Chapter 4 — Cash Flow Hedges | DART – Deloitte Accounting Research Tool

Chapter 4 — Cash Flow Hedges

4.1 Overview

As indicated in ASC 815-30-20 (and discussed briefly in Section 1.3.2), a cash flow hedge is a “hedge of the exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk.” The variability in that risk must have the potential to affect reported earnings.

ASC 815-30

35-3 When the relationship between the hedged item and hedging instrument is highly effective at achieving offsetting changes in cash flows attributable to the hedged risk, an entity shall record in other comprehensive income the entire change in the fair value of the designated hedging instrument that is included in the assessment of hedge effectiveness. More specifically, a qualifying cash flow hedge shall be accounted for as follows:

An entity’s defined risk management strategy for a particular hedging relationship may exclude a specific component of the gain or loss, or related cash flows, on the hedging derivative from the assessment of hedge effectiveness (as discussed in paragraphs 815-20-25-81 through 25-83B). That excluded component of the gain or loss shall be recognized in earnings either through an amortization approach in accordance with paragraph 815-20-25-83A or through a mark-to-market approach in accordance with paragraph 815-20-25-83B. Under either approach, the amount recognized in earnings for an excluded component shall be presented in the same income statement line item as the earnings effect of the hedged item in accordance with paragraph 815-20-45-1A. For example, if the effectiveness of a hedging relationship with an option is assessed based on changes in the option’s intrinsic value, the changes in the option’s time value would be excluded from the assessment of hedge effectiveness and either may be recognized in earnings through an amortization approach in accordance with paragraph 815-20-25-83A or currently in earnings in accordance with paragraph 815-20-25-83B.
Amounts in accumulated other comprehensive income related to the derivative designated as a hedging instrument included in the assessment of hedge effectiveness are reclassified to earnings in the same period or periods during which the hedged forecasted transaction affects earnings in accordance with paragraphs 815-30-35-38 through 35-41 and presented in the same income statement line item as the earnings effect of the hedged item in accordance with paragraph 815-20-45-1A. The balance in accumulated other comprehensive income associated with the hedged transaction shall be the cumulative gain or loss on the derivative instrument from inception of the hedge less all of the following:
1. Subparagraph superseded by Accounting Standards Update No. 2017-12.
1a. The derivative instrument’s gains or losses previously reclassified from accumulated other comprehensive income into earnings pursuant to paragraphs 815-30-35-38 through 35-41.
1b. The cumulative amount amortized to earnings related to excluded components accounted for through an amortization approach in accordance with paragraph 815-20-25-83A.
1c. The cumulative change in fair value of an excluded component for which changes in fair value are recorded currently in earnings in accordance with paragraph 815-20-25-83B.
2. Subparagraph superseded by Accounting Standards Update No. 2017-12.
If hedge accounting has not been applied to a cash flow hedging relationship in a previous effectiveness assessment period because the entity’s retrospective evaluation indicated that the relationship had not been highly effective in achieving offsetting changes in cash flows in that period, the cumulative gain or loss on the derivative referenced in (b) would exclude the gains or losses occurring during that period. That situation may arise if the entity had previously determined, for example, under a regression analysis or other appropriate statistical analysis approach used for prospective assessments of hedge effectiveness, that there was an expectation in which the hedging relationship would be highly effective in future periods. Consequently, the hedging relationship continued even though hedge accounting was not permitted for a specific previous effectiveness assessment period. . . .

An entity with a cash flow hedge that meets all the hedging criteria in ASC 815 would record in OCI the changes in fair value attributable to components of the hedging instrument that are included in the assessment of hedge effectiveness. Unlike the accounting for a fair value hedge, the carrying value of the hedged item is not adjusted in the accounting for a cash flow hedge. Instead, the changes in fair value that are recorded in OCI are (1) reclassified from AOCI to earnings when the hedged item affects earnings and (2) presented in earnings in the same line item as the earnings effect of the hedged item. When the hedged transaction occurs, the amounts in AOCI that accumulated from the hedging relationship cannot be recorded as a basis adjustment to the hedged item.

If the hedged item is a forecasted transaction and it becomes probable that the transaction will not occur within two months of the originally specified time period, amounts that were recorded in AOCI should generally be immediately reclassified (see Section 4.1.5 for further discussion of discontinued cash flow hedges).

The table below includes common examples of cash flow hedging strategies.

Hedged Item	Derivative
Variable-rate debt	A receive-variable, pay-fixed interest rate swap or purchased interest rate cap
Variable-rate loans	A receive-fixed, pay-variable interest rate swap or purchased interest rate floor
Forecasted issuance of debt	Forward-starting interest rate swap, option, or forward on U.S. Treasuries
Forecasted commodity purchases	Fixed-price forward or option to purchase commodity
Forecasted commodity sales	Fixed-price forward or option to sell commodity
Foreign-currency-denominated variable-rate debt	Pay-fixed, receive-variable cross-currency interest rate swap
Forecasted foreign-currency-denominated purchases	Forward or option to purchase foreign currency
Forecasted foreign-currency-denominated sales	Forward or option to sell foreign currency

This chapter discusses the accounting for cash flow hedges from start to finish, including how to reclassify amounts out of AOCI throughout the hedging relationship and beyond. We first explain some of the general concepts behind cash flow hedging relationships. The discussion is then broken down into the two major categories of cash flow hedging relationships: hedges involving financial instruments and hedges involving nonfinancial assets. Foreign currency hedges (both fair value and cash flow hedges) are discussed separately in Chapter 5.

4.1.1 Forecasted Transactions

ASC Master Glossary

Forecasted Transaction

A transaction that is expected to occur for which there is no firm commitment. Because no transaction or event has yet occurred and the transaction or event when it occurs will be at the prevailing market price, a forecasted transaction does not give an entity any present rights to future benefits or a present obligation for future sacrifices.

ASC 815-20

25-15 A forecasted transaction is eligible for designation as a hedged transaction in a cash flow hedge if all of the following additional criteria are met:

The forecasted transaction is specifically identified as either of the following:
1. A single transaction
2. A group of individual transactions that share the same risk exposure for which they are designated as being hedged. A forecasted purchase and a forecasted sale shall not both be included in the same group of individual transactions that constitute the hedged transaction.
The occurrence of the forecasted transaction is probable.
The forecasted transaction meets both of the following conditions:
1. It is a transaction with a party external to the reporting entity (except as permitted by paragraphs 815-20-25-30 and 815-20-25-38 through 25-40).
2. It presents an exposure to variations in cash flows for the hedged risk that could affect reported earnings. . . .

