt instrument.

Example 4-8

Esquandolas Gearshift Company has $100 million of debt outstanding, with an interest rate that is based on three-month term SOFR plus 1.5 percent per year; the interest rate resets every three months. To hedge the risk of interest rate changes, Esquandolas could designate (1) as the hedged item the quarterly interest payments and (2) as the hedged risk the risk of changes in those quarterly interest payments that is attributable to changes in the contractually specified interest rate (i.e., three-month term SOFR). In this case, the contractually specified interest rate happens to qualify as a benchmark interest rate, but that is not a requirement for the rate to be designated as the hedged risk in a qualifying cash flow hedging relationship involving interest payments on an existing variable-rate debt instrument. The only requirement is that the interest rate designated must (1) be specified in the debt agreement and (2) affect the interest paid on the debt.

Example 4-18 illustrates a hedge of interest payments on variable-rate debt with an interest rate swap, and Example 4-20 illustrates a hedge of interest payments on variable-rate debt with an interest rate cap.

The following is a detailed discussion of some unique aspects of Dutch auction bonds and overnight deposits with financial institutions and how their nonstandard terms affect an entity’s ability to hedge them in a cash flow hedging relationship:

Dutch auction bonds — Entities may issue bonds whose interest rates are periodically reset on the basis of a competitive “Dutch” auction. The auction process, which occurs at predetermined intervals, requires bondholders to tender their bonds. Potential new investors and existing holders (at their option) then enter into a “blind” competitive-bid process in which they specify the lowest interest rate and the quantity that they are willing to accept. The winning bid (1) represents the lowest interest rate that bidders are willing to accept to purchase the entire issue being offered and (2) establishes the interest rate on the bonds until the next reset date.
ASC 815-20-25-15(j) allows entities to hedge the following three general risks related to cash flow hedges of interest payments on debt:
- Overall changes in cash flows.
- Changes that are attributable to changes in the interest rate risk.
- Changes in functional-currency-equivalent cash flows that are attributable to foreign currency risk.
In connection with interest rate risk, ASC 815-20-25-15(j)(2) states, in part, that an entity may choose to designate the following hedged risks:

For forecasted interest receipts or payments on an existing variable-rate financial instrument, the risk of changes in its cash flows attributable to changes in the contractually specified interest rate (referred to as interest rate risk). For a forecasted issuance or purchase of a debt instrument (or the forecasted interest payments on a debt instrument), the risk of changes in cash flows attributable to changes in the benchmark interest rate or the expected contractually specified interest rate.

Dutch auction bonds are existing variable-rate financial instruments, so the only identifiable interest rate risk is changes in the cash flows that are attributable to changes in the contractually specified interest rate. An entity may not designate as the hedged risk the changes in the benchmark interest rate because the Dutch auction process results in a full reset of interest to a market rate for the issuer. Accordingly, there is no difference between hedging the overall changes in cash flows under ASC 815-20-25-15(j)(1) and hedging an inferred contractually specified interest rate (which would potentially be the rate that results from the auction process) under ASC 815-20-25-15(j)(2).
Overnight deposits — Banks offer investors overnight deposits that might be viewed as fixed-rate liabilities that mature daily. Investors can “roll over” their deposit (i.e., reinvest their funds or leave the funds on deposit), but banks are not legally obligated to accept the continuation of rollover deposits. When establishing the periodic rate to pay each investor, a bank may consider the current federal funds interest rate as a base rate, and it can periodically adjust the deposit rate to take into consideration the bank’s current creditworthiness and other market conditions. However, it is not explicitly agreed that the periodic rate the investor receives will be determined on the basis of the federal funds rate plus or minus a fixed spread.
Banks encounter cash flow variability as a result of periodic changes in the fixed rates they pay on these overnight deposits. If a bank wants to hedge the risk of daily changes in the cash flows of the forecasted rollover of these overnight deposits, it would most likely enter into a pay-fixed, receive-variable interest rate swap that is indexed to a benchmark interest rate (e.g., three-month daily SOFR). The bank should consider whether the specific terms and conditions of the deposit account indicate that the forecasted cash flows pertaining to the account represent either (1) a variable-rate instrument or (2) the forecasted issuance of short-term fixed-rate debt. As discussed in more detail below, many features commonly found in deposit arrangements suggest that the rollover of a deposit account is a variable-rate instrument rather than the reissuance of short-term fixed-rate debt. In connection with forecasted reissuances of debt, ASC 815-20-25-19A states the following:
In accordance with paragraph 815-20-25-6, if an entity designates a cash flow hedge of interest rate risk attributable to the variability in cash flows of a forecasted issuance or purchase of a debt instrument, it shall specify the nature of the interest rate risk being hedged as follows:
1. If an entity expects that it will issue or purchase a fixed-rate debt instrument, the entity shall designate the variability in cash flows attributable to changes in the benchmark interest rate as the hedged risk.
2. If an entity expects that it will issue or purchase a variable-rate debt instrument, the entity shall designate the variability in cash flows attributable to changes in the contractually specified interest rate as the hedged risk.
Thus, if the terms and conditions of a deposit account (when the overall substance is considered) indicate that it is appropriate to view the rollovers as a series of short-term fixed-rate debt issuances, an entity can designate as the hedged risk the changes in the hedged item’s cash flows that are attributable to changes in the designated benchmark interest rate. However, in accordance with ASC 815-20-25-15(j)(2), if the terms and conditions indicate that the forecasted cash flows pertaining to the deposit account represent a variable-rate instrument, an entity can designate as the hedged risk “the risk of changes in its cash flows attributable to changes in the contractually specified interest rate.” As with Dutch auction bonds, discussed above, the concept of benchmark interest rates does not apply to hedges of existing variable-rate instruments.

In informal discussions, the staff of the SEC’s OCA shared its views on factors that entities should consider in determining whether the terms and conditions of a deposit account indicate that the account is a variable-rate liability or fixed-rate debt. In the staff’s view, for deposit rollovers to be considered short-term fixed-rate debt issuances, they must meet the following three conditions:
- The interest rate is not explicitly based on any specified index.
- There is a stipulated fixed rate of interest for a specified contractual period (i.e., a stated maturity). Note that the mere lack of explicit indexation to any specified index (the criterion above) does not itself mean that an arrangement contains a fixed rate.
- As of each reset date, the stipulated fixed rate of interest on the new contractual relationship is based on existing market conditions at the time of issuance.
The following terms, which are common in deposit accounts, suggest that a deposit account may not meet the above criteria:
- The deposit relationship is marketed to investors as a variable-rate demand deposit. Often, the actual deposit agreement indicates that a variable rate of interest is paid to investors periodically. (This term suggests that the interest rate is not fixed for any period.)
- The bank, at its sole discretion, can change the interest rate paid on the deposit at any time during its contractual term. (This term suggests that the interest rate is not fixed for any period; rather, it is a “managed” variable rate that the bank can change at any time.)
- The investor can withdraw its funds at any time during the day or on any date during the contractual term without penalty (i.e., funds are callable by the depositor at any time). (This term indicates that the deposit account does not contain a stated maturity but is a demand deposit.)
- The bank can cancel the deposit account at any time. (This term indicates that the deposit account does not have a stated maturity.)
- A new contractual arrangement is not entered into at each rollover date. (This term indicates that the deposit account is not a new contractual arrangement with a new stipulated fixed rate of interest for a specified period; rather, it is the continuation of a variable-rate contractual relationship.) Note that an investor’s choice not to withdraw funds is not the same as an active election to reinvest its funds upon maturity. In addition, just because the investor or bank can elect to close the account on short notice does not necessarily mean that there is a new contractual relationship on a daily basis; instead, an entity should consider the terms and conditions of the deposit account in concluding that the substance of the contractual arrangement is not continuous.
- The investor will forfeit interest accrued within an interest period if it withdraws its funds before the interest crediting date. For example, in many deposit account agreements, the investor will lose interest accrued during the month if it withdraws the funds on a date other than the monthly interest crediting date. (This term indicates that the deposit account does not contain a stated maturity but is a contractual continuation of a debtor-creditor banking relationship.)
In addition, the staff of the SEC’s OCA has informally indicated that the substance of a deposit agreement is relevant in the determination of whether that arrangement is a variable-rate liability. For example, if an entity asserts that there is a one-day contractual relationship and changes in the interest rate on the deposit agreement (1) occur much less frequently and (2) do not follow the general movements of market interest rates, the deposit arrangement is most likely to be a managed variable-rate liability.

4.2.1.1.1 Partial-Term Hedging

When an entity is hedging the interest payments or receipts on a variable-rate debt instrument, it is required under the cash flow hedging model to designate specified contractual cash flows as the hedged item. However, an entity is not required to designate all the interest payments or receipts related to a debt instrument to qualify for hedge accounting. ASC 815-20-25-13(a) states, in part, that the hedged risk exposure may be associated with “all or certain future interest payments on variable-rate debt.” Typically, the contractually specified interest rate in a debt arrangement is not affected by the term of the debt instrument but is instead driven by how often the interest rate resets. If an entity is hedging multiple interest payments on the same debt instrument, such payments will usually share the same risk exposure because in most cases the payment amounts will each be determined by reference to the same interest rate index (see our discussion of choose-your-rate debt in Section 4.2.1.1.2). The term of the debt usually affects the credit spread that is added to the contractually specified interest rate in the determination of each payment; however, that spread is fixed at the inception of the debt agreement and is not part of the hedged risk in hedges of the changes in cash flows related to interest payments or receipts on a debt instrument that are attributable to changes in the contractually specified interest rate (i.e., interest rate risk).

Example 4-9

Esquandolas Gearshift Company has a five-year debt arrangement that has interest payable quarterly and the interest rate is set at the beginning of each quarter on the basis of three-month term SOFR plus 1.5 percent per year. Consequently, Esquandolas could hedge any of the 20 interest payments (or a combination of several interest payments) on that debt. For example, it could enter into a three-year pay-fixed, receive-three-month term SOFR interest rate swap and designate the first 12 quarterly interest payments as the hedged items in a cash flow hedging relationship for changes that are attributable to changes in three-month term SOFR (the contractually specified interest rate).

An entity may also apply the shortcut method to a partial-term hedge of an existing variable-rate debt instrument provided that the conditions for the shortcut method are met (Example 4-19 illustrates the application of the shortcut method to a partial-term hedge of interest payments on variable-rate debt). However, the shortcut method cannot be applied to a partial-term hedge that involves a forward-starting swap (see Example 2-32). Therefore, if an entity wants to apply the shortcut method to a partial-term hedging relationship, the partial term of the debt instrument must include a period that begins with the next interest payment due on the debt instrument. This does not mean that an entity cannot apply the shortcut method to a partial-term hedging relationship involving debt that was issued before the inception of the relationship. For example, if Esquandolas Gearshift Company had decided to enter into the above noted interest rate swap one year after the debt was issued, it could identify the next 12 quarterly interest payments (quarterly payments 5–16 in the life of the debt) as the hedged items and might qualify for the shortcut method if the other conditions for the shortcut method are met.

4.2.1.1.2 Choose-Your-Rate Debt

As discussed in Chapter 2, many entities have debt that allows them to select from multiple interest rate indexes. In some cases, the rates selected may also affect the frequency of rate resets and interest payments. Debt that enables the borrower to change the interest rate index or reset period used for its variable interest rate payments is typically called “choose-your-rate” or “you-pick-‘em” debt. The remainder of this discussion will refer to such debt as choose-your-rate debt.

An entity that issues choose-your-rate debt may hedge the risk of changes in its variable cash flows that are attributable to changes in the contractually specified interest rate if certain conditions are met. As is the case for all cash flow hedges, it must be probable that the forecasted transactions (in this case a series of variable interest payments) will occur. The hedging relationship also must be expected to be highly effective, and the entity must document that assessment at inception and on an ongoing basis. The optionality associated with choose-your-rate debt may cause uncertainty about (1) the index that will be used to determine the interest payments in the future and (2) the timing of the interest rate resets and interest payments. This optionality complicates the assessment of effectiveness and the application of cash flow hedge accounting.

If an entity formally documents an assertion that it will always select a single contractually specified interest rate on each reset date, it may designate as its hedged risk the risk of changes in its cash flows that are attributable to changes in the selected rate and ignore the other rate options in the debt in the hedge effectiveness assessment. When documenting such a hedging relationship at the hedge’s inception, the entity may designate as the hedged risk changes in cash flows that are attributable to changes in either of the following:

One contractually specified interest rate index (e.g., SOFR) and one specific reset frequency (e.g., one month).
One contractually specified interest rate index but no specific reset frequency.

Each approach has advantages and disadvantages, as follows:

Approach 1 — Select a specific interest rate index and tenor. The entity designates as the hedged risk the changes in cash flows that are attributable to changes in one contractually specified interest rate index and one specific reset frequency (e.g., three-month term SOFR). It will not have to consider any other interest rate options of the choose-your-rate debt in its hedge effectiveness assessment. Therefore, such a designation results in the highest level of hedge effectiveness.