As discussed in Section 2.2.2, ASC 815 allows an entity to hedge the risk of changes in cash flows related to forecasted transactions. To qualify as the hedged item in a cash flow hedging relationship, a forecasted transaction must meet the following criteria:

It is either a “single transaction” or “a group of individual transactions that share the same risk exposure for which they are designated as being hedged” (see Section 2.2.2.2.2).
It is probable that the transaction will occur (see Section 4.1.1.1).
The transaction is with a party that is external to the reporting entity, except as permitted for certain foreign currency hedges discussed in Section 5.3.1.1.1 (see Section 4.1.1.2).
It presents an exposure to variations in cash flows for the hedged risk that could affect reported earnings (see Section 4.1.1.3).

ASC 815-20-25-14 also clarifies that “[f]or purposes of [applying the cash flow hedge accounting rules], the individual cash flows related to a recognized asset or liability and the cash flows related to a forecasted transaction are both referred to as a forecasted transaction.”

4.1.1.1 Probable That the Transaction Will Occur

ASC 815-20

Probability of a Forecasted Transaction

55-24 An assessment of the likelihood that a forecasted transaction will take place (see paragraph 815-20-25-15(b)) should not be based solely on management’s intent because intent is not verifiable. The transaction’s probability should be supported by observable facts and the attendant circumstances. Consideration should be given to the following circumstances in assessing the likelihood that a transaction will occur.

The frequency of similar past transactions
The financial and operational ability of the entity to carry out the transaction
Substantial commitments of resources to a particular activity (for example, a manufacturing facility that can be used in the short run only to process a particular type of commodity)
The extent of loss or disruption of operations that could result if the transaction does not occur
The likelihood that transactions with substantially different characteristics might be used to achieve the same business purpose (for example, an entity that intends to raise cash may have several ways of doing so, ranging from a short-term bank loan to a common stock offering).

55-25 Both the length of time until a forecasted transaction is projected to occur and the quantity of the forecasted transaction are considerations in determining probability. Other factors being equal, the more distant a forecasted transaction is or the greater the physical quantity or future value of a forecasted transaction, the less likely it is that the transaction would be considered probable and the stronger the evidence that would be required to support an assertion that it is probable.

As discussed above, for an entity to designate a forecasted transaction as the hedged item in a cash flow hedging relationship, it must be probable that the transaction will occur, but there does not necessarily have to be a firm commitment (see Section 4.1.1.3.1 for further discussion of hedging firm commitments). The term “probable” requires a significantly greater likelihood of occurrence than the phrase “more likely than not.” The assertion that it is probable that a transaction will occur should be supported by observable facts and circumstances.

Note that for hedge accounting to be applied, (1) it must be probable at the inception of the hedge that the forecasted transaction will occur and (2) it must continue to be probable during the life of the hedge that the transaction will occur. If it is no longer probable that the forecasted transaction will occur, the entity should discontinue hedge accounting at the time it becomes no longer probable (see Section 4.1.5 for further discussion of discontinuing cash flow hedging).

The following are some of the factors that an entity should consider in determining whether a forecasted transaction is probable under ASC 815:

Frequency of similar past transactions and the quantity involved — ASC 815-20-55-24(a) requires an entity to consider the “frequency of similar past transactions,” and ASC 815-20-55-25 states, in part, that “the greater the physical quantity or future value of a forecasted transaction, the less likely it is that the transaction would be considered probable.” We believe that it makes sense to consider these criteria in combination. If the frequency and quantity of a forecasted transaction is consistent with history, in the absence of changes in current and future conditions, it may not be difficult to assert that the forecasted transaction is probable. For example, if an entity has consistently purchased 100 tons of aluminum on a monthly basis for its production of tweezers over the last three years, it would be reasonable for the entity to assert that forecasted monthly purchases of 100 tons of aluminum for the next six months would be probable as long as there are no significant changes in expected production. However, if the entity wants to hedge the forecasted purchase of 300 tons of aluminum in three months, it would be difficult for the entity to assert that the purchase is probable unless it has decided to change its purchase frequency from monthly to quarterly and has the ability to obtain and store the increased quantity.

Note that an entity cannot rely solely on past transactions to support an assertion that a forecasted transaction is probable. It should also consider changes in internal factors (e.g., operating budgets or plans, decisions to increase or decrease certain activities) and external factors (e.g., changes in economic conditions or in customer demand).
Financial and operational ability to carry out transactions or the creditworthiness of a counterparty — ASC 815-20-55-24(b) requires an entity to consider its financial and operational ability to carry out transactions. This is especially relevant for significant nonrecurring transactions. If the transaction involves the payment of significant consideration, the entity should evaluate whether the party that would make the payment has the funds available or has access to them. In addition, if the forecasted transaction involves the delivery of assets, the entity should evaluate whether (1) the seller can deliver the quantity of assets underlying the forecasted transaction and (2) the buyer is capable of accepting the quantity of assets underlying the forecasted transaction. If the transaction involves nonfinancial assets, the entity should consider not just whether the seller is expected to have access to the assets to be delivered but also whether there are any constraints involved in transporting them to the delivery location. In addition, the entity should consider any constraints for the buyer to either store the assets at the delivery location or transport the assets to their ultimate destination.

If the forecasted transaction involves a specific counterparty (e.g., a specific buyer or seller), the entity should consider the creditworthiness of that counterparty when evaluating its ability to perform under the transaction. The entity should also consider whether the forecasted transaction could be fulfilled by other counterparties.
Substantial commitments of resources to a particular activity — As noted in ASC 815-20-55-24(c), “[s]ubstantial commitments of resources to a particular activity” may be an indicator of whether it is probable that a forecasted transaction will occur. For example, if an entity has committed to a substantial financing transaction to fund a nonrecurring forecasted purchase of assets, that commitment would be a significant indicator that the forecasted transaction is probable. Conversely, if an entity has limited funding and has committed substantial resources to an activity that would conflict with the forecasted transaction, that would be a significant indicator that the forecasted transaction is not probable.
Extent of loss or disruption of operations if transaction does not occur and likelihood of using a different transaction — In accordance with ASC 815-20-55-24(d), an entity should consider the “extent of loss or disruption” that could result from the nonoccurrence of a forecasted transaction. If an entity needs to complete a forecasted transaction to fulfill commitments to customers or to maintain production, that would be an indicator that the transaction is probable. However, ASC 815-20-55-24(e) also notes that an entity should consider whether a transaction “with substantially different characteristics might be used to achieve the same business purpose.” For example, an entity may be firmly committed to a significant expenditure but may be considering whether to fund that expenditure with debt or an equity raise. If the entity wants to hedge changes in interest rates related to a forecasted debt issuance, it should consider the potential for the transaction to be funded by issuing equity instead of incurring debt when assessing whether the forecasted debt issuance is probable.
Length of time before the transaction is projected to occur — ASC 815-20-55-25 notes that an entity should consider “the length of time until a forecasted transaction is projected to occur.” This is an important consideration, and the paragraph states that “[o]ther factors being equal, the more distant a forecasted transaction is . . . , the less likely it is that the transaction would be considered probable and the stronger the evidence that would be required to support an assertion that it is probable.”
Pattern of previous similar forecasted transactions that did not occur — ASC 815-30-40-5 addresses the accounting for amounts in AOCI related to a previously qualifying cash flow hedging relationship when it becomes probable that a designated forecasted transaction will not occur (see Section 4.1.5.2). That paragraph also states 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.”