If the entity decides on a later date to select a different rate or a different tenor or reset frequency, it would be required to discontinue the hedging relationship because the hedged item would no longer share the same risk as the documented hedged risk. The impact of discontinuing a hedging relationship under both approaches is discussed below.
Approach 2 — Select a broad interest rate index but no specific tenor. The entity designates as the hedged risk the changes in cash flows that are attributable to changes in one contractually specified interest rate index but does not specify a reset frequency (e.g., the entity designates SOFR as the interest rate exposure being hedged but does not specify a tenor or reset frequency). In this scenario, it would have to consider the other rate reset frequency options in the designated contractually specified interest rate index in its hedge effectiveness assessment. For example, if the entity broadly designates SOFR, it would need to consider all the different tenor or reset frequency options for SOFR that are available in the debt agreement; however, it may ignore all the other interest rate options in the agreement (e.g., the U.S. Treasury rate). While the hedging instrument most likely will only have one reset frequency (such as a pay-fixed, receive-three-month term SOFR interest rate swap), the hedged cash flows could be based on several different tenors of SOFR depending on the borrower’s execution of the choose-your-rate option embedded in the debt. The consideration of other options reduces the overall effectiveness of the hedging relationship.

However, the benefit of this approach is that if the entity decides on a later date to select a different reset frequency for its designated contractually specified interest rate, it does not have to dedesignate its existing hedging relationship (i.e., as long as the entity continues to meet all the hedge accounting requirements).

Note that if the entity decides on a later date to select a rate that is not one of the designated contractually specified interest rates (e.g., it chooses a U.S. Treasury rate when the designated interest rate in its hedge documentation was SOFR), it would be required to discontinue the hedging relationship because the hedged item would no longer share the same risk as the documented hedged risk. The impact of discontinuing a hedging relationship is discussed below.

Changing Lanes

In September 2024, the FASB issued a proposed ASU that includes certain refinements to how an entity can hedge forecasted interest payments on choose-your-rate-debt. The proposed amendments are intended to eliminate diversity in practice while also reducing the potential for “unintuitive accounting outcomes.” Under the proposal, an entity would not have to choose between the two methods discussed above. Instead, for the purpose of the hedge effectiveness assessment, the entity could assume that it would always choose the rate it selected when the hedging relationship was initiated, unless it selects a different rate for the debt during the term of the hedge. If a different rate is selected, the entity would be required to (1) perform a final retrospective assessment of hedge effectiveness on the basis of the previous contractually specified interest rate and (2) begin prospectively assessing hedge effectiveness on the basis of the new contractually specified interest rate to determine whether the hedging relationship still qualifies for hedge accounting. As of the date of this publication, the FASB has not issued a final ASU.

4.2.1.1.2.1 Discontinued Hedge Under Both Approaches

As noted above, under either approach, if an entity selects an interest rate option that is inconsistent with the designated risk in its hedge designation documentation, it is required to discontinue the hedging relationship. In that case, the entity would need to perform a hedge effectiveness assessment by using its previously documented hedging strategy and the newly revised best estimate of the debt cash flows. If the assessment shows that the hedge has been highly effective, the changes in the hedging instrument’s fair value during the period since the last assessment date would be recorded in OCI. However, if the assessment shows that the hedging relationship has not been highly effective, the changes in the hedging instrument’s fair value during the period since the last assessment date would be recognized in earnings.

In addition, we believe that if an entity changes the designated hedged risk in a hedge of interest payments on choose-your-rate debt, it would need to consider the guidance in ASC 815-30-40-5 that states, in part, that “[a] pattern of determining that hedged forecasted transactions are probable of not occurring would call into question both an entity’s ability to accurately predict forecasted transactions and the propriety of using hedge accounting in the future for similar forecasted transactions.” That guidance is not directly on point (in the assumption that the hedged forecasted interest payments are not probable); however, on the basis of discussions with the SEC staff, our understanding is that if an entity has designated its hedged risk in a manner that allows it to ignore some or all of the optionality related to the interest rate indexes in a debt arrangement, analogy to that guidance is required to continue to make those assumptions going forward.

Upon dedesignation of a hedging relationship under either approach, the entity also should consider whether it is probable that the transactions forecasted in its original hedging relationship documentation will not occur. As discussed in Section 4.1.5.1.2.2, such a conclusion may trigger a reclassification of amounts related to that hedging relationship out of AOCI and into current-period earnings.

As long as it is still appropriate to use hedge accounting for hedging interest payments on choose-your-rate debt, an entity is permitted to redesignate the hedging instrument in a new hedging relationship by using either Approach 1 or Approach 2. However, in determining whether a dedesignated hedging relationship would qualify for hedge accounting, the entity would have to assess the effectiveness of the new relationship. A redesignated hedging relationship is less likely to be highly effective than the original hedging relationship because (1) the hedging instrument would be off-market at the inception of the new hedge (i.e., it is likely to have a nonzero fair value) and (2) the designated hedged contractually specified interest rate for the forecasted interest payments is likely to be different from the interest rate index for the existing hedging instrument. In addition, the entity would still need to ensure that the new hedging relationship satisfies all the other criteria for hedge accounting (e.g., it must be probable that the forecasted transactions at the new reset frequency will occur).

4.2.1.1.2.2 Both Approaches — Additional Considerations

Regardless of its hedging approach, an entity should consider all the provisions of a debt agreement to gauge the probability that the interest payments on the debt will be based on the designated contractually specified interest rate (i.e., the entity should assess the probability of the forecasted transaction and challenge its assertion that it will always choose its designated contractually specified interest rate). For example, an agreement may incorporate a provision that allows the lender or debt holder, under certain circumstances, to override the issuer’s choice of the interest rate index that will be applied during a period or specified periods. The mere existence of this type of provision does not preclude an entity from assuming that a contractually specified interest rate will be chosen; however, before the entity can make such an assumption, it must consider the probability that a lender or debt holder would override the specified rate. It would not be appropriate to assume that the contractually specified interest rate will be selected unless there is only a remote probability that the lender or debt holder will enforce its ability to override the entity’s interest rate selection. The entity should assess this probability in each reporting period.

Note that under both hedging approaches, a hedging relationship in which a typical pay-fixed, receive-variable interest rate swap is used, such as the relationship described above, would not qualify for the shortcut method under ASC 815-20-25-102 through 25-111 (see Example 2-28) because the hedging instrument (i.e., the interest rate swap) does not include a mirror interest rate index option. Other aspects of the hedging relationship may also be disqualifying factors.

Under both approaches, an entity may apply one of the methods described in ASC 815-30-35-10 through 35-32 to assess the effectiveness of a hedging relationship. As discussed above, when performing the assessment, the entity may ignore optionality in the debt, as applicable to each approach, as long as it has (1) appropriately asserted and sufficiently documented that all future interest payments will be based on the selected contractually specified interest rate and (2) concluded that the probability is remote that the lender or debt holder will enforce any ability to override the entity’s interest rate selection.

For example, under the change-in-variable-cash-flows method, an entity that determines the variable-rate cash flows associated with the hedged debt under Approach 1 would only consider the variability that is attributable to the designated contractually specified interest rate and the specified tenor or reset frequency. However, under Approach 2, the entity would need to consider the variability that could arise from the different tenors and reset frequencies for the designated contractually specified interest rate. Under the hypothetical-derivative method, an entity determining the terms of the variable leg of the hypothetical derivative would consider the same variability under each approach as it would for the change-in-variable-cash-flows method.

As long as the other terms of the debt and the swap are identical, the application of either assessment method under Approach 1 may result in a conclusion that the hedging relationship is perfectly effective despite the entity’s inability to use the shortcut method. Note, however, that even if the entity expects its assessment method to result in perfect hedge effectiveness, it still must (1) document at the inception of the hedging relationship the method it will use to assess hedge effectiveness and the justification for its expectation that the hedging relationship will be highly effective in future periods and (2) perform and document its quarterly assessments of whether the hedging relationship was highly effective retrospectively and whether it is expected to be highly effective prospectively. An entity’s failure to perform these steps precludes the relationship from qualifying for hedge accounting. By contrast, under Approach 2, the assessment takes into account the variability in the hedged debt’s cash flows that is attributable to the optionality in the rate reset periods for the designated contractually specified interest rate that is not present in the variable leg of the hedging interest rate swap. Therefore, the application of Approach 2 would result in a source of ineffectiveness in the hedging relationship that could affect whether the hedging relationship is highly effective.

The guidance in this section should not be analogized to other circumstances involving contractual options (i.e., entities cannot assume that stated intent overcomes optionality in other circumstances unless other accounting literature explicitly permits them to make such an assumption).

Example 4-10

Hedging Choose-Your-Rate Debt

On January 1, 20X1, Esquandolas Gearshift Company issues $10 million of variable-rate debt that matures in three years and requires periodic interest payments. Under the terms of the debt, Esquandolas may select any of the following interest rates a few days before the beginning of each interest period:

Index	Spread	Interest Period
One-month term SOFR	3.50%	1 month
Three-month term SOFR	3.50%	3 months
Three-month U.S. Treasury rate	3.25%	3 months

The terms of the debt do not include a provision that allows the lender or debt holder to override Esquandolas’s election. On the date it issues the debt, Esquandolas enters into a three-year pay-fixed, receive-three-month term SOFR interest rate swap; it hopes to use this swap as the hedging instrument in a cash flow hedge of the changes in its future interest payments that are attributable to changes in the contractually specified SOFR. Esquandolas can take either of the approaches below to designate its cash flow hedging relationship.

Approach 1

In its hedge documentation, Esquandolas could designate as the hedged risk the changes in the variable interest payment cash flows that are attributable to changes in three-month term SOFR. As a result, (1) the amount of ineffectiveness would be minimized (or eliminated) because the hedging instrument (i.e., the interest rate swap) contains a variable leg that is also based on three-month term SOFR and (2) Esquandolas could ignore the ineffectiveness associated with the option to choose one-month term SOFR or the three-month U.S. Treasury rate for the interest payments. In other words, in the hedge effectiveness assessment, the forecasted cash flows would only vary on the basis of three-month term SOFR. Accordingly, unless there were any mismatches between the other terms of the debt and the interest rate swap (e.g., a mismatch in repricing/settlement dates or in caps or floors that were not mirrored), the hedge effectiveness assessment would indicate that the hedging relationship is perfectly effective.

If Esquandolas makes a subsequent election to change its borrowing rate to one-month term SOFR, it would be required to first perform a revised hedge effectiveness assessment that reflects its updated cash flow assumptions (i.e., future payments based on one-month term SOFR) to determine whether it is appropriate to apply hedge accounting for the period leading up to that change. In addition, it would then have to dedesignate the hedging relationship because it would no longer be exposed to the risk designated at hedge inception (i.e., interest payment changes that are attributable to changes in three-month term SOFR). Esquandolas also needs to consider whether it is probable that any of its originally designated forecasted transactions will not occur to determine whether amounts in AOCI should be reclassified into earnings. A similar process would be required if Esquandolas selected the three-month U.S. Treasury rate.

Esquandolas could redesignate the interest rate swap in a new hedging relationship related to interest payments on the same debt instrument provided that the new relationship is expected to be highly effective and meets the other conditions to qualify for hedge accounting (including the assessment of whether there has been a pattern of selecting interest rates that are inconsistent with the designated hedged risk or of determining that forecasted transactions are no longer probable). To do so, Esquandolas could designate any of the following as the hedged risk for that new hedging relationship:

Changes in cash flows that are attributable to changes in one-month term SOFR (Approach 1).
Changes in cash flows that are attributable to changes in the contractually specified SOFR interest rate index (Approach 2).
Changes in overall cash flows.

However, regardless of the approach chosen, the new hedging relationship would have more ineffectiveness than the original relationship because (1) the interest rate swap would most likely have a nonzero fair value at the inception of the new relationship and (2) the hedged interest payments would be based on at least one interest rate that is different from the interest rate underlying the interest rate swap. For example, under Approach 1, the interest payments would be based on one-month term SOFR with a monthly basis while the hedging interest rate swap would still be valued on the basis of three-month term SOFR with a quarterly reset.

Approach 2

In its hedge documentation, Esquandolas could designate as the hedged risk the changes in its interest payment cash flows that are attributable to changes in the contractually specified SOFR and assert that it will always choose SOFR on each reset date (without specifying a reset frequency). If Esquandolas elects to designate changes in the interest cash flows that are attributable to changes in SOFR as the hedged interest rate risk, it will need to consider in its hedge effectiveness assessment that its hedging interest rate swap is based on three-month term SOFR but the hedged interest payments could be based on either one- or three-month term SOFR. However, it could ignore the option of selecting the three-month U.S. Treasury rate in its hedge effectiveness assessment.

If Esquandolas makes a subsequent election to change its borrowing rate to the three-month U.S. Treasury rate, it would be required to first perform a revised hedge effectiveness assessment to reflect its updated cash flow assumptions (i.e., future payments based on one-month term SOFR, three-month term SOFR, or the three-month U.S. Treasury rate) to determine whether it is appropriate to apply hedge accounting for the period leading up to that change. It would then be required to dedesignate the hedging relationship because the hedged risk was changed to another contractually specified interest rate (i.e., the U.S. Treasury rate instead of SOFR). In addition, to determine whether amounts in AOCI should be reclassified into earnings, Esquandolas would need to consider whether it is probable that its originally designated forecasted transactions will not occur.

Changes in the cash flows that are attributable to changes in the three-month U.S. Treasury rate (Approach 1 with a different contractually specified interest rate).
Changes in overall cash flows.

However, regardless of the approach chosen, the new hedging relationship would have more ineffectiveness than the original hedging relationship because (1) the interest rate swap would most likely have a nonzero fair value at the inception of the new relationship and (2) the hedged interest payments would be based on at least one interest rate that is different from the interest rate underlying the interest rate swap. For example, under Approach 1, the interest payments would be based on the three-month U.S. Treasury rate while the hedging interest rate swap would still be valued on the basis of three-month term SOFR with a quarterly reset.

4.2.1.1.3 Prepayable Variable-Rate Debt

ASC 815-20

Example 7: Determination of the Appropriate Hypothetical Derivative for Variable-Rate Debt That Is Prepayable at Par at Each Interest Reset Date

55-106 This Example illustrates the application of paragraph 815-20-25-20.

55-107 Entity A issues variable-rate debt that is prepayable at par on each interest rate reset date. The credit sector spread on the debt issuance is not reset on the interest rate reset dates. Specifically, the debt bears interest at a rate of LIBOR plus 100 basis points, with LIBOR reset every quarter. Entity A also enters into a receive-variable, pay-fixed interest rate swap that is designated as a hedge of the variability in the debt interest payments due to changes in the contractually specified interest rate (LIBOR). During the term of the hedging relationship (that is, the specific term of the interest rate swap), Entity A expects to issue new variable-rate debt (in the event the original debt is repaid before maturity) to maintain an aggregate debt principal balance equal to or greater than the notional amount of the interest rate swap, and expects the new debt (if any) to share the key characteristics of the original debt issuance (specifically, quarterly repricing to the LIBOR index and no minimum, maximum, or periodic constraints of the debt interest rate). The hedging relationship meets all of the criteria for shortcut method accounting beginning in paragraph 815-20-25-102 except for the criterion in paragraph 815-20-25-104(e); the debt is prepayable and the interest rate swap does not contain a mirror-image call option to match the call option embedded in the debt instrument, as required by that paragraph.

55-108 Entity A wishes to apply the hypothetical derivative method (as described beginning in paragraph 815-30-35-25) for its initial and subsequent quantitative assessments of hedge effectiveness. Because the actual interest rate swap used in Entity A’s hedging relationship already meets all of the criteria in paragraph 815-20-25-102 except the criterion in paragraph 815-20-25-104(e), this guidance would seem to suggest that the hypothetical interest rate swap would need to be the same as the actual interest rate swap except that a mirror-image call option would need to be added to meet the criterion in that paragraph and the guidance beginning in paragraph 815-30-35-10. However, Entity A observes that because the hedged transactions are the variable interest payments (on debt with a principal amount equal to the notional amount of the swap) due to changes in the contractually specified interest rate (LIBOR), and because the transaction had to be probable of occurring under paragraph 815-20-25-15(b) for it to qualify for hedge accounting, the actual swap would be expected to perfectly offset the hedged cash flows.

55-109 In this fact pattern, the hypothetical interest rate swap under the guidance beginning paragraph 815-30-35-10 would be the same as the actual interest rate swap described in this Example. Because Entity A has concluded that if the original debt issuance is repaid before maturity, it is probable that a sufficient principal amount of variable-rate debt with key characteristics that match those of the original debt issuance (specifically quarterly repricing to the LIBOR index and no minimum, maximum, or periodic constraints of the debt interest rate) will be issued and remain outstanding during the term of the hedging relationship (providing exposure to LIBOR-interest-rate-based variable cash payments), the prepayment provisions of the debt instrument should not be considered in determining the appropriate hypothetical derivative under that guidance. The prepayment of the original variable-rate debt eliminates the contractual obligation to make those interest payments; however, this Subtopic permits replacing the hedged interest payments that are no longer contractually obligated to be paid without triggering the dedesignation of the original cash flow hedging relationship. Replacing the original debt issuance with a new variable-rate debt issuance is permissible in a cash flow hedge of interest rate risk and does not automatically result in the discontinuation of the original cash flow hedging relationship.

55-110 Although the entity can terminate the debt at any interest rate reset date for reasons that may be totally unrelated to changes in the contractually specified interest rate (which is the hedged risk), it expects to be at risk for variability in cash flows due to changes in the contractually specified interest rate in an amount based on debt principal equal to or greater than the notional amount of the swap during the specific term of the interest rate swap. Therefore, the prepayment feature of the debt is not relevant for purposes of determining the appropriate hypothetical swap under the guidance beginning in paragraph 815-30-35-10 as long as the relevant conditions to qualify for cash flow hedge accounting have been met with respect to the hedged transaction.

Most variable-rate loans may be prepaid by the borrower, and in many cases the borrower does not incur a penalty for prepaying its debt. Accordingly, entities often decide to refinance their existing debt arrangements before the maturity date of the debt because of a tightening of the issuer’s credit spread or simply a desire to put longer-term financing in place before the maturity date of the current debt arrangement. In either case, if an entity wants to hedge the interest payments related to an existing debt arrangement that is prepayable but believes that any prepayment of the debt would be affected by a refinancing, it could designate as the hedged items the interest payments on the debt instrument or any replacement debt to support the assertion that all the interest payments are probable (provided that it is probable that the debt would be replaced by other debt if it were prepaid). If an entity did not include interest payments on potential replacement debt in its designated hedged item, it would have to assert that it was probable that the debt would not be prepaid so that it could assert that all the hedged interest payments were probable. However, if it includes interest payments on the replacement debt, the entity just needs to assert that even if the current debt arrangement is prepaid, it is probable that it will be replaced with debt whose payments (1) occur at the same frequency as the current arrangement and (2) cover the remaining term of the hedging relationship.

In addition, an entity that designates as the hedged item the interest payments on both a prepayable debt instrument and a replacement debt instrument will benefit from that designation in performing its hedge effectiveness assessments. For example, as noted in Example 7 in ASC 815-20-55-106 through 55-110, the prepayment option may be ignored as long as the entity believes that “if the original debt issuance is repaid before maturity, it is probable that a sufficient principal amount of variable-rate debt with key characteristics that match those of the original debt issuance . . . will be issued and remain outstanding during the term of the hedging relationship.” In such cases, “the prepayment provisions of the debt instrument should not be considered in determining the appropriate hypothetical derivative under that guidance.” When performing a hedge effectiveness assessment, the entity can ignore the prepayment option in the debt instrument if the replacement debt has the same key characteristics as the original debt, which would include:

The same contractually specified interest rate that resets at the same frequency (i.e., the same tenor).
Matching caps and floors on the contractually specified interest rate, if any.
Matching frequency and timing of interest payments.
A term that covers the remainder of the hedging relationship.

If all the key characteristics of the replacement debt are expected to match both the original debt and the terms of the interest rate swap, the entity will achieve shortcut-method-like results under the hypothetical-derivative method even though the hedging relationship does not qualify for the shortcut method, as illustrated by Example 7 in ASC 815-20-55-106 through 55-110. If any of the key characteristics of the replacement debt are not expected to match the original debt or the terms of the interest rate swap, those differences must be reflected in the hedge effectiveness assessment. For example, if an entity is assessing the effectiveness of the hedging relationship by using the hypothetical-derivative method, it should adjust the terms of the variable leg of the hypothetical derivative to match all of the interest payments (ignoring any credit spread on the debt) during the term of the hedging relationship.

As noted above, an entity may not apply the shortcut method if it has designated as the hedged item the interest payments on both the existing debt and any potential replacement debt. For the shortcut method to be applied, the hedge of interest payments can only involve an existing debt instrument. If an entity would like to apply the shortcut method to a hedge of prepayable debt, (1) the designated forecasted transactions can only be interest payments related to the existing debt instrument and (2) the interest rate swap must have a termination option with terms that mirror the prepayment option in the debt, as discussed in Section 2.5.2.2.1.3.

4.2.1.1.4 Hedging a Portfolio of Variable-Rate Debt Instruments

ASC 815-20

Example 4: Variable Interest Payments on a Group of Variable-Rate, Interest-Bearing Loans as Hedged Item

55-88 The following Cases illustrate the implications of two different approaches to designation of variable interest payments on a group of variable-rate, interest-bearing loans:

Designation based on first payments received (Case A)
Designation based on a specific group of individual loans (Case B).

55-89 For Cases A and B, assume Entity A and Entity B both make to their respective customers London Interbank Offered Rate- (LIBOR-) indexed variable-rate loans for which interest payments are due at the end of each calendar quarter, and the LIBOR-based interest rate resets at the end of each quarter for the interest payment that is due at the end of the following quarter. Both entities determine that they will each always have at least $100 million of those LIBOR-indexed variable-rate loans outstanding throughout the next 3 years, even though the composition of those loans will likely change to some degree due to prepayments, loan sales, and potential defaults.

55-90 This Example does not address cash flow hedging relationships in which the hedged risk is the risk of overall changes in the hedged cash flows related to an asset or liability, as discussed in paragraph 815-20-25-15(j)(1).

Case A: Designation Based on First Payments Received

55-91 In this Case, Entity A wishes to hedge its interest rate exposure to changes in the quarterly interest receipts on $100 million principal of those LIBOR-indexed variable-rate loans by entering into a 3-year interest rate swap that provides for quarterly net settlements based on Entity A receiving a fixed interest rate on a $100 million notional amount and paying a variable LIBOR-based rate on a $100 million notional amount.

55-92 In a cash flow hedge of interest rate risk, Entity A may identify the hedged forecasted transactions as the first LIBOR-based interest payments received by Entity A during each 4-week period that begins 1 week before each quarterly due date for the next 3 years that, in the aggregate for each quarter, are payments on $100 million principal of its then existing LIBOR-indexed variable-rate loans. The LIBOR-based interest payments received by Entity A after it has received payments on $100 million aggregate principal would be unhedged interest payments for that quarter.

55-93 The hedged forecasted transactions for Entity A in this Case are described with sufficient specificity so that when a transaction occurs, it is clear whether that transaction is or is not the hedged transaction.

55-94 Because Entity A has designated the hedging relationship as hedging the risk of changes attributable to changes in the LIBOR interest rate in Entity A’s first LIBOR-based interest payments received, any prepayment, sale, or credit difficulties related to an individual LIBOR-indexed variable-rate loan would not affect the designated hedging relationship.

55-95 Provided Entity A determines it is probable that it will continue to receive interest payments on at least $100 million principal of its then existing LIBOR-indexed variable-rate loans, Entity A can conclude that the hedged forecasted transactions in the documented cash flow hedging relationships are probable of occurring.

55-96 An entity may not assume perfect effectiveness in such a hedging relationship as described in paragraph 815-20-25-102 because the hedging relationship does not involve hedging the interest payments related to the same recognized interest-bearing loan throughout the life of the hedging relationship. Consequently, at a minimum, Entity A must consider the timing of the hedged cash flows vis-à-vis the swap’s cash flows when assessing effectiveness.

Case B: Designation Based on a Specific Group of Individual Loans

55-97 In this Case, Entity B wishes to hedge its interest rate exposure to changes in the quarterly interest receipts on $100 million principal of those LIBOR-indexed variable-rate loans by entering into a 3-year interest rate swap that provides for quarterly net settlements based on Entity B receiving a fixed interest rate on a $100 million notional amount and paying a variable LIBOR-based rate on a $100 million notional amount. Entity B initially designates cash flow hedging relationships of interest rate risk and identifies as the related hedged forecasted transactions each of the variable interest receipts on a specified group of individual LIBOR-indexed variable-rate loans aggregating $100 million principal but then some of those loans experience prepayments, are sold, or experience credit difficulties.

55-98 This Case addresses whether the original cash flow hedging relationships remain intact if the composition of the group of loans whose interest payments are the hedged forecasted transactions is changed by replacing the principal amount of the specified loans with similar variable-rate interest-bearing loans. Entity B cannot conclude that the original cash flow hedging relationships have remained intact if the composition of the group of loans whose interest payments are the hedged forecasted transactions is changed by replacing the principal amount of the originally specified loans with similar variable-rate interest-bearing loans. Paragraph 815-20-25-15(a) requires that, for a cash flow hedge, the forecasted transaction be specifically identified as a single transaction or group of transactions. At inception, the entity designated cash flow hedging relationships for each of the variable interest receipts on a specified group of variable-rate loans. If a loan within the group experiences a prepayment, has been sold, or experiences an unexpected change in its expected cash flows due to credit difficulties, the remaining hedged interest payments to Entity B specifically related to that loan are now no longer probable of occurring. Pursuant to paragraphs 815-30-40-1 through 40-3, Entity B must discontinue the hedging relationships with respect to the hedged forecasted transactions that are now no longer probable of occurring. However, had the hedged forecasted transactions been designated in a manner similar to that described in Case A, the consequences of a loan’s prepayment, a loan sale, or an unexpected change in a loan’s expected cash flows due to credit difficulties would not have been the same. How the forecasted transaction in a cash flow hedge is designated can have a significant effect on the application of the Derivatives and Hedging Topic.

55-99 Changing the composition of the specified individual loans within the group of variable-rate interest-bearing loans due to prepayment, a loan sale, or an unexpected change in a loan’s expected cash flows due to credit difficulties reflects a change in the probability of the identified hedged forecasted transactions for the hedging relationships related to the individual loans removed from the group of variable-rate interest-bearing loans. Consequently, the hedging relationships for future interest payments that are no longer probable of occurring must be terminated. The provisions related to immediately reclassifying a derivative instrument’s gain or loss out of accumulated other comprehensive income into earnings are based on the hedged forecasted transaction being probable that it will not occur — not no longer being probable of occurring — and includes consideration of an additional two-month period of time. After the discontinuation of the hedging relationships for interest payments related to the individual loans removed from the group of variable-rate interest-bearing loans and the reclassification into earnings of the net gain or loss in accumulated other comprehensive income related to those hedging relationships, the derivative instrument (or a proportion thereof) specifically related to the hedging relationships that have been terminated is eligible to be redesignated as the hedging instrument in a new cash flow hedging relationship. However, paragraph 815-30-40-5 warns that a pattern of determining that hedged forecasted transactions are probable of not occurring would call into question both the entity’s ability to accurately predict forecasted transactions and the propriety of using hedge accounting in the future for similar forecasted transactions.