4.1.1.1.1 Unique Considerations for Business Combinations

While an entity cannot hedge an expected business combination or a firm commitment to enter into such a combination (see Section 2.2.1.3), it is not prohibited from designating a transaction that is contingent on a business combination (e.g., interest payments related to the acquirer’s forecasted issuance of debt to fund the business combination) as the hedged item in a qualifying cash flow hedging relationship. However, the hedging relationship would need to meet the criteria to qualify for cash flow hedge accounting, and it may be difficult to assert that the consummation of a business combination is probable. An entity should consider the many uncertainties involved in entering into a business combination, including the need to obtain shareholder and regulatory approvals.

Some entities enter into deal-contingent derivatives to hedge transactions that are contingent on a proposed business acquisition. One example is a “deal contingent swap,” which is a forward-starting interest rate swap that is designed to hedge the forecasted issuance of debt for changes in cash flows that are attributable to changes in the designated benchmark rate (i.e., the index rate for the variable-rate leg of the swap). However, if the acquisition is not consummated by a specified date, the swap is terminated for no consideration.

While these deal-contingent swaps are very effective economic hedges, they do not fare particularly well under the cash flow hedging model in ASC 815. Under that guidance, an entity does not consider the probability of the forecasted transaction when measuring the changes in the cash flows of a forecasted transaction for the assessment of hedge effectiveness. In other words, for a cash flow hedge of a forecasted issuance of debt to fund a potential acquisition that is deemed probable, the only factor that affects the changes in the estimated cash flows attributable to changes in the designated benchmark interest rate (e.g., LIBOR) is the changes in that designated benchmark interest rate. However, the fair value of the hedging instrument (i.e., the deal-contingent swap) is affected by both changes in the interest rate specified in the hedging instrument (e.g., LIBOR) and changes in the probability that the deal will be consummated by the date specified in the swap.

The changes in the probability of the deal being consummated can result in a source of ineffectiveness that is significant enough to cause the hedging relationship to not be highly effective and, therefore, be disqualified from hedge accounting. Even if the hedging relationship does qualify for hedge accounting, it would not qualify for any of the “perfectly effective” qualitative hedge assessment methods because of the optionality in the swap that is not matched in the assessment of the hedged forecasted transaction. For example, if an entity chose to apply the hypothetical-derivative method discussed in Section 2.5.2.1.2.4 to a hedging relationship that involves a deal-contingent swap, it would compare the changes in the fair value of the swap with the fair value of a forward-starting swap without the deal-contingent termination option.

In addition, entities are required to assess whether the forecasted debt issuance is probable throughout the hedging relationship. If it is no longer probable that the forecasted debt issuance is going to occur, hedge accounting must be discontinued (see further discussion of discontinued cash flow hedges in Section 4.1.5).

4.1.1.1.2 LIBOR — Reference Rate Reform

ASC 848-50

25-2 An entity shall continue to assess whether the underlying hedged forecasted transaction (for example, the future interest receipts of a financial asset or future interest payments of a financial liability or the forecasted issuance or purchase of a debt instrument) remains probable in accordance with paragraph 815-20-25-15(b). If the designated hedged interest rate risk in a cash flow hedge of a forecasted transaction is a reference rate that meets the scope of paragraph 848-10-15-3, an entity may assert that the hedged forecasted transaction (for example, the future interest receipts of a financial asset or future interest payments of a financial liability or the forecasted issuance or purchase of a debt instrument) remains probable in accordance with paragraph 815-20-25-15(b) regardless of the modification or expected modification of terms in accordance with paragraphs 848-20-15-2 through 15-3.

As the global markets actively plan the transition from the use of LIBOR and other interbank offering rates to alternative reference rates, questions are arising about the impact of reference rate reform on an entity’s ability to assert that a forecasted transaction is still probable if it involves payments based on reference rates such as LIBOR that are expected to be discontinued. The FASB issued ASU 2020-04 and ASU 2021-01 to address the impact of reference rate reform activities on several areas of financial reporting, including this issue. ASU 2020-04 establishes a new Codification topic, ASC 848, and ASU 2021-01 expands the scope of ASC 848 (see Chapter 8 for an overview of ASC 848). Under ASC 848-50-25-2, as long as the underlying transactions (i.e., the payments) are still probable, an entity may assume that those payments will still be based on the current reference rate.

4.1.1.2 Transaction With External Party

In accordance with ASC 815-20-25-15(c)(1), a forecasted transaction can only be designated as the hedged item in a qualifying cash flow hedging relationship if the transaction is with an external party (except for certain foreign currency hedges discussed in Section 5.3.1.1.1). In the Background Information and Basis for Conclusions of Statement 133, the FASB reasoned that only transactions with a party that is external to the reporting entity would affect earnings. In other words, since intercompany transactions are typically eliminated in the preparation of consolidated financial statements, they do not expose the entity to changes in cash flows that could affect earnings. This is consistent with the prohibition in ASC 815-20-25-43(b)(4) discussed in Section 2.2.1.5.2.

4.1.1.3 Exposure to Variations in Cash Flows That Could Affect Earnings

To be designated as the hedged item in a cash flow hedging relationship, a forecasted transaction also must have exposure to variations in cash flows that could affect earnings. Common examples of such transactions are interest payments on variable-rate debt, interest payments related to a forecasted issuance of debt, and the forecasted purchase or sale of assets that are not subject to fixed-price contracts. The exposure to variations in cash flows must have the potential to affect earnings, so this precludes forecasted transactions in an entity’s own stock (e.g., future issuances of shares or treasury stock transactions). See Section 2.2.1.4 for a discussion of the prohibition on hedging transactions that involve an entity’s own equity.

4.1.1.3.1 Forecasted Transaction Versus Firm Commitment

The price of a forecasted transaction is exposed to changes in market factors. If market prices change before the date on which the transaction is firmly committed, earnings may be affected. However, once an agreement is reached that meets the definition of a firm commitment, the entity is no longer exposed to changes in cash flows for the underlying transaction (except for transactions denominated in a foreign currency in which there is still exposure to changes in foreign currency exchange rates). In fact, the ASC master glossary defines a forecasted transaction as “[a] transaction . . . for which there is no firm commitment.” Accordingly, a transaction that occurs under a firm commitment cannot be a designated forecasted transaction in a qualifying cash flow hedge unless it is either (1) a hedge of foreign currency risk or (2) an “all-in-one” hedge (discussed in Section 4.1.1.3.2). The table below summarizes the types of hedging strategies available for transactions subject to fixed-price firm commitments.

Type of Firm Commitment	Price Fixed in:
Type of Firm Commitment	Functional Currency	Foreign Currency
ASC 815 derivative	All-in-one hedge (see Section 4.1.1.3.2)	All-in-one hedge (see Section 4.1.1.3.2)
Nonderivative	Fair value hedge (see Section 3.1.1)	Foreign currency cash flow hedge (see Section 5.3)

4.1.1.3.2 All-in-One Hedges

ASC 815-20

25-21 Paragraph 815-10-15-4 states that, if a contract meets the definition of both a derivative instrument and a firm commitment under the Derivatives and Hedging Topic (as illustrated in Example 8 [see paragraph 815-20-55-111]), then an entity shall account for the contract as a derivative instrument unless one of the exceptions in this Topic applies. In that circumstance, either of the following may be true:

The forecasted transaction and the derivative instrument used to hedge it are with the same counterparty.
The derivative instrument is the same contract under which the entity executes the forecasted transaction.

25-22 Assuming other cash flow hedge criteria are met, a derivative instrument that will involve gross settlement may be designated as the hedging instrument in a cash flow hedge of the variability of the consideration to be paid or received in a forecasted transaction that will occur upon gross settlement of the derivative instrument itself (an all-in-one hedge). This guidance applies to fixed-price contracts to acquire or sell a nonfinancial or financial asset that are accounted for as derivative instruments under this Topic provided the criteria for a cash flow hedge are met.

As noted in Section 4.1.1.3.1, the definition of a forecasted transaction excludes transactions for which there is a firm commitment. If a firm commitment must be accounted for as a derivative instrument within the scope of ASC 815, it must be recognized at fair value as of each reporting date. If the derivative cannot be used as a hedging instrument in a qualifying hedging relationship, changes in the derivative’s fair value would be recognized in earnings. DIG Issue G2 arose because of concerns that the prohibition on identifying the transactions underlying the firm commitment as a hedged forecasted transaction would cause unintended consequences, even though a firm commitment acts as a perfect hedge against potential changes in cash flows related to the purchase or sale of the item underlying the firm commitment.

DIG Issue G2 (codified in ASC 815-20-25-21 and 25-22 and ASC 815-20-55-111 through 55-116) established the notion of an all-in-one hedge by specifying that “a derivative instrument that will involve gross settlement may be designated as the hedging instrument in a cash flow hedge of the variability of the consideration to be paid or received in a forecasted transaction that will occur upon gross settlement of the derivative instrument itself (an all-in-one hedge).” ASC 815-20-55-114 resolves the potential conflict regarding a firm commitment’s ineligibility to be designated as a forecasted transaction as follows:

The forecasted purchase or sale at a fixed price is eligible for cash flow hedge accounting because the total consideration paid or received is variable. The total consideration paid or received for accounting purposes is the sum of the fixed amount of cash paid or received and the fair value of the fixed price purchase or sale contract, which is recognized as an asset or liability, and which can vary over time.

In other words, while the terms of a firm commitment specify a fixed price to be paid for the asset, if the firm commitment is accounted for as a derivative and recognized as an asset or liability, the consideration paid by the buyer of the asset is a combination of (1) the contractual price and (2) either the delivery of an asset or the extinguishment of a liability represented by the derivative. In that sense, the forecasted transaction that results from such a firm commitment is exposed to changes in consideration that have the potential to affect earnings because the total consideration varies on the basis of changes in the derivative’s fair value from the inception of the firm commitment through its settlement. See Example 4-31 for a detailed example of an all-in-one hedge.

4.1.1.3.2.1 Options Do Not Qualify for All-in-One Hedging

The term “all-in-one hedge” applies only to hedging relationships involving a firm commitment that is accounted for as a derivative. An option or warrant does not meet the definition of a firm commitment under ASC 815.

An entity is not precluded from designating the purchase of an asset underlying an option as a forecasted transaction in a cash flow hedging relationship that is not an all-in-one hedge simply because the option does not meet the definition of a firm commitment. However, to qualify for cash flow hedge accounting for an option designated as the hedging instrument in a hedge of the forecasted acquisition of an asset, the entity should be able to establish at the inception of the relationship that the acquisition of the asset is probable regardless of how it is acquired. In other words, the entity must be able to assert that even if the option expires out-of-the-money, it will still be probable that the entity will acquire the asset (e.g., it will instead acquire the asset in the marketplace).

ASC 815-20-55-27 through 55-32 provide guidance on an example of the forecasted acquisition of a marketable debt security. ASC 815-20-55-31 and 55-32 state:

55-31 Therefore, to qualify for cash flow hedge accounting in this circumstance, the entity shall be able to establish that it is probable that it will acquire the marketable debt security by any of the following means:

Exercising the option designated as the hedging instrument if it is in the money
Purchasing the security in the marketplace at its prevailing market price if the option is out of the money.

55-32 If the entity expects to acquire the marketable debt security only by exercising the option and only if the option were in the money, a cash flow hedging relationship typically would not be designated because acquisition of the security is contingent and thus would not be considered probable.

In documenting the hedging relationship, the entity should specify the date of the forecasted acquisition or the period in which it will occur. The assertion that the forecasted acquisition is probable should be assessed in each reporting period (see Section 4.1.1.1).

A traditional loan commitment that is accounted for as a derivative cannot be designated as a hedging instrument in an all-in-one cash flow hedge because such a commitment is not a firm commitment as defined in ASC 815. A loan commitment does not require the borrower to exercise the loan commitment and initiate the borrowing.

In addition, an entity may not designate a loan commitment that is a derivative under ASC 815 as a hedged item in other hedge accounting strategies because ASC 815 does not permit derivatives to be designated as hedged items. However, loan commitments that are derivatives may be economically hedged with another derivative (e.g., a forward loan sales contract that is a derivative) if both derivatives are marked to fair value through earnings.