The examples in ASC 815-20-55-88 through 55-99 illustrate the importance of how the hedged item is designated in a hedge of a portfolio of prepayable variable-rate debt instruments. For example, if the entity identifies as the hedged item the interest payments related to a specific group of loans (Example 4, Case B), it would need to consider expected sales, defaults, and prepayments in determining whether the forecasted interest payments are probable and in assessing hedge effectiveness. This is similar to the treatment of a designation of an individual debt instrument that would not include replacement debt (see Section 4.2.1.1.3). In this case, it would likely be difficult for the entity to assert that all the interest payments during the term of the hedging relationship are probable.

However, as illustrated in Example 4, Case A, in ASC 815-20-55-88 through 55-99, an entity may also designate as the hedged forecasted transactions the first payments based on a contractually specified interest rate (e.g., three-month term SOFR) that (1) it receives during each specifically identified period (e.g., four-week period) that begins at a specifically identified time (e.g., one week before each swap settlement date) for the duration of the swap and (2) in the aggregate for each period, are interest payments on the designated principal amount of the entity’s then existing variable-rate assets. After the entity has received the first payments on the designated aggregate principal amount for that specified period, any additional interest payments the entity receives that are based on a contractually specified interest rate would be unhedged. This “first payments” designation allows an entity to evaluate whether it will have enough specified interest payments during the term of the hedging relationship regardless of whether the related loans are currently owned by the entity. In other words, the hedged item is not a static, closed portfolio of loans. Any loans that are sold, defaulted, or prepaid can essentially be replaced by other loans that have interest payments based on the same contractually specified interest rate, even if those loans were originated or acquired after the inception of the hedging relationship. For this reason, most entities use this first payments method for identifying the hedged item when they are hedging interest payments related to a portfolio of variable-rate debt instruments.

Example 4-11

Hedging First Payments Received

Weekapaug Regional Bank wants to hedge its interest rate exposure on its quarterly interest receipts on $100 million principal of three-month term SOFR-indexed variable-rate loans (i.e., the contractually specified interest rate is three-month term SOFR). It enters into a three-year interest rate swap that includes quarterly net settlements under which Weekapaug receives a fixed interest rate and pays a variable three-month term SOFR-based rate on a $100 million notional amount. When identifying the hedged forecasted transactions in cash flow hedges of interest rate risk, Weekapaug could designate as the hedged forecasted transactions the first three-month term SOFR-based interest payments that (1) it will receive during each four-week period that begins one week before each quarterly reset date for the next three years and (2) in the aggregate for each quarter’s specified four-week period, are payments on $100 million principal of its then existing three-month term SOFR-indexed variable-rate loans. After Weekapaug has received payments on $100 million aggregate principal during the four-week period, any additional three-month term SOFR-based interest payments it receives would be unhedged for that quarter.

Generally, an entity should not designate interest rate risk in a cash flow hedging relationship and identify as the related hedged forecasted transactions each of the variable interest receipts on a specified group of individual SOFR-indexed variable-rate assets if it expects some of those assets to (1) experience prepayments, (2) be sold, or (3) experience credit difficulties. This is because if an asset within such a group experiences a prepayment, has been sold, or experiences an unanticipated change in its expected cash flows because of credit difficulties, the remaining hedged interest payments to the entity that are specifically related to that asset would no longer be probable. Thus, if an entity designates the interest payments on a group of loans as the forecasted transactions in a cash flow hedge and the composition of the designated loans changes, the original hedging relationship cannot remain intact, even if the entity replaces the principal amount of the specified loans with similar variable-rate interest-bearing loans. In such a case, the entity must discontinue the hedging relationships with respect to those hedged forecasted transactions that are no longer probable. The related derivative gain or loss reported in AOCI is immediately reclassified into earnings because it is probable that the interest payments will not occur within two months of the originally specified time period. The derivative (or a proportion thereof) that is specifically related to the terminated hedging relationships would be eligible to be redesignated as the hedging instrument in a new cash flow hedging relationship; however, the entity needs to consider whether it has established a pattern of determining that its hedged forecasted transactions are not probable (see Section 4.1.5.2.1).

The “first payments” designation also applies to a hedging relationship that involves interest payments on variable-rate liabilities if the entity expects to have several outstanding debt arrangements that are based on the same contractually specified interest rate.

4.2.1.1.5 Simplified Hedge Accounting Approach

As discussed in Section 2.5.2.2.5, certain private companies can apply the simplified hedge accounting approach to cash flow hedges of plain-vanilla variable-rate debt by using a plain-vanilla interest rate swap. The simplified hedge accounting approach provides special considerations that affect the measurement of the interest rate swap, allowing an entity to assume that a qualifying hedging relationship is perfectly effective and thereby achieve shortcut-method-like results.

ASC 815-10

35-1A As a practical expedient, a receive-variable, pay-fixed interest rate swap for which the simplified hedge accounting approach (see paragraphs 815-20-25-133 through 25-138 for scope) is applied may be measured subsequently at settlement value instead of fair value.

35-1B The primary difference between settlement value and fair value is that nonperformance risk is not considered in determining settlement value. One approach for estimating the receive-variable, pay-fixed interest rate swap’s settlement value is to perform a present value calculation of the swap’s remaining estimated cash flows using a valuation technique that is not adjusted for nonperformance risk.

35-1C If any of the conditions in paragraph 815-20-25-131D for applying the simplified hedge accounting approach subsequently cease to be met or the relationship otherwise ceases to qualify for hedge accounting, the General Subsections of this Topic shall apply at the date of change and on a prospective basis. For example, if the related variable-rate borrowing is prepaid without terminating the receive-variable, pay-fixed interest rate swap, the gain or loss on the swap in accumulated other comprehensive income shall be reclassified to earnings in accordance with paragraphs 815-30-40-1 through 40-6 with the swap measured at fair value on the date of change and subsequent changes in fair value reported in earnings in accordance with paragraph 815-10-35-2. Similarly, if the receive-variable, pay-fixed interest rate swap is terminated early without the related variable-rate borrowing being prepaid, the gain or loss on the swap in accumulated other comprehensive income shall be reclassified to earnings in accordance with paragraphs 815-30-40-1 through 40-6.

If a hedging relationship qualifies for the simplified hedge accounting approach, the interest rate swap may be measured (1) at fair value or (2) at settlement value by applying a practical expedient. Settlement value is similar to fair value, except that the counterparties’ nonperformance risk may be ignored for measurement purposes. ASC 815-10-35-1B notes that one way to calculate settlement value would be to “perform a present value calculation of the swap’s remaining estimated cash flows using a valuation technique that is not adjusted for nonperformance risk.” Note that application of the simplified hedge accounting approach does require an entity to assert that it is probable that neither party will default under the swap (see Section 2.5.2.2.5).

Regardless of the measurement method selected by the entity, as long as the hedging relationship qualifies for the simplified hedge accounting approach, (1) all changes in the swap’s measurement value (fair value or settlement value) are recognized in OCI and (2) all interest rate swap settlements are reclassified out of AOCI and into interest expense as they are accrued. As a result, the variable-rate interest payments on the debt are effectively converted into fixed-rate interest expense.

The journal entries under the simplified hedge accounting approach are similar to those under the shortcut method (see Example 4-18 for an example of the shortcut method). If the entity elects the settlement-value practical expedient for measuring the interest rate swap, it will measure the swap at settlement value instead of fair value, but the accounting for the debt (including interest payments) and the interest rate swap settlements will be unaffected.

4.2.1.1.6 Interaction With Capitalized Interest Under ASC 835-20

ASC 835-20 permits an entity to capitalize the interest cost for “assets that require a period of time to get them ready for their intended use” and to include those capitalized amounts in the assets’ cost basis.

Any gains and losses on derivatives that are designated in cash flow hedges and are included in the hedge effectiveness assessment are reported in OCI, even if the derivative is hedging debt associated with assets under construction that qualify for interest capitalization. When the variable-rate interest on a specific borrowing is associated with an asset under construction and capitalized as a cost of that asset, amounts recorded in AOCI related to that hedging relationship (the realized gains and losses) should be reclassified into earnings in accordance with ASC 815-30-35-45, which specifies that such cost should be recognized over the depreciable life of the related asset. For example, the amount in AOCI would be reclassified into earnings over the depreciable life of the constructed asset when depreciation begins on that asset (upon substantial completion) since that depreciable life coincides with the amortization period for the capitalized interest cost on the debt.

Some have questioned whether premiums paid for derivatives related to hedging the interest rate risk on debt associated with assets under construction could be capitalized in accordance with ASC 835-20. Interest cost, as defined in the ASC master glossary, includes “amounts resulting from periodic amortization of discount or premium and issue costs on debt.” Therefore, the premium paid on the derivatives does not meet the definition of interest cost.

4.2.1.2 Hedging Forecasted Issuance, Purchase, or Sale of Debt

ASC 815-20

25-19A In accordance with paragraph 815-20-25-6, if an entity designates a cash flow hedge of interest rate risk attributable to the variability in cash flows of a forecasted issuance or purchase of a debt instrument, it shall specify the nature of the interest rate risk being hedged as follows:

If an entity expects that it will issue or purchase a fixed-rate debt instrument, the entity shall designate the variability in cash flows attributable to changes in the benchmark interest rate as the hedged risk.
If an entity expects that it will issue or purchase a variable-rate debt instrument, the entity shall designate the variability in cash flows attributable to changes in the contractually specified interest rate as the hedged risk.

25-19B If an entity does not know at the inception of the hedging relationship whether the debt instrument that will be issued or purchased will be fixed rate or variable rate, the entity shall designate as the hedged risk the variability in cash flows attributable to changes in a rate that would qualify both as a benchmark interest rate if the instrument issued or purchased is fixed rate and as a contractually specified interest rate if the instrument issued or purchased is variable rate.

In hedges of the forecasted issuance of debt or the forecasted acquisition of a debt instrument, the nature of the forecasted transaction and the designated risk can vary depending on the circumstances. Note that the designated hedged item in a cash flow hedge is either an individual cash flow or a series of cash flows. In most cases, entities that are hedging the issuance or acquisition of a not-yet-existing debt instrument are hedging the changes to the interest cash flows from that forecasted debt instrument that are attributable to changes in the designated interest rate. That is because the not-yet-existing debt instrument will presumably be issued at an at-market interest rate since debt issuers generally seek to raise a fixed amount of money rather than to attain a nonmarket interest rate by issuing debt at a discount or premium.

Accordingly, if the forecasted transaction is the future issuance of debt, (1) the issuer is exposed to increased interest expense on the debt if interest rates increase before issuance and (2) the investor or lender in the transaction is exposed to a decrease in interest income if interest rates decrease before the debt is issued. As noted in Section 2.3.1.1, the overall risk related to interest on a debt instrument is composed of credit risk and interest rate risk. Most entities hedge only the interest rate risk component of a forecasted debt issuance because most derivative instruments in the marketplace are based on a broad interest rate index (e.g., Treasury, SOFR OIS, SIFMA). In hedges of changes in the interest payments on a forecasted debt issuance, the designated interest rate risk depends on whether the instrument is expected to be a fixed-rate debt instrument or a variable-rate debt instrument:

Fixed-rate debt instrument — The designated interest rate risk is a benchmark interest rate that typically matches the interest rate index that is the underlying of the derivative instrument used to hedge the forecasted debt issuance.
Variable-rate debt instrument — The designated interest rate risk is the contractually specified interest rate that is forecasted to be in the debt instrument when it is issued.

As noted in ASC 815-20-25-19B, if an entity is unsure whether the forecasted debt issuance will be a fixed-rate debt instrument or a variable-rate debt instrument, the entity’s designated interest rate risk must be a qualifying benchmark interest rate. See Example 4-22 for an example of an entity hedging the forecasted issuance of debt with a Treasury lock.

If the forecasted transaction is the acquisition or sale of a debt instrument in the secondary market (i.e., the purchase or sale a debt instrument that already exists and is owned by a seller), the forecasted transaction and designated risk depends on whether the instrument is fixed-rate debt or variable-rate debt. If the entity intends to hedge the forecasted purchase or sale of fixed-rate debt, the hedged forecasted transaction is the risk of changes to the forecasted purchase or sale price of the debt that is attributable to changes in the designated benchmark interest rate. The purchaser is exposed to increases in the purchase price if market interest rates decline, and the seller is exposed to decreases in the purchase price if market interest rates increase.

If the entity intends to hedge the forecasted purchase of variable-rate debt, the forecasted transaction is usually the changes in the forecasted interest receipts on the to-be-acquired debt instrument that are attributable to changes in the contractually specified interest rate. An entity that intends to sell a variable-rate debt instrument is only exposed to changes in the proceeds from the sale of the debt instrument that are attributable to the contractually specified interest rate until the next interest rate reset date for the debt instrument, which is not necessarily before the date of the forecasted sale.

4.2.1.2.1 Forecasted Zero-Coupon Debt

Zero-coupon bonds are instruments that do not require any periodic interest payments. Accordingly, they are issued at a discount to the face amount to compensate the holder for the lack of interest payments. ASC 815-20-25-17 clarifies that even though there are no periodic interest payments, the issuance of a zero-coupon instrument is considered the issuance of fixed-rate debt “because the interest element in a zero-coupon instrument is fixed at its issuance.”

If an entity intends to hedge the forecasted issuance or purchase of zero-coupon debt, it can designate the hedged item as a hedge of either:

The interest element of the final cash flow related to the forecasted issuance or purchase of the fixed-rate debt.
The forecasted total proceeds or purchase price of the fixed-rate debt.