4.1.2 Specificity of Designation

As discussed in Section 2.6.1, to qualify for hedge accounting for a cash flow hedging relationship, an entity must document all relevant details about the hedged forecasted transaction in its hedge designation documentation. In paragraph 458 of the Background Information and Basis for Conclusions of Statement 133, the FASB discusses its rationale for requiring specific identification of the forecasted transaction at the outset of a hedge. It notes that such “information is necessary to (a) assess the likelihood that the transaction will occur, (b) determine if the cumulative cash flows of the designated derivative are expected to be highly effective at offsetting the change in expected cash flow of the forecasted transaction attributable to the risk being hedged, and (c) assess the hedge’s effectiveness on an ongoing basis.” In addition, since changes in the fair value of a derivative that is designated as a hedging instrument in a qualifying cash flow hedge are recorded in OCI, the timing of when amounts are reclassified out of AOCI is linked to when the forecasted transaction affects earnings.

ASC 815-20-25-3(d)(1)(vi) states:

The hedged forecasted transaction shall be described with sufficient specificity so that when a transaction occurs, it is clear whether that transaction is or is not the hedged transaction. Thus, a forecasted transaction could be identified as the sale of either the first 15,000 units of a specific product sold during a specified 3-month period or the first 5,000 units of a specific product sold in each of 3 specific months, but it could not be identified as the sale of the last 15,000 units of that product sold during a 3-month period (because the last 15,000 units cannot be identified when they occur, but only when the period has ended).

As noted in Section 2.6.1, the hedge designation documentation for the hedge of a forecasted transaction should include the following details:

The specific nature of the asset or liability involved (if any).
The current price of the forecasted transaction.
The quantity of the forecasted item(s). The expected currency amount for hedges of foreign currency risk or the quantity (i.e., the number of items or units of measure) of the forecasted transaction for hedges of other risks.
The date on or period within which the forecasted transaction is expected to occur.

4.1.2.1 Identification of the Hedged Item

The hedge designation documentation must describe the hedged forecasted transaction with enough specificity to (1) ensure that an entity can properly perform the hedge effectiveness assessments and (2) make it clear when the transaction has occurred and when it would affect earnings. The level of specificity provided in the designation documentation is critical in the entity’s determination of whether it is probable that the forecasted transaction will occur (or if it is probable that the transaction will not occur and amounts will need to be reclassified out of AOCI; see Section 4.1.5 for the accounting for discontinued cash flow hedges).

When the terms of a forecasted transaction are subject to variability, there is a natural tension between describing the transaction (1) broadly enough to allow for such variability and (2) narrowly enough that the hedging instrument is still highly effective at offsetting the changes in cash flows that are attributable to the hedged risk.

Example 4-1

Reprise purchases aluminum on the spot market at several locations and with differing grades. It is not able to find one derivative that is highly effective at hedging all its aluminum purchases. If Reprise enters into a derivative that is only highly effective at hedging purchases of a specific grade at a specific location, it should specify both the grade and location in its documentation for the forecasted purchases. However, the risk of providing that level of specificity (i.e., grade- and location-specific purchases) is that if Reprise shifts its production to different locations or uses different grades of aluminum than it had originally expected, it may no longer be probable that the specified forecasted transactions will occur.

As discussed in Section 2.2.2.2, when hedging a group of forecasted transactions in a single hedging relationship, entities should be mindful that the designated forecasted transactions must have the same exposure to the hedged risk. In other words, to qualify to be the hedged item in a cash flow hedging relationship, all of the transactions in a group of forecasted transactions must be similar.

4.1.2.2 Date or Range of Dates

ASC 815-20

25-16 Example 4 (see paragraph 815-20-55-88) illustrates that how the hedged forecasted transaction is designated and documented in a cash flow hedge is critically important in determining whether it is probable that the hedged forecasted transaction will occur. The following guidance expands on the timing and probability criteria in paragraphs 815-20-25-3 and 815-20-25-15(b): . . .

c. Uncertainty of timing within a range. For forecasted transactions whose timing involves some uncertainty within a range, that range could be documented as the originally specified time period if the hedged forecasted transaction is described with sufficient specificity so that when a transaction occurs, it is clear whether that transaction is or is not the hedged transaction. As long as it remains probable that a forecasted transaction will occur by the end of the originally specified time period, cash flow hedge accounting for that hedging relationship would continue. See paragraph 815-30-40-4 for related guidance and Example 5 (see paragraph 815-20-55-100), which illustrates the application of this paragraph.

d. Importance of timing in both documentation and hedge effectiveness. Although documenting only the period within which the forecasted transaction will occur is sufficient to comply with the requirements of paragraph 815-20-25-3, compliance with Section 815-20-35 and paragraph 815-20-25-75(b) requires that the best estimate of the forecasted transaction’s timing be both documented and used in assessing hedge effectiveness. As explained in paragraphs 815-20-25-84 and 815-20-25-120 through 25-121, the time value of money is likely to be important in the assessment of cash flow hedge effectiveness, especially if the entity plans to use a rollover or tailing strategy to hedge its forecasted transaction. The use of time value of money requires information about the timing of cash flows. . . .

ASC 815-20-25-3(d)(1) requires an entity to document “[t]he date on or period within which the [hedged] forecasted transaction is expected to occur.” ASC 815-20-25-16(c) expands on this concept by noting that “[f]or forecasted transactions whose timing involves some uncertainty within a range, that range could be documented as the originally specified time period if the hedged forecasted transaction is described with sufficient specificity so that when a transaction occurs, it is clear whether that transaction is or is not the hedged transaction.” An example provided in ASC 815-20-55-100 through 55-104 discusses an entity undertaking a construction project that has a term of five years. The entity wants to hedge a forecasted foreign-currency-denominated payment to a subcontractor that it expects to make at the end of year 2. ASC 815-20-55-102 states, in part:

The general contractor could document . . . that the hedged forecasted transaction is the foreign-currency-denominated payment to the foreign subcontractor to be paid within the five-year contract period of the overall project (which is the originally specified time period referred to in paragraphs 815-30-40-4 through 40-5). In accordance with paragraph 815-20-25-16(c), as long as it remains probable that the forecasted transaction will occur by the end of the originally projected five-year period of the overall project, cash flow hedge accounting for that hedging relationship would continue. Consequently, if the subcontractor’s payment is delayed by more than two months, but less than three years and two months, then the forecasted transaction would still be considered probable of occurrence within the originally specified time period.

As noted in ASC 815-20-25-16(d), even though an entity may specify a range of time in which it expects a forecasted transaction to occur, “compliance with Section 815-20-35 and paragraph 815-20-25-75(b) requires that the best estimate of the forecasted transaction’s timing be both documented and used in assessing hedge effectiveness.” For example, if an entity is using the hypothetical-derivative method to assess the effectiveness of a hedge, the settlement date for the hypothetical derivative should match the best estimate of the forecasted transaction date.

An entity must reevaluate its best estimate of the forecasted transaction’s timing on each hedge effectiveness assessment date and use its current best estimate of the most likely date in each assessment. See Section 4.1.4 for further discussion of how changes in the forecasted transaction affect hedge accounting.

Connecting the Dots

Given that hedge accounting must be discontinued when it is no longer probable that a forecasted transaction will occur by the originally specified date or time period (see further discussion in Section 4.1.5.1.2.3), an entity should consider documenting the expected timing of a forecasted transaction whose timing is uncertain by using a range that allows for unexpected delays. ASC 815-20-25-16(d) requires an entity to use its best estimate of the date the transaction will occur (as opposed to considering all potential dates for the designated period) in its hedge effectiveness assessment. This requirement would appear to conflict with the guidance in ASC 815-20-25-79(a), which states, in part, that “[t]he quantitative prospective assessment may not be limited only to the likely or expected changes in fair value (if a fair value hedge) or in fair value or cash flows (if a cash flow hedge) of the derivative instrument or the hedged items.” We believe that the estimated timing of the forecasted transaction is the only element of the transaction for which an entity may use its best estimate rather than considering all reasonably possible changes, as described in ASC 815-20-25-79(a) (except for hedges of interest payments on “choose-your-rate” debt, as discussed in Section 4.2.1.1.2).

Changing Lanes

The FASB staff has proposed refining the model for considering changes in the forecasted transaction and the designated risk. In November 2019, it issued a proposed ASU that would permit an entity that is assessing hedge effectiveness to use its best estimate for all aspects of the forecasted transaction regardless of how broadly or narrowly the forecasted transaction is described in the hedge designation documentation. The staff is currently working to respond to comments received from stakeholders related to the 2019 proposed ASU and hopes to resolve the issues during 2024.

4.1.2.3 Designated Transaction Versus Designated Risk

When an entity is hedging a forecasted transaction in a cash flow hedging relationship, its hedge designation documentation must describe both the forecasted transaction and the designated risk component of that transaction. As discussed in Sections 4.1.2.1 and 4.1.2.2, the specificity of the forecasted transaction is important for determining (1) whether it is probable that the forecasted transaction will occur, (2) when the transaction has occurred, and (3) when it affects earnings, as well as for the hedge effectiveness assessment. On the other hand, the entity’s identification of a specific risk as the hedged risk is only relevant in its calculation of the changes in the hedged item’s cash flows that are attributable to the identified risk for the hedge effectiveness assessment (see Section 2.3 for a discussion of the risks that may be identified as the hedged risk). Changes in either the description of the forecasted transaction or the designated hedged risk can only be accomplished through a dedesignation and redesignation of the hedging relationship.

The table below includes examples that illustrate the differences between the specified forecasted transaction and the designated hedged risk.

Forecasted Transaction	Designated Risk
Quarterly interest payments on existing $10 million variable-rate debt with Weekapaug Regional Bank	Contractually specified interest rate (e.g., three-month LIBOR)
Forecasted issuance of $100 million of five-year fixed-rate debt that will occur within the next six months	Benchmark interest rate (e.g., five-year LIBOR swap rate)
Forecasted first ton of aluminum purchased under supply contract with Supplier ABC at Factory XYZ under supply contract for each of the next 12 months	Contractually specified component of purchase price (e.g., the Midwest Transaction Price of aluminum)

4.1.3 Terminal Value Method

Under the terminal value method of assessing the effectiveness of a cash flow hedging relationship, an entity can compare an option’s ultimate settlement amount to the change in the cash flows of the hedged transaction that are attributable to the hedged risk (see Section 2.5.2.1.2.2). While the terminal value method can eliminate the impact of the changes in an option’s time value from the hedge effectiveness assessment, it does not exclude any components of the option’s fair value from the assessment. Because the option’s ultimate settlement amount is used in the calculation, an entity will only compare changes in the option’s intrinsic value to changes in the hedged transaction’s cash flows that are attributable to the hedged risk; however, all of the changes in the option’s fair value are recognized in OCI in a qualifying cash flow hedging relationship for which the terminal value method is used. Amounts in AOCI are reclassified into earnings when the forecasted transaction affects earnings.

An entity may use the terminal value method for a hedging relationship in which the hedging instrument is a purchased option made up of a series of options that are each hedging an individual hedged transaction in a series of hedged transactions. In such cases, the entity should evaluate each option separately when (1) assessing hedge effectiveness and (2) allocating the time value of the combined option to the individual forecasted transactions for determining when to record amounts in OCI and when to reclassify related amounts out of AOCI.

Example 4-2

Reprise hedges the next eight quarterly interest payments on variable-rate debt with an interest rate cap that covers those eight quarterly periods. It views the interest rate cap as a series of eight interest rate options (“caplets”) that are each hedging an individual interest payment in a series of hedged interest payments with different repricing dates. Therefore, it should allocate the cap’s fair value at inception to each of the eight individual caplets on the basis of its relative fair value (“the caplet method”). In this case, the initial fair value allocated to each caplet (as well as any related intrinsic value that is recorded in AOCI) will be (1) reclassified into earnings when the respective hedged interest payment affects earnings and (2) presented in the same income statement line item (interest expense) as the earnings effect of the hedged forecasted transactions. See Example 4-21 for a more detailed example.

The hedge effectiveness assessment results under the terminal value method may be similar to the results of an assessment in which an option’s time value is excluded, but the recognition of the option’s time value is different under the two approaches. As noted above, under the terminal value method, all changes in the fair value of an option in a qualifying hedging relationship are recognized in OCI (including all the initial time value) and reclassified from AOCI into income when the forecasted transaction affects earnings. However, in assessments in which the option’s time value is excluded, the entity recognizes the initial time value in earnings over the life of the hedging relationship but only reclassifies the changes in the option’s intrinsic value out of AOCI when the forecasted transaction affects earnings. See Section 4.1.6 for a more detailed discussion of approaches that exclude components of changes in the derivatives’ fair value from the hedge effectiveness assessment.

The table below illustrates some of the differences between approaches that exclude an option’s time value and the terminal value method.

Terminal Value Method	Time Value Excluded From Assessment
Changes in time value recorded in OCI — Reclassified into earnings when the forecasted transaction affects earnings	Changes in time value recorded in OCI — Reclassified into earnings over the life of the hedging relationship unless the entity elects to recognize changes in fair value currently in earnings
If series of options — The caplet method must be applied to allocate initial time value to individual forecasted transactions	If series of options — No requirement to apply the caplet method
Hedge effectiveness assessment — If the critical-terms-match method cannot be applied, compare to hypothetical option (see Section 2.5.2.2.3)	Hedge effectiveness assessment — Time value is ignored

4.1.4 Impact of Changes in Forecasted Transaction

As noted in Section 4.1.2, the identification of the hedged forecasted transaction in the designation documentation is critical to the assessment of (1) whether the hedging relationship is highly effective and (2) the probability that the designated forecasted transaction will occur. An entity must perform these assessments throughout the life of the hedging relationship.