In either case, if the hedged risk is interest rate risk, the risk should be the changes in the cash flows for the hedged item that are attributable to a benchmark interest rate because the hedged item is the forecasted issuance or purchase of fixed-rate debt.

4.2.1.2.2 Rollover of Short-Term Fixed-Rate Debt

In some cases, an entity may want to hedge the interest rate risk associated with the continued rollover of short-term fixed-rate debt. While some may view the continued rollover of such debt as being similar to having longer-term variable-rate debt, there are important differences. First, whenever an entity issues fixed-rate debt, the interest rate is the current market rate of interest, which takes into account the issuer’s creditworthiness on the issuance date. However, when an entity has existing variable-rate debt, while the interest rate on the debt will reset periodically on the basis of a contractually specified interest rate index, the credit spread is fixed on the basis of the market credit spread on the issuance date of the debt. Second, each time an entity issues new debt to replace maturing short-term fixed-rate debt, it is likely to evaluate all available options for the type of debt it would currently like to issue (e.g., amount, fixed rate versus variable rate, maturity, timing of principal payments, frequency of payments). In addition, the entity is exposed to the possibility that it will not be able to issue the replacement debt. By contrast, when an entity has existing variable-rate debt, although there may be prepayment options or mandatory prepayment events (e.g., change in control or failed debt covenants), it is easier to assert that the debt will remain outstanding for the duration of its term because the entity has an existing lending agreement covering the term of the debt.

Because of these differences, an entity is not permitted to characterize the anticipated rollover of short-term fixed-rate debt as a variable-rate debt instrument. Conversely, an entity cannot assert that a variable-rate debt instrument is a series of short-term debt instruments.

Example 4-12

Hedging Commercial Paper Programs

Some entities use a commercial paper program as a funding tool. The term “commercial paper” refers to short-term (e.g., 90-, 180-, or 270-day) borrowings, which are often unsecured and issued by highly creditworthy companies. The paper does not bear an interest coupon; instead, it is issued at a discount from par, payable at maturity. Thus, commercial paper is fixed-rate debt, but because companies typically roll it over at maturity, the economic effect over time resembles the issuance of variable-rate longer-term debt. However, as noted above, a commercial paper program should be viewed as the rollover of fixed-rate debt.

Accordingly, in a hedge of a commercial paper program, an entity would be permitted to designate its hedged transaction and risk in either of the following ways:

Designate the variability in the proceeds to be received upon each forecasted rollover of commercial paper that is attributable to changes in the benchmark interest rate.
Designate the variability in the amount of each forecasted interest component at maturity related to each issuance that is attributable to the changes in the benchmark interest rate.

Assume that Company A forecasts that it will have a minimum level of 30-day commercial paper outstanding for five years. Although the consequences of this financing resemble the issuance of five-year variable-rate debt, the entity is not permitted to designate as the hedged item five-year variable-rate term debt that is indexed to commercial paper rates and resets every 30 days; this is because no such instrument exists as the hedged item.

Commercial paper programs are complex, and it is likely to be difficult to adequately designate a hedging relationship and assess hedge effectiveness. Among the many considerations are the following (this list is not intended to be all-inclusive):

ASC 815-30-35-11(c) states that the quantitative assessment guidance in ASC 815-30-35-10 (see Section 2.5.2.1.2.4) can be applied to cash flow hedges in rollover situations. If an entity uses the hypothetical-derivative method, the derivative must reset at the same time as the related amount of commercial paper. For example, although most interest rate swaps reset quarterly, swaps with this tenure should not be used as the hypothetical derivative in hedges of commercial paper that matures or rolls over every 30 days.
The entity that is hedging must continually assess the probability of the forecasted transactions, including the dates and volumes of future issuances.
Cash flow hedge documentation requires the inclusion of all relevant details, such as the date on or period within which the forecasted transaction is expected to occur and the expected quantity to be exchanged in the transaction. According to ASC 815-20-25-3(d)(1)(vi), it must be clear whether a transaction is or is not the hedged transaction.
For example, if Company A rolls over $1 billion of 30-day commercial paper during each month and wants to hedge $500 million of that paper, it must specify which of the rollovers it is hedging (e.g., designate a hedge of the first $500 million of paper to roll over each month).
Many entities do not determine the tenure of some or all of their future commercial paper issuances (e.g., 30-, 90-, or 180-day) until previously issued commercial paper rolls over. Because hedge documentation must include all relevant details of a hedge, entities should evaluate the consequences of this flexibility when determining the terms of the hedged item (e.g., the terms of a hypothetical derivative) and assessing whether the hedging relationship is highly effective and therefore may qualify for hedge accounting.
The fact that commercial paper is a zero-coupon instrument should be taken into account in the hedge designation documentation and the hedge effectiveness assessment.

Note that the required specificity discussed in point three above applies to many common hedging strategies. Hedge documentation must clarify whether a particular transaction is or is not covered by the hedge.

4.2.1.2.3 Hedge of a Portion of the Term of a Forecasted Purchase or Sale of a Debt Instrument or Loan

When hedging the forecasted purchase or sale of an asset, an entity is not required under ASC 815 to designate a hedging relationship that covers the entire period up to the transaction date. The entity is permitted to hedge the changes in the price of a forecasted purchase or sale of a debt instrument that are attributable to the designated risk for a portion of the period that precedes the forecasted transaction. In such a case, amounts recorded in OCI related to the qualifying cash flow hedge covering a portion of the period before the transaction should be reclassified out of AOCI when that transaction affects earnings, regardless of when the hedging relationship terminates, unless it becomes probable that the forecasted transaction will not occur within two months of the time period specified in the designation documentation.

Example 4-13

Hedging Forecasted Sale of Loans With Forward That Settles Before Sale

On January 1, 20X1, Weekapaug Regional Bank wants to hedge the forecasted sale of fixed-rate loans on July 1, 20X1, for changes in the cash flows that are attributable to the benchmark interest rate. It typically enters into forwards to sell “to-be-announced” securities (TBAs) to hedge forecasted loan sales. In a TBA transaction, the seller of MBSs agrees to a sale price but does not specify which securities will be delivered to the buyer upon settlement. The TBA defines the basic characteristics of the MBS to be delivered, including the coupon rate, issuer, and approximate face value. Most TBAs involve MBSs that are issued by Fannie Mae or Freddie Mac.

Because TBAs generally settle within three months, with the highest volumes and liquidity concentrated in the first two months, Weekapaug does not have the ability to enter into a TBA that settles in six months. However, on January 1, 20X1, it enters into a TBA that settles on April 1, 20X1, to hedge the changes in cash flows that are attributable to the benchmark interest rate that will occur over the next three months (January 1–April 1) related to the forecasted sale of loans on July 1, 20X1, provided that the conditions to qualify for hedge accounting are met. It is important that Weekapaug document both (1) the timing of the forecasted transaction (i.e., the sale of loans in six months) and (2) the period of the hedge (i.e., the changes in cash flows that are attributable to changes in the benchmark interest rate over the next three months). When performing the hedge effectiveness assessment, Weekapaug could compare the following:

The changes in the fair value, from January 1 to April 1, of the actual derivative (a TBA entered into on January 1 that settles on April 1).
The changes in the fair value, from January 1 to April 1, that are attributable to the benchmark interest rates for a hypothetical derivative (a hypothetical forward entered into on January 1 that settles on July 1).

As the settlement date of the TBA approaches, if Weekapaug decides to hedge further changes in cash flows that are attributable to the benchmark interest rate for an additional period leading up to (and potentially including) the ultimate forecasted sale date, it could purchase a TBA that settles on the same date as its existing TBA (April 1, 20X1) and simultaneously sell a TBA that settles on a future date. (Transactions in which one TBA is traded in combination with a simultaneous offsetting TBA trade settling on a different date are known as “dollar-roll transactions.”) In such a case, Weekapaug would discontinue hedge accounting for the original hedging relationship, and all previous amounts recorded in OCI would remain in AOCI until the forecasted sale of loans occurs. The new “sell” TBA could be designated as a hedge of the same forecasted sale of loans, and any future amounts recorded in OCI would also be reclassified out of AOCI when the forecasted sales occur.

4.2.1.2.4 Partial-Term Hedging of Debt Subject to Forecasted Purchase Prohibited

Entities are not allowed to apply partial-term hedges to debt that is subject to a forecasted purchase. Instead, they must hedge the purchase price of the debt, which takes into account all of the cash flows of the security.

Example 4-14

Partial-Term Hedge of Debt Subject to Forecasted Purchase

Weekapaug Regional Bank expects to purchase an existing 10-year fixed-rate corporate bond in 30 days. The bond is prepayable by the issuer at any time after the five-year anniversary of the debt issuance. To hedge the change in purchase price, Weekapaug would like to enter into a forward-starting interest rate swap that begins in 30 days and has a maturity date that matches the five-year anniversary of the debt issuance (since it believes that the bond’s pricing is more closely aligned with a bond that matures on the call date).

When an entity is hedging the forecasted purchase of a debt security, it can designate as the hedged item either (1) the security’s purchase price or (2) the interest payments on the security. Since Weekapaug will be acquiring a preexisting fixed-rate debt security, the interest payments are already fixed. Accordingly, it could designate a hedge of the changes in the purchase price that are attributable to changes in the designated benchmark interest rate. While an entity may select any contractual cash flows as the designated hedged item, in this case, the forecasted transaction has only one cash flow — the payment of the purchase price to the holder of the debt security. Weekapaug is not permitted to “look through” to identify selected cash flows within the security to be acquired and designate as the hedged item the portion of the purchase price related to those specific contractual cash flows of the underlying item (i.e., the fair value of interest payments only to the call date instead of all the way to the maturity date).

However, as long as the hedging relationship is highly effective, Weekapaug is not prohibited from designating the forward-starting swap as a hedge of changes in the purchase price that are attributable to changes in the designated benchmark interest rate. If Weekapaug elects to use the hypothetical-derivative method to assess the effectiveness of the hedging relationship, the hypothetical derivative would be a forward-starting swap that has (1) a starting date that matches the acquisition date of the security, (2) a maturity date that matches that of the security, and (3) a termination option that mirrors the call option in the security.

In addition, if Weekapaug were firmly committed to acquiring the debt security, it could not apply a partial-term hedging strategy to hedge the unrecognized firm commitment. For reasons similar to those discussed above, while an entity can hedge fair value exposures related to selected cash flows, there is only one cash flow under the firm commitment — the purchase of the debt security.

Once it acquires the debt security, Weekapaug may enter into a partial-term fair value hedge of the debt security (see Section 3.2.1.1).

4.2.1.2.5 Terms of Forecasted Debt Issuance Change

As discussed in Section 4.1.4.2, if the terms of a hedged forecasted transaction change, an entity is required to consider whether the revised forecasted transaction still meets the definition of the forecasted transaction in the original hedge designation documentation. If the revised transaction no longer meets the definition in the original documentation, the entity must discontinue hedge accounting and reclassify amounts from AOCI into earnings. If the revised forecasted transaction still meets the definition in the original documentation, the entity should perform a revised hedge effectiveness assessment to determine whether it is appropriate to continue hedge accounting.

Example 4-15

Rollover Strategy Changes

Gotham Possum specifically documents as the hedged item “the variability of forecasted quarterly interest payments over five years from the rollover of repurchase agreements that are attributable to the changes in three-month term SOFR.” It subsequently changes its source of funding to another form of debt and, therefore, the designated forecasted transactions are no longer probable. In accordance with ASC 815-30-40-5, Gotham Possum should reclassify amounts from AOCI into earnings at the time it becomes probable that any of the forecasted transactions will not occur (i.e., when it becomes probable that the repurchase agreements will not be rolled over). It does not need to perform a revised hedge effectiveness assessment because the hedge accounting relationship will be discontinued and amounts in AOCI will be reclassified.

ASC 815-20-25-16 emphasizes that how a hedged forecasted transaction is designated and documented in a cash flow hedge is “critically important” to the determination of whether it is probable that the transaction will occur. Because Gotham Possum specifically identified as the hedged item the forecasted interest payments related to the repurchase agreements that would be rolled over, its decision to change its source of funding made it probable that the forecasted transactions would no longer occur. As discussed in Sections 4.1.2.1 and 4.1.4.2, an entity can achieve a different result by being less specific in its identification of the forecasted transaction(s) in the initial hedge designation and documentation. For example, if Gotham Possum had identified as the hedged item the variability of the forecasted interest payments under its five-year borrowing program that is attributable to changes in three-month term SOFR, the change in funding sources would not have made it probable that the forecasted transactions would not occur. Thus, amounts in AOCI would have remained until the forecasted transactions affected earnings.

Note that if Gotham Possum still has variable interest rate exposure for the new funding program and the hedging instrument still exists, it could potentially redesignate the derivative as a hedge of the variability in interest payments related to the new debt (as long as all other hedge criteria were met for the new hedging relationship). This would not affect the reclassification of previous gains or losses out of AOCI into earnings but would allow Gotham Possum to prospectively record the changes in the derivative’s fair value in OCI.

Example 4-16

Forecasted Issuance of 10-Year Debt Changes to 5-Year Debt

Ocelot Spot, a day spa for cats, is a private company with rapidly expanding operations across the United States. Ocelot Spot expects to issue $100 million of fixed-rate 10-year debt with quarterly interest payments. To hedge the forecasted debt issuance, it designates a hedge of interest rate risk related to the interest payments generated by the forecasted debt issuance (as opposed to the proceeds from the debt issuance). Thus, the hedged transaction is actually a series of 40 forecasted transactions represented by the 40 quarterly interest payments on the debt.