If the terms of the hedged forecasted transaction change, the entity needs to consider how the changes affect its ability to continue applying hedge accounting to the hedging relationship.

4.1.4.1 Change in Timing

If the expected timing of a hedged forecasted transaction changes during the life of a hedging relationship, the entity must first assess whether it is still probable that the forecasted transaction will occur within the period established in the hedge designation documentation and then determine whether hedge accounting can be continued:

If it is still probable that the forecasted transaction will occur within the timing specified in the hedge designation documentation, the entity is not necessarily required to discontinue hedge accounting. However, it must assess the effectiveness of the hedging relationship on the basis of the revised terms of the forecasted transaction to determine whether the hedging relationship is still highly effective.
If it is no longer probable that the forecasted transaction will occur within the timing specified in the hedge designation documentation, the entity should discontinue hedge accounting for the hedging relationship (see Section 4.1.5.1.2.3).
If the entity is hedging a group of forecasted transactions in a single hedging relationship and it is no longer probable that a portion of those forecasted transactions will occur within the timing specified in the hedge designation documentation, it should discontinue at least a portion of the hedging relationship (see Section 4.1.5.1.3.1).

Note that if the forecasted transaction is expected to occur shortly after the timing specified in hedge designation documentation, the entity is still required to discontinue hedge accounting. ASC 815-30-40-4 states, in part, that “[t]he net derivative instrument gain or loss related to a discontinued cash flow hedge shall continue to be reported in accumulated other comprehensive income unless it is probable that the forecasted transaction will not occur by the end of the originally specified time period (as documented at the inception of the hedging relationship) or within an additional two-month period of time thereafter” (emphasis added). While the guidance in ASC 815-30-40-4 might be interpreted to mean that a delay of a forecasted transaction for up to two months will not disqualify the hedging relationship from hedge accounting, it is actually related to the treatment of amounts in AOCI for a hedging relationship that is already discontinued (see further discussion in Section 4.1.5.2). ASC 815-20-25-16 addresses some of the considerations regarding the assessment of whether the occurrence of the hedged forecasted transaction is probable. Specifically, ASC 815-20-25-16(c) states, in part, that “[a]s long as it remains probable that a forecasted transaction will occur by the end of the originally specified time period, cash flow hedge accounting for that hedging relationship would continue.” There is no such grace period in the evaluation of whether an entity can continue applying hedge accounting to a hedging relationship in which it is no longer probable that the forecasted transaction will occur within the time period originally specified in the hedge designation documentation.

4.1.4.2 Change in Terms Other Than Timing

When there is a change in the expected terms of a forecasted transaction that is unrelated to its timing, the process for evaluating such a change is similar to the process for evaluating timing changes discussed in Section 4.1.4.1, but the application of the steps is more complicated.

An entity first needs to consider whether the revised forecasted transaction still matches the description of the forecasted transaction specified in the hedge designation documentation. The distinction between the specified forecasted transaction and the designated hedged risk is important in this analysis.

Example 4-3

TreyCo has $100 million of variable-rate debt outstanding, with an interest rate that resets every three months to a rate equal to the current three-month LIBOR plus 5 percent. After two years, TreyCo refinances the debt and replaces it with variable-rate debt that resets every three months to a rate equal to the current prime rate plus 2 percent. It is still probable that TreyCo will have interest payments on $100 million of variable-rate debt for the remaining term of the hedging relationship.

The table below illustrates four different ways that TreyCo could define the forecasted transaction in its original hedge designation documentation and how the differences in those designations would affect whether the originally specified forecasted transactions would still be probable at the time TreyCo determines that it will replace the LIBOR-based debt with prime-based debt.

Forecasted Transaction	Designated Risk	Transaction Still Probable?
Interest payments on the specific debt issuance of $100 million	Contractually specified interest rate	No.
Interest payments on the specific debt issuance of $100 million and any replacement debt for the specified term	Contractually specified interest rate	Yes.
Interest payments on first $100 million of three-month LIBOR-based debt	Contractually specified interest rate	No. However, if the debt was replaced with three-month LIBOR debt, the forecasted interest payments might still be probable, depending on whether it was probable that there would be three-month LIBOR debt outstanding over the remaining life of the hedge.
Interest payments on first $100 million of variable-rate borrowings	Contractually specified interest rate	Yes.

If the revised forecasted transaction no longer matches the description of the forecasted transaction in the designation documentation, an entity should discontinue hedge accounting since it is no longer probable that the forecasted transaction will occur. In addition, amounts in AOCI should be reclassified into earnings because it is then probable that the forecasted transaction will not occur (see Section 4.1.5.2).

If the revised forecasted transaction still matches the description of the forecasted transaction in the designation documentation, an entity should assess the effectiveness of the hedging relationship on the basis of the revised transaction’s terms to determine whether the relationship is still highly effective in accordance with ASC 815-30-55-98A. If it is not highly effective, it should be discontinued, but amounts in AOCI should remain in AOCI until the forecasted transaction affects earnings (see Section 4.1.5.1.2.1).

4.1.5 Discontinuing a Cash Flow Hedge

There are several reasons why any entity may need to discontinue hedge accounting for a cash flow hedging relationship. In many cases, discontinuation is required because of a change in circumstances (e.g., it is no longer probable that the hedged forecasted transaction will occur). In other cases, hedge accounting is discontinued at the option of the entity. The next section discusses the reasons why hedge accounting may be discontinued for a cash flow hedging relationship, and Section 4.1.5.2 explains how to account for the related amounts in AOCI after a discontinuation (including amounts associated with components that were excluded from the hedge effectiveness assessment).

4.1.5.1 Reasons for Discontinuing a Cash Flow Hedge

ASC 815-30

40-1 An entity shall discontinue prospectively the accounting specified in paragraphs 815-30-35-3 and 815-30-35-38 through 35-41 for an existing hedge if any one of the following occurs:

Any criterion in Section 815-30-25 is no longer met.
The derivative instrument expires or is sold, terminated, or exercised.
The entity removes the designation of the cash flow hedge.

4.1.5.1.1 Derivative No Longer Held or Is Modified

In a manner similar to the treatment of fair value hedges, discussed in Section 3.5.1.1, ASC 815-30-40-1(b) requires entities to discontinue cash flow hedge accounting for a hedging relationship if the hedging derivative “expires or is sold, terminated, or exercised.” In such a case, hedge accounting should be applied through the date of the expiration, sale, termination, or exercise as long as the relationship met the criteria to qualify for hedge accounting up until that date. After that date, the derivative is not remeasured on the balance sheet, so there would be no more changes in fair value to potentially record in OCI. See Section 4.1.5.2 for a discussion of the accounting for amounts in AOCI related to a discontinued hedging relationship.