However, because of pricing conditions at issuance, Ocelot Spot decides to instead issue fixed-rate debt with a five-year maturity and quarterly interest payments. (Note that if Ocelot Spot had determined that the term of the debt would differ from what was originally forecasted before the issuance date, it would have needed to early terminate the hedge if either (1) it became no longer probable that certain hedged forecasted transactions would occur by the date [or within the time period] originally specified in the hedge documentation or (2) the hedging instrument was no longer expected to be highly effective at offsetting the changes in the cash flows of the hedged forecasted transactions that are attributable to the hedged risk [interest rate risk]). In this case, hedge effectiveness could be affected by a change in the benchmark interest rate index (i.e., because the actual variability in the hedged interest payments for years 1–5 is determined on the basis of the five-year borrowing rate rather than the original 10-year rate). Upon issuance of the debt, the hedge will terminate because the variability of the first 20 hedged payments ceases on that date.

After hedge termination, amounts recorded in AOCI that are associated with forecasted transactions for which hedge accounting was discontinued will remain in AOCI until the related transaction (interest payment) occurs unless Ocelot Spot concludes that it is probable that one or more of those forecasted transactions will not occur (1) on the date originally forecasted or (2) within an additional two-month period. The five-year debt, once issued, will generate only 20 of the 40 transactions originally forecasted. Since the remaining 20 interest payments will not occur, Ocelot Spot must reclassify from AOCI into earnings an amount that would have offset the changes in cash flows on the original forecasted transactions whose occurrence is not probable (i.e., payments 21–40). To calculate the present value, Ocelot Spot should use the same discount rate that applies to the determination of the derivative’s fair value.

If Ocelot Spot had designated its hedging relationship a little more broadly, the accounting may have been different. For example, assume instead that it designates as the hedged item the quarterly interest payments related to its borrowing program over that 10-year period. It will have to consider whether it is probable that the forecasted payments over the final five years will not occur as scheduled or within an additional two months (i.e., consider whether it is probable that its existing five-year debt will not be replaced for the five-years after maturity with debt that has quarterly interest payments over that time). If it is probable that any quarterly interest payments will not occur, Ocelot Spot will have to reclassify from AOCI into earnings an amount that would have offset the changes in cash flows on any of the original forecasted transactions that probably will not occur. The present value would be calculated by using the discount rate that applies to the determination of the derivative’s fair value.

For additional discussion, see ASC 815-30-55-94 through 55-99.

4.2.1.2.6 Delay of Forecasted Debt Issuance

As discussed in Section 4.1.4.1, if the timing of a hedged forecasted transaction changes, an entity must consider whether it is still probable that the transaction will occur within the timing established in the hedge designation documentation. When the hedging strategy is related to a forecasted debt issuance, this analysis is complicated by the fact that the hedged item is typically a series of interest payments associated with that forecasted debt issuance.

As illustrated by the guidance in ASC 815-30-55-128 through 55-133, if the entity documented that it was hedging the interest payments related to its forecasted debt issuance, the hedged item is a series of forecasted interest payments. If, at any time during the hedging relationship, the entity determines that it is no longer probable that one or more of the forecasted transactions in the series will occur by the date (or within the period) specified in the original hedge documentation, it must terminate the original hedging relationship for each of those specific nonprobable forecasted transactions, even if it still expects the forecasted debt issuance to occur within an additional two-month period after the originally specified date. This is because the forecasted transactions are a series of individual interest payments, not the forecasted debt issuance from which those interest payments were expected to arise. The entity is not necessarily required to terminate the hedging relationship for those specific forecasted transactions whose occurrence remains probable by the date or within the period originally specified.

If the hedging relationship is terminated, the entity must then determine whether it is probable that the previously hedged forecasted transactions will not occur within an additional two-month period after the original specified hedge period. If the entity concludes that it is probable that one or more of the forecasted transactions will not occur within the additional two-month period, it should immediately reclassify the amount(s) related to the forecasted transaction(s) from AOCI to earnings.3

Example 4-17

Delayed Forecasted Debt Issuance

On January 1, 20X0, Reprise (1) asserts that it is probable that it will issue $1 billion of 20-year fixed-rate debt on June 30, 20X0, to fund the purchase of a significant asset and (2) enters into a derivative to hedge its exposure to the variability in its interest payments that is attributable to changes in the benchmark interest rate that may occur during the six months before the debt is issued. Reprise’s hedge documentation identifies as the hedged forecasted transactions the fixed interest payments that will occur every quarter over 20 years. On May 1, 20X0, Reprise and the seller sign an agreement that delays the closing of the asset sale until September 30, 20X0, and Reprise asserts that it is probable that it will issue $1 billion of 20-year fixed-rate debt on September 30, 20X0.

In the original cash flow hedge documentation, Reprise designated the 80 quarterly interest payments as the forecasted transactions; therefore, it first needs to consider whether it is still probable that all the forecasted transactions will occur on the originally forecasted dates. Because of the delay, the 80 consecutive quarterly payments will begin on December 31, 20X0 (rather than September 30, 20X0, the date indicated in the hedge documentation), and continue through September 30, 20Z0 (rather than June 30, 20Z0). Thus, it is not probable that the first hedged payment (i.e., the first forecasted transaction) will occur on September 30, 20X0, as originally scheduled. Reprise must discontinue cash flow hedge accounting for that payment and then determine whether the amounts reported in AOCI that are related to that payment must be reclassified into earnings.

To make that determination, Reprise must assess whether it is probable that the forecasted payment will not occur within two months of its originally scheduled period. In other words, because the forecasted payment was scheduled to occur on September 30, 20X0, upon discontinuation of the cash flow hedge for that payment, Reprise needs to assess whether it is probable that the payment will not be made before November 30, 20X0. Because Reprise does not expect to make its first payment until December 31, 20X0, it is probable that the forecasted payment will not occur before November 30, and Reprise must reclassify, from AOCI to earnings, an amount equal to the present value of the amount that would have offset the changes in cash flows on the original forecasted transactions whose occurrence is not probable (i.e., the first payment). In addition, it should perform a hedge effectiveness assessment on the basis of the revised terms of the transaction to determine whether hedge accounting is still appropriate for the remaining 79 forecasted interest payments.

If, however, the hedge documentation identifies as the forecasted transaction the proceeds from the forecasted debt issuance on June 30, 20X0 (instead of the forecasted interest payments), and on May 1, 20X0, the issuance is delayed until September 30, 20X0, any amounts related to the hedge that were recorded in AOCI must be reclassified into earnings immediately on May 1 because (1) it is no longer probable that the forecasted transaction (the issuance of debt on June 30, 20X0) will occur, which triggers discontinuation of hedge accounting, and (2) it is probable that the forecasted transaction (the issuance of debt) will not occur within two months of the originally specified period.

4.2.2 Credit Risk Hedging

While ASC 815-20-25-15(j)(4) permits an entity to designate credit risk as the hedged risk related to a forecasted transaction involving a financial instrument, it is very uncommon for an entity to hedge the credit risk of a financial instrument, especially in a cash flow hedging relationship. This is because most hedging instruments available in the market do not correspond to the credit risk of an individual entity. Furthermore, hedging the risk of default related to an existing variable-rate debt instrument seems to conflict with the notion that the forecasted cash flows are probable.

4.2.3 Foreign Currency Risk Hedging

An entity may hedge the variability in cash flows attributable to changes in foreign currency risk for an existing foreign-currency-denominated financial instrument or a forecasted transaction related to a foreign-currency-denominated financial instrument. We discuss foreign currency hedging in detail in Chapter 5.

4.2.4 Overall Cash Flow Hedging

ASC 815-20-25-15(j)(1) allows an entity to hedge the variability in overall cash flows related to a forecasted transaction involving a financial instrument. Generally, when an entity is hedging the interest payments on an existing debt instrument, it will elect to hedge the contractually specified interest rate risk. However, as noted in the discussion of Dutch auction bonds in Section 4.2.1.1, in certain circumstances, an entity may not be able to designate a contractually specified interest rate. In such cases, the entity may designate as the hedged risk the overall changes in the cash flows, provided that the relationship meets the other conditions to qualify for hedge accounting.

4.2.5 Reclassifications From AOCI

Amounts recorded in AOCI related to a qualifying cash flow hedging relationship are (1) reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings in accordance with ASC 815-30-35-38 through 35-41 and (2) presented in the same income statement line item as the earnings effect of the hedged item in accordance with ASC 815-20-45-1A. The nature of the hedging relationship dictates the income statement classification of the reclassified amounts. Below are some examples of hedged financial instrument transactions and their respective income statement classifications.

Hedged Item	Income Statement Classification
Interest payments on variable-rate debt (issuer/borrower)	Interest expense
Forecasted issuance of debt (issuer/borrower)	Interest expense
Interest receipts on variable-rate loans or debt securities (investor/lender)	Interest income
Forecasted purchase of loans or debt securities (investor)	Interest income
Forecasted sale of loans	Gain or loss on sale

Depending on the nature of the hedging relationship, the amounts in AOCI may be reclassified into earnings during or after the hedging relationship, or a combination of both (for a discontinued relationship). For example, if an entity is hedging interest payments on variable-rate debt, it should reclassify amounts from AOCI to interest expense over the life of the hedging relationship, which in most cases will coincide with the term of the relationship. If an entity uses a forward-starting swap to cover interest payments in the future, the reclassifications out of AOCI will occur during the period in which the hedged interest payments affect earnings.

If an entity is hedging the forecasted issuance of debt, amounts recorded in AOCI during the hedging relationship remain in AOCI and are reclassified into interest expense over the life of the debt by using the interest method. This is the case even though the derivative is typically settled and the hedging relationship is terminated upon the debt issuance. While this accounting would be similar to creating a discount or premium on the debt and amortizing the premium or accreting the discount, amounts in AOCI should not be reclassified as basis adjustments of the debt because the hedged item is typically the interest payments related to the forecasted debt issuance. See Example 4-22 for an example of a Treasury lock hedging the forecasted issuance of debt.

Section 4.1.5 covers the accounting for discontinued cash flow hedging relationships, including the treatment of amounts in AOCI.

4.2.6 Illustrative Examples

Example 4-18

Interest Rate Swap Hedging Variable-Rate Debt (Full-Term Hedge)

On January 2, 20X4, Mercury Provisions issues $100 million of variable-rate debt, with interest payable quarterly. The interest rate is three-month SOFR plus 1.5 percent per year and resets quarterly. Principal is payable at maturity, which is on December 31, 20X8, and the debt is not prepayable. Management is concerned about future increases in three-month SOFR and, therefore, Mercury enters into an interest rate swap on January 2, 20X4, to effectively convert the debt from variable-rate to fixed-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	Mercury
Fixed-leg rate	1.7346%
Variable-leg payer	Counterparty
Variable rate	Three-month term SOFR
Reset/settlement frequency	Quarterly: March 31, June 30, September 30, December 31

Mercury designates the swap as a hedge of changes in the cash flows of the interest payments on the debt that are attributable to changes in the contractually specified interest rate (three-month term SOFR). As part of its hedge designation documentation, Mercury notes that the hedging relationship qualifies for the shortcut method, which will be applied. Note that even if the shortcut method were not applied, as long as the hedging relationship is highly effective, the accounting for the interest rate swap in the detailed example entries below would be the same.

For this example, assume that neither Mercury’s creditworthiness nor that 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. Also assume that it remains probable throughout the hedging relationship that all the interest payments under the debt will occur.

Mercury recognizes 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 recognizes the difference in the swap’s clean fair value in OCI each period. Alternatively, Mercury could have recognized the change in the swap’s fair value including the accruals in OCI and then reclassified those accruals out of AOCI as the hedged item affects earnings. The amounts recognized as interest expense and the timing of that recognition would be the same under either method.

The journal entries throughout the term of the hedge are as follows:

January 2, 20X4

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

March 31, 20X4

The table below shows (1) the three-month term SOFR at the beginning of the period (which affects the current period’s swap settlement and the current interest payment on the debt) 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, (4) the change in the swap’s fair value for the period, and (5) the interest payment on the debt for the period.

The journal entries are as follows:

June 30, 20X4

The table below shows (1) the three-month term SOFR at the beginning of the period (which affects the current period’s swap settlement and the current interest payment on the debt) and the end of the period, (2) the current period’s settlement, (3) the swap’s fair values at the beginning and end of the period, (4) the change in the swap’s fair value for the period, and (5) the interest payment on the debt for the period.

The journal entries are as follows:

September 30, 20X4

The journal entries are as follows:

December 31, 20X4

The journal entries are as follows:

March 31, 20X5

The journal entries are as follows:

June 30, 20X5

The journal entries are as follows:

September 30, 20X5

The journal entries are as follows:

December 31, 20X5

The journal entries are as follows:

March 31, 20X6

The journal entries are as follows:

June 30, 20X6

The journal entries are as follows:

September 30, 20X6

The journal entries are as follows:

December 31, 20X6

The journal entries are as follows:

March 31, 20X7

The journal entries are as follows:

June 30, 20X7

The journal entries are as follows:

September 30, 20X7

The journal entries are as follows:

December 31, 20X7

The journal entries are as follows:

March 31, 20X8

The journal entries are as follows:

June 30, 20X8

The table below shows (1) the three-month term SOFR at the beginning of the period (which affects the current period’s swap settlement and the current interest payment on the debt) and the end of the period, (2) the current period’s swap settlement, (3) the fair values of the swap at the beginning and end of the period, (4) the change in the swap’s fair value for the period, and (5) the interest payment on the debt for the period.

The journal entries are as follows:

September 30, 20X8

The journal entries are as follows:

December 31, 20X8

The table below shows (1) the three-month term SOFR at the beginning of the period (which affects the current period’s swap settlement and the current interest payment on the debt), (2) the current period’s swap settlement, (3) the swap’s fair value at the beginning and end of the period, (4) the change in the swap’s fair value for the period, and (5) the interest payment on the debt for the period.

The journal entries are as follows:

Example 4-18A

Interest Rate Swap Hedging Variable-Rate Debt (Off-Market)

On March 31, 20X2, Scoops Ice Cream enters into a pay-fixed, receive-variable interest rate swap. Its goal is to mitigate the risk of changes in cash flows that are attributable to changes in three-month term SOFR. Although the interest rate swap is an economic hedge, management does not immediately designate the swap in a formal hedge accounting relationship. Therefore, Scoops recognizes changes in the swap's fair value currently in earnings under ASC 815-10-35-2. The interest rate swap has the following terms:

Notional	$100 million
Swap effective date	March 31, 20X2
Maturity date	March 31, 20X4
Fixed-leg payer	Scoops
Fixed-leg rate	2.2073%
Variable-leg payer	Counterparty
Variable rate	Three-month term SOFR
Reset/settlement frequency	Quarterly: March 31, June 30, September 30, December 31

On June 30, 20X2, Scoops issues a variable-rate debt instrument with a face value of $100 million. The interest on the debt is payable quarterly and is indexed to three-month term SOFR plus 2 percent per year, resetting quarterly. Principal is payable upon maturity, which is on March 31, 20X4; the debt is not prepayable.

Scoops elects to formally designate the existing interest rate swap as a hedge of changes in the cash flows of the interest payments on the debt that are attributable to changes in the contractually specified interest rate (three-month term SOFR). At the time of designation, the swap is a derivative asset with a fair value of $1,292,501. In its hedge designation documentation, Scoops notes that the existing interest rate swap is considered “off-market” with regard to the hedging relationship because it has a nonzero fair value at the inception of the hedging relationship.

Scoops will assess hedge effectiveness by using the dollar-offset method on a cumulative basis and will measure changes in the hedged item (i.e., the forecasted interest payments on variable-rate debt) by using the hypothetical-derivative method.

To perform the dollar-offset test, Scoops will compare (1) the change in the swap's fair value from inception to the current period to (2) the change in the fair value of a hypothetical interest rate swap whose terms are identical to the critical terms of the variable-rate debt for the same period. The hypothetical interest rate swap has a fair value of zero at the inception of the hedging relationship (i.e., it will be an “at-market” contract) and has the following terms:

Notional	$100 million
Swap effective date	June 30, 20X2
Maturity date	March 31, 20X4
Fixed-leg payer	Scoops
Fixed-leg rate	2.9559%
Variable-leg payer	Counterparty
Variable rate	Three-month term SOFR
Reset/settlement frequency	Quarterly: March 31, June 30, September 30, December 31

To properly assess the effectiveness of the hedging relationship, Scoops must exclude the off-market component of the existing swap from its comparison of the changes in fair value. The off-market component of the existing swap is represented by the difference between the fixed leg of the existing swap and the fixed leg of the hypothetical swap; that is, for the purpose of the hedging relationship, the swap essentially represents a combination of a debt instrument and an at-market swap. The “debt instrument” is repaid over the life of the swap because the fixed leg that Scoops is paying under the swap is less than the fixed leg on the hypothetical at-market swap. Each quarterly settlement has the same “underpayment” on the fixed leg, which represents a partial paydown of the “debt instrument.” Therefore, Scoops will measure the changes in the swap’s fair value before any settlements occur during the period; this is because after settlements occur, some of the change in fair value will be attributable to payments that were made on the actual swap (and theoretically made on the hypothetical swap) and not due to changes in interest rates. See Example 2-24 for further illustration of effectiveness assessments of off-market swaps.

For this example, assume that neither the creditworthiness of Scoops 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. Also assume that it remains probable throughout the hedging relationship that all the interest payments under the debt agreement will occur.

Scoops 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 swap’s clean fair value in OCI each period. Alternatively, Scoops could have recognized the change in the swap’s fair value, including the accruals, in OCI and then reclassified those accruals out of AOCI as the hedged item affects earnings. The amounts recognized as interest expense and the timing of that recognition would be the same under either method.

In addition, Scoops will recognize the off-market element of the interest rate swap in earnings over the period during which the hedged forecasted transactions affect earnings by using a systematic and rational approach under ASC 815-30-35-41A. To accomplish this, Scoops will recognize the fair value of the swap as of the inception date in interest expense on a straight-line basis over the period the designated interest payments on the variable-rate debt affect earnings ($1,292,501 ÷ 7 = $184,643).

The journal entries throughout the term of the hedge are as follows:

No entry is required for the interest rate swap. For this example, assume that the swap was marked to fair value and all interest payable related to the swap was accrued (i.e., recognized in the income statement as a fair value gain or loss) immediately before the swap was designated in the hedging relationship on June 30, 20X2.

September 30, 20X2

The journal entries are as follows:

Scoops correctly recognizes the off-market component of the swap’s fair value at hedge inception in earnings on a straight-line basis. The table below shows (1) the correct AOCI balances at the beginning and end of the period, with the off-market component recognized in earnings, and (2) what the AOCI balances would have been if the off-market component had not been recognized in earnings.

Before the first period of hedge accounting, there is no balance in AOCI related to the hedging relationship; changes in the mark-to-market fair value of the interest rate swap are recognized in earnings in the current period. The purpose of recognizing the off-market component of the derivative in earnings is not to remove existing amounts in AOCI but rather to address the implicit impact of the off-market swap settlements over the life of the relationship. If Scoops does not recognize the straight-line entry in each period, there will be a “dangling” amount remaining in AOCI at the end of the relationship (i.e., the AOCI balance will not return to zero as it should). See the March 31, 20X4, journal entry for illustration.

The table below shows the calculation of retrospective hedge effectiveness under the dollar-offset method by using a cumulative approach. For this period, assume that Scoops’ prospective hedge effectiveness assessment for the hedging relationship passed. To appropriately remove the impact of changes in fair value that are attributable to payments on the off-market component of the actual swap, Scoops will add the swap settlements back to the change in each swap's fair value before calculating the dollar-offset ratio as follows:

If Scoops did not add back the net settlements during the period, it would inappropriately calculate a dollar-offset ratio of 88.9 percent, or $1,623,343 ÷ $1,817,234. The difference between the correctly calculated effectiveness (99.84 percent) and the incorrectly calculated effectiveness (88.9 percent) is attributable to the “debt” component of the existing off-market interest rate swap; the hypothetical at-market swap does not have such a component.

December 31, 20X2

The journal entries are as follows:

Scoops correctly recognizes the off-market component of the swap’s fair value at hedge inception in earnings on a straight-line basis. The table below shows (1) the correct AOCI balances at the beginning and end of the period, with the off-market component recognized in earnings, and (2) what the AOCI beginning and ending balances would have been if the off-market component had not been recognized in earnings.

The table below shows the calculation of retrospective hedge effectiveness under the dollar-offset method by using a cumulative approach. For this period, assume that Scoops passed the prospective hedge effectiveness assessment. To appropriately remove the impact of changes in fair value that are attributable to payments on the off-market component of the actual swap, Scoops will add the swap settlements back to the change in each swap’s fair value before calculating the dollar-offset ratio as follows:

If Scoops did not add back the cumulative net settlements, it would incorrectly calculate a dollar-offset ratio of 91.9 percent, or $2,114,754 ÷ $2,301,560. The difference between the correctly calculated effectiveness (108.62 percent) and the incorrectly calculated effectiveness (91.9) is attributable to the “debt” component of the existing off-market interest rate swap; the hypothetical at-market swap does not have such a component.

March 31, 20X3

The journal entries are as follows:

Scoops correctly recognizes the off-market component of the swap’s fair value at hedge inception in earnings on a straight-line basis. The table below shows (1) the correct AOCI balances at the beginning and end of the period, with the off-market component recognized in earnings, and (2) what the AOCI beginning and ending balances would have been if the off-market component had not been recognized in earnings.

The table below shows the calculation of retrospective hedge effectiveness under the dollar-offset method by using a cumulative approach. For this period, assume that the swap hedge passed the prospective hedge effectiveness assessment. To appropriately remove the impact of changes in fair value that are attributable to payments on the off-market component of the actual swap, Scoops will add the swap settlements back to the change in each swap's fair value before calculating the dollar-offset ratio as follows:

If Scoops did not add back the cumulative net settlements, it would inappropriately calculate a dollar-offset ratio of 66.7 percent, or $1,108,899 ÷ $1,663,086. The difference between the correctly calculated effectiveness (100.77 percent) and the incorrectly calculated effectiveness (66.7 percent) is attributable to the “debt” component of the existing off-market interest rate swap; the hypothetical at-market swap does not have such a component.

Hedge accounting can only be applied for reporting periods in which both the prospective assessment and the retrospective assessment of hedge effectiveness indicate that the hedging relationship is highly effective. If Scoops had inappropriately calculated the dollar-offset ratio, the results would have indicated that the hedging relationship was not highly effective during the current period. Therefore, Scoops would have been at risk of not applying hedge accounting even though the relationship was in fact highly effective (as indicated by the appropriately calculated dollar-offset ratio).

June 30, 20X3

The journal entries are as follows:

Scoops correctly recognizes the off-market component of the swap’s fair value at hedge inception in earnings on a straight-line basis. The table below shows (1) the correct AOCI balances at the beginning and end of the period, with the off-market component recognized in earnings, and (2) what the AOCI beginning and ending balances would have been if the off-market component had not been recognized in earnings.

The table below shows the calculation of retrospective hedge effectiveness under the dollar-offset method by using a cumulative approach. For this period, assume that the swap hedge passed the prospective hedge effectiveness assessment. To appropriately remove the impact of changes in fair value that are attributable to payments on the off-market component of the actual swap, Scoops will add the swap settlements back to the change in each swap’s fair value before calculating the dollar-offset ratio as follows:

If Scoops did not add back the cumulative net settlements, it would inappropriately calculate a dollar-offset ratio of 58.4 percent, or $1,031,127 ÷ $1,767,138. The difference between the correctly calculated effectiveness (100.88 percent) and the incorrectly calculated effectiveness (58.4 percent) is attributable to the “debt” component of the existing off-market interest rate swap; the hypothetical at-market swap does not have such a component.

September 30, 20X3

The journal entries are as follows:

Scoops correctly recognizes the off-market component of the swap’s fair value at hedge inception in earnings on a straight-line basis. The table below shows (1) the correct AOCI balances at the beginning and end of the period, with the off-market component recognized in earnings, and (2) what the AOCI beginning and ending balances would have been if the off-market component had not been recognized in earnings.

The table below shows the calculation of retrospective hedge effectiveness under the dollar-offset method by using a cumulative approach. For this period, assume that Scoops passed the prospective hedge effectiveness assessment. To appropriately remove the impact of changes in fair value that are attributable to payments on the off-market component of the actual swap, Scoops will add the swap settlements back to the change in each swap's fair value before calculating the dollar-offset ratio as follows:

If Scoops did not add back the cumulative net settlements, it would inappropriately calculate a dollar-offset ratio of 59.8 percent, or $1,086,086 ÷ $1,814,748. The difference between the correctly calculated effectiveness (106.76 percent) and the incorrectly calculated effectiveness (59.8 percent) is attributable to the “debt” component of the existing off-market interest rate swap; the hypothetical at-market swap does not include such a component.

December 31, 20X3

The journal entries are as follows:

Scoops correctly recognizes the off-market component of the swap’s fair value at hedge inception in earnings on a straight-line basis. The table below shows (1) the correct AOCI balances at the beginning and end of the period, with the off-market component recognized in earnings, and (2) what the AOCI beginning and ending balances would have been if the off-market component had not been recognized in earnings.

The table below shows the calculation of retrospective hedge effectiveness under the dollar-offset method by using a cumulative approach. For this period, assume that Scoops passed the prospective hedge effectiveness assessment. To appropriately remove the impact of changes in fair value attributable to payments on the off-market component of the actual swap, Scoops will add the swap settlements back to the change in fair value of each swap before calculating the dollar-offset ratio as follows:

If Scoops did not add back the cumulative net settlements, it would inappropriately calculate a dollar-offset ratio of 24.8 percent, or $301,738 ÷ $1,216,473. The difference between the correctly calculated effectiveness (106.81 percent) and the incorrectly calculated effectiveness (24.8 percent) is attributable to the “debt” component of the existing off-market interest rate swap; the hypothetical at-market swap does not include such a component.

March 31, 20X4

The journal entries are as follows:

Scoops correctly recognizes the off-market component of the swap’s fair value at hedge inception in earnings on a straight-line basis. The table below shows (1) the correct AOCI balances at the beginning and end of the period, with the off-market component recognized in earnings, and (2) what the AOCI beginning and ending balances would have been if the off-market component had not been recognized in earnings.

If Scoops had not recognized the straight-line amortization of the off-market component of the existing interest rate swap in earnings from hedge inception, the day-one fair value as of $1,292,501 would be left dangling in AOCI (i.e., the AOCI balance would not return to zero as it should).

If Scoops did not add back the cumulative net settlements, it would not be possible to calculate a dollar-offset ratio since the cumulative change in the hypothetical swap’s fair value is zero while the cumulative change in the actual swap was a decrease of $1,292,501.

Example 4-19

Interest Rate Swap Hedging Variable-Rate Debt (Partial-Term Hedge)

On January 2, 20X6, Mercury Provisions issues $100 million of 10-year variable-rate debt, with interest payable semiannually. The interest rate is six-month term SOFR plus 1.5 percent per year and resets semiannually. The principal is payable on the maturity date, December 31, 20Y5; the debt is not prepayable. However, management is only concerned about increases in six-month term SOFR over the next three years and, therefore, Mercury enters into an interest rate swap on January 2, 20X6, to effectively fix the interest payments over the first three years of the debt. The interest rate swap has the following terms:

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

Mercury designates the swap as a hedge of changes in the cash flows of the first six semiannual interest payments on the debt that are attributable to changes in six-month term SOFR (i.e., the contractually specified interest rate). As part of the hedge designation documentation, Mercury notes that the hedging relationship qualifies for the shortcut method, which will be applied.

Note that even if the shortcut method were not applied, as long as the hedging relationship was highly effective, the accounting for the interest rate swap in the detailed example entries below would be the same.

Mercury recognizes 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 recognizes the difference in the swap’s clean fair value in OCI each period. Alternatively, Mercury could have recognized the change in the swap’s fair value, including the accruals, in OCI and then reclassified those accruals out of AOCI as the hedged item affects earnings. The amounts recognized in interest expense and the timing of that recognition would be the same under either method.

The following table shows six-month term SOFR and the interest rate on the debt arrangement as of each of the interest rate reset dates for the life of the hedging relationship:

The journal entries throughout the term of the hedge are as follows:

January 2, 20X6

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

March 31, 20X6

The table below shows (1) the quarterly accrual on the interest rate swap, (2) the swap’s fair values at the beginning and end of the period, (3) the change in the swap’s fair value for the period and (4) the interest accrual on the debt for the period. There were no required interest rate swap settlements or debt interest payments since those are only required semiannually.

The journal entries are as follows:

June 30, 20X6

The table below shows (1) the quarterly accrual on the interest rate swap, (2) the semiannual swap settlement, (3) the swap’s fair values at the beginning and end of the period, (4) the change in the swap’s fair value for the period, (5) the quarterly interest accrual on the debt, and (6) the semiannual interest payment on the debt for the period.

The journal entries are as follows:

September 30, 20X6

The table below shows (1) the quarterly accrual on the interest rate swap, (2) the swap’s fair values at the beginning and end of the period, (3) the change in the swap’s fair value for the period, and (4) the interest accrual on the debt for the period. There were no required interest rate swap settlements or debt interest payments since those are only required semiannually.

The journal entries are as follows:

December 31, 20X6

The journal entries are as follows:

March 31, 20X7

The table below shows (1) the quarterly accrual on the interest rate swap, (2) the swap’s fair values at the beginning and end of the period, (3) the change in the swap’s fair value for the period, and (4) the interest accrual on the debt for the period. There were no required interest rate swap settlements or debt interest payments since those are only required semiannually.

The journal entries are as follows:

June 30, 20X7

The table below shows (1) the quarterly accrual on the interest rate swap, (2) the semiannual swap settlement, (3) the swap’s fair value at the beginning and end of the period, (4) the change in the swap’s fair value for the period, (5) the quarterly interest accrual on the debt, and (6) the semiannual interest payment on the debt for the period.

The journal entries are as follows:

September 30, 20X7

The journal entries are as follows:

December 31, 20X7

The journal entries are as follows:

March 31, 20X8

The table below shows (1) the quarterly accrual on the interest rate swap, (2) the swap’s fair values at the beginning and end of the period, (3) the change in the swap’s fair value for the period, and (4) the interest accrual on the debt for the period. There were no required interest rate swap settlements or debt interest payments since those are only required semiannually.

The journal entries are as follows:

June 30, 20X8

The journal entries are as follows:

September 30, 20X8

The table below shows (1) the quarterly accrual on the interest rate swap, (2) the swap’s fair values at the beginning and end of the period, (3) the change in the swap’s fair value for the period, and (4) the interest accrual on the debt for the period. There were no required interest rate swap settlements or debt interest payments since those are only required semiannually.

The journal entries are as follows:

December 31, 20X8

The journal entries are as follows:

Example 4-20

Interest Rate Cap Hedging Variable-Rate Debt (Time Value Excluded From Hedge Effectiveness Assessment)

Ocelot Spot wants to build new cat spa locations. It issues five-year $100 million variable-rate debt on January 2, 20X1. Ocelot Spot will pay 12-month term SOFR plus 2.5 percent on an annual basis reset on December 31. On January 1, 20X1, 12-month term SOFR was 2.25 percent.

Seeking to hedge its exposure to interest rate risk above 5.5 percent (12-month term SOFR of 3.0 percent + 2.5 percent), Ocelot Spot enters into an interest rate cap that (1) is indexed to 12-month term SOFR, (2) has a $100 million notional amount, and (3) has a strike rate of 3.0 percent. The cap pays the difference between 3.0 percent and 12-month term SOFR if 12-month term SOFR rises above 3.0 percent. Ocelot Spot paid a $1.44 million premium to enter into the cap, whose terms reset annually on December 31.

Ocelot Spot appropriately identified 12-month term SOFR as the contractually specified interest rate in the debt agreement. On the date it purchased the interest rate cap, its treasurer designated the cap as a hedge of its exposure to variable cash flows related to its annual interest payments in situations in which the contractually specified interest rate rises above 3.0 percent. Ocelot Spot’s risk management policy permits it to hedge such exposures. Ocelot Spot documents that it will exclude changes in time value from its assessment of hedge effectiveness and elects to recognize the initial value of this excluded component in earnings by using the amortization method (see ASC 815-20-25-83A). In addition, it will assess the effectiveness of the hedge by comparing (1) the change in the cash flows on the debt for those periods in which 12-month term SOFR is above 3.0 percent with (2) the cap’s intrinsic value, which is defined as the difference between its strike price (3.0 percent) and the spot rate for 12-month term SOFR (see Section 2.5.2.1.2.2). Accordingly, Ocelot Spot’s hedge should be perfectly effective as long as there are no concerns about the performance of the counterparty to the cap and the interest payments are still probable.

For this example, assume that the creditworthiness of the counterparty to the interest rate cap does not call into question whether it is probable that it will perform under the interest rate cap over the life of the cap. Also assume that it remains probable throughout the hedging relationship that all the interest payments under the debt will occur.

Note that Ocelot Spot could have applied the terminal value method discussed in ASC 815-20-25-126 through 25-129, which also would have resulted in perfect effectiveness (see Example 4-21), and a different treatment for the premium it paid for the interest rate cap.

Ocelot Spot recognizes the current-period accruals of any settlements of the interest rate cap directly in the same income statement line item in which the hedged item affects earnings (interest expense) and recognizes only the difference between the clean fair values of the interest rate cap in OCI each period. Alternatively, Ocelot Spot could have recognized the change in fair value related to current-period accruals of settlements in OCI and then reclassified those accruals out of AOCI as the hedged item affects earnings. The amounts recognized in interest expense and the timing of that recognition would be the same under either method.

The table below shows (1) 12-month term SOFR and (2) the interest rate on the debt as of each reset date, which is also the measurement date for the next period’s interest rate cap settlement.

Ocelot Spot is a private company with a December 31 year-end, and it only prepares annual financial statements. Assume that it performs its hedge effectiveness assessments on a quarterly basis and that the hedge is perfectly effective throughout the life of the hedging relationship.

The journal entries throughout the term of the hedge are as follows:

January 2, 20X1

December 31, 20X1

The table below shows (1) the interest rate cap’s fair values at the beginning and end of the year, (2) the change in the cap’s fair value for the year, (3) any settlement received on the interest rate cap during the year, and (4) the interest expense on the debt for the year.

The journal entries are as follows:

December 31, 20X2

The table below shows (1) the fair value of the interest rate cap at the beginning and end of the year, (2) the change in the cap’s fair value for the year, (3) any settlement received on the interest rate cap during the year, and (4) the interest expense on the debt for the year.

The journal entries are as follows:

December 31, 20X3

The journal entries are as follows:

December 31, 20X4

The journal entries are as follows:

December 31, 20X5

The journal entries are as follows:

Example 4-21

Interest Rate Cap Hedging Variable-Rate Debt (Terminal Value Method)

The fact pattern for this example is the same as that for Example 4-20 except that instead of excluding the time value of the interest rate cap from the assessment of hedge effectiveness, Ocelot Spot has documented that it will (1) assess effectiveness on the basis of the total changes in the cash flows of each caplet comprising the cap and (2) compare each caplet’s terminal value (i.e., the expected pay-off amount on the maturity date) with the expected change in the related cash flows that would result from an increase in the contractually specified interest rate (12-month term SOFR) above 3.0 percent.

Ocelot Spot may assume perfect effectiveness because (1) the terms of the cap perfectly match the repricing terms of the debt, (2) the cap is a 12-month term SOFR-based cap and 12-month term SOFR is the contractually specified interest rate in the hedged debt, (3) a caplet cannot be exercised before its maturity, and (4) all the other conditions specified in ASC 815-20-25-126 and ASC 815-20-25-129 have been satisfied (see Section 2.5.2.1.2.2).

Ocelot Spot has documented that it will recognize the initial time value ($1.44 million) of the purchased option by allocating the initial time value of the cap to a series of five interest rate caplets based on each caplet’s fair value at inception (a separate caplet for each year; see Section 4.1.3). The table below shows the allocation of the cap’s fair value to each separate caplet. Note that all amounts reclassified from AOCI into earnings must be presented in the same income statement line in which the hedged item affects earnings.

Ocelot Spot recognizes the current-period accruals of any settlements of the interest rate cap directly in the same income statement line item in which the hedged item affects earnings (interest expense) and recognizes only the difference between the interest rate cap’s clean fair values in OCI each period. Alternatively, Ocelot Spot could have recognized the change in fair value related to current-period accruals of settlements in OCI and then reclassified those accruals out of AOCI as the hedged item affects earnings. The amounts recognized in interest expense and the timing of that recognition would be the same under either method.

Since Ocelot Spot is a private company with a December 31 year-end, it only prepares annual financial statements. Assume that Ocelot Spot performs its hedge effectiveness assessments on a quarterly basis and that the hedge is perfectly effective throughout the life of the hedging relationship.

The journal entries throughout the term of the hedge are as follows:

January 2, 20X1

December 31, 20X1

The journal entries are as follows:

No journal entry is required to reclassify amounts from AOCI because none of the initial time value is related to the first year.

December 31, 20X2

The journal entries are as follows:

December 31, 20X3

The journal entries are as follows:

December 31, 20X4

The journal entries are as follows:

December 31, 20X5

The journal entries are as follows:

Example 4-22

Treasury Lock Hedging Forecasted Issuance of Debt

Fluff Heads, a hat manufacturer, has an AA credit rating and is expecting to issue $100 million of five-year fixed-rate bonds on June 30, 20X1. On January 1, 20X1, Fluff Heads believes that interest rates may increase during the next six months. Accordingly, it wants to hedge against the risk of increased interest payments on its forecasted debt issuance by locking in existing five-year fixed rates. Fluff Heads’s risk management strategy permits it to lock in the benchmark rate when it has determined that a debt issuance is probable within nine months. According to its hedge designation documentation, to hedge against the risk of increased interest payments on its forecasted debt issuance, Fluff Heads enters into a $100 million Treasury lock agreement on January 1, 20X1, with a settlement date of June 30, 20X1. The value of the Treasury lock increases and decreases with changes to a five-year Treasury security; the Treasury lock meets the definition of a derivative. As of January 1, 20X1, five-year Treasury rates were 5.50 percent, and five-year AA rates were 6.10 percent. Fluff Heads identifies the U.S. Treasury rate as the benchmark interest rate for its interest rate exposure. On June 30, 20X1, Fluff Heads (1) issues $100 million of debt with interest payable quarterly at 5.95 percent per year and the principal amount repayable at maturity and (2) closes out the Treasury lock agreement. For simplicity, assume there were no debt issuance costs.

For this example, assume that neither Fluff Heads’s creditworthiness nor that of the counterparty to the Treasury lock agreement call into question whether it is probable that both parties will perform under the agreement over its life. Also assume that it remains probable throughout the hedging relationship that all the interest payments related to the forecasted debt issuance will occur without delay.

The table below shows (1) the five-year Treasury rate, (2) the five-year AA corporate bond rates, and (3) the fair values of the Treasury lock as of January 1, 20X1; March 31, 20X1, and June 30, 20X1.

Provided that the hedging relationship is highly effective over the life of the hedge, the journal entries for this hedging relationship are as follows:

January 2, 20X1

No entry is required because the Treasury lock has a fair value of zero at inception.

March 31, 20X1

June 30, 20X1

September 30, 20X1

December 31, 20X1

The journal entries for the remaining term of the debt are condensed in this example because each quarter only involves the quarterly interest payments and the quarterly reclassification of amounts from AOCI. Accordingly, the journal entries below are shown for each year.

Year Ended December 31, 20X2

Year Ended December 31, 20X3

Year Ended December 31, 20X4

Year Ended December 31, 20X5

Six Months Ended June 30, 20X6

June 30, 20X6

Footnotes

As discussed in Section 4.1.5.2, if certain rare extenuating circumstances exist, it may be possible to continue to report gains and losses associated with a discontinued cash flow hedge in AOCI, even if it is probable that the forecasted transaction will not occur within two months of the originally specified period.

Confidential and Proprietary — for Use Solely by Authorized Personnel

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