If any of the critical terms of a derivative that is designated in a cash flow hedging relationship are modified, the hedging relationship should be dedesignated and discontinued. The novation of the derivative from one counterparty to another counterparty is not, in and of itself, a change in a critical term of the hedging relationship. See Sections 3.5.1.1.1 and 3.5.1.1.2 for a more thorough discussion of derivative modifications and novations, which is also applicable to all types of hedging relationships.

4.1.5.1.2 Relationship No Longer Qualifies for Hedge Accounting

4.1.5.1.2.1 Hedging Relationship Not Highly Effective

As noted in ASC 815-30-40-1(a), hedge accounting should be discontinued for a cash flow hedging relationship if any of the qualifying criteria for a cash flow hedge are no longer met. Accordingly, an entity should discontinue hedge accounting if the results of a hedge effectiveness assessment indicate that the relationship is no longer highly effective. As discussed in Section 2.5.1, we do not believe that a hedging relationship needs to be dedesignated upon a failed hedge effectiveness assessment because the discontinuation of hedge accounting ensures that it is not applied during the period in which the relationship does not qualify for such accounting. ASC 815-30-35-3(b) discusses the accounting for amounts in AOCI that are related to a cash flow hedging relationship. After describing the composition of the balance in AOCI for a qualifying cash flow hedging relationship, ASC 815-30-35-3(b) states, in part:

If hedge accounting has not been applied to a cash flow hedging relationship in a previous effectiveness assessment period because the entity’s retrospective evaluation indicated that the relationship had not been highly effective in achieving offsetting changes in cash flows in that period, the cumulative gain or loss on the derivative referenced in (b) would exclude the gains or losses occurring during that period. That situation may arise if the entity had previously determined, for example, under a regression analysis or other appropriate statistical analysis approach used for prospective assessments of hedge effectiveness, that there was an expectation in which the hedging relationship would be highly effective in future periods. Consequently, the hedging relationship continued even though hedge accounting was not permitted for a specific previous effectiveness assessment period.

If a hedging relationship is not dedesignated, hedge accounting may be applied in any subsequent period in which the entity can provide (1) a prospective hedge effectiveness assessment that shows at the beginning of the period that the hedging relationship is expected to be highly effective and (2) a retrospective hedge effectiveness assessment that shows that the hedging relationship was highly effective during the period. However, as noted in Section 2.5.1, if there are repeated failed hedge effectiveness assessments, an entity may want to consider whether a different hedging strategy could qualify for hedge accounting.

As noted in the discussion of fair value hedges in Section 3.5.1.2.1, ASC 815-25-40-4 states that “if the event or change in circumstances that caused the hedging relationship to fail the effectiveness criterion can be identified, the entity shall recognize in earnings the changes in the hedged item’s fair value attributable to the risk being hedged that occurred before that event or change in circumstances.” ASC 815-30 does not provide similar guidance for cash flow hedging relationships; however, we believe that the same concepts apply to cash flow hedges because the requirement for a hedging relationship to be highly effective applies to all hedging relationships. In other words, if an entity can identify an event or change in circumstances that caused the hedging relationship to fail the effectiveness criterion, it should recognize the changes in the derivative’s fair value that occurred before that event or change in circumstances in OCI.

4.1.5.1.2.2 Forecasted Transaction Not Probable

As discussed in Section 4.1.1.1, a forecasted transaction can only be designated as the hedged item in a qualifying cash flow hedging relationship if it is probable that the transaction will occur. To maintain hedge accounting, the entity must be able to assert that the forecasted transaction is probable throughout the life of the hedging relationship. If it becomes no longer probable that the designated forecasted transaction will occur, (1) the transaction would no longer qualify to be the hedged item in a cash flow hedging relationship and (2) hedge accounting should be discontinued under ASC 815-30-40-1(a). Amounts in AOCI related to the discontinued cash flow hedging relationship are not necessarily reclassified into earnings at the time hedge accounting is discontinued. See Section 4.1.5.2 for a discussion of the accounting for a cash flow hedging relationship after hedge accounting is discontinued.

When determining whether it is probable that a forecasted transaction will occur, an entity should consider whether the parties to the transaction have the ability to perform, as noted in Section 4.1.1.1. ASC 815-20-25-16(a) states that “[a]n entity using a cash flow hedge shall assess the creditworthiness of the counterparty to the hedged forecasted transaction in determining whether the forecasted transaction is probable, particularly if the hedged transaction involves payments pursuant to a contractual obligation of the counterparty.” Similarly, the reporting entity also must consider how its own creditworthiness (i.e., its ability to execute the forecasted transaction) affects the hedging relationship. For example, if the entity wants to apply hedge accounting to a cash flow hedging relationship in which the forecasted transactions are interest payments on its variable-rate debt, it needs to consider the probability that the interest payments will be made.

As discussed in Section 2.5.2.1.2.6, changes in the creditworthiness of the counterparties to the derivative contract can also affect the ability to apply hedge accounting.

4.1.5.1.2.3 Forecasted Transaction Is Delayed

As noted in Section 4.1.4.1, ASC 815-20-25-16(c) states, in part, that “[a]s long as it remains probable that a forecasted transaction will occur by the end of the originally specified time period, cash flow hedge accounting for that hedging relationship would continue.” If it is no longer probable that the forecasted transaction will occur within the time frame specified in the designation documentation, hedge accounting should be discontinued.

Alternatively, if a forecasted transaction will be delayed but is still expected to occur within the time frame described in the hedge designation documentation, the entity should perform the hedge effectiveness assessment on the basis of the change in the forecasted transaction’s timing. If the hedging relationship is no longer highly effective, hedge accounting should be discontinued.

See Section 4.1.5.2 for a discussion of the accounting for a cash flow hedging relationship when hedge accounting is discontinued.

4.1.5.1.2.4 Forecasted Transaction Changes

If a forecasted transaction changes and therefore no longer meets the description in the hedge designation documentation, the hedging relationship should be discontinued. In addition, even if the terms of the transaction change and the transaction still meets the description in the hedge designation documentation, the hedging relationship should be discontinued if it is no longer highly effective. See Section 4.1.4.2 for a more thorough discussion of the changes in the terms of a forecasted transaction and Section 4.1.5.2 for a discussion of the accounting for a cash flow hedging relationship when hedge accounting is discontinued.

4.1.5.1.3 Dedesignations

In a manner similar to the requirements for fair value hedges, discussed in Section 3.5.1.3, ASC 815-30-40-1(c) requires cash flow hedge accounting to be discontinued for a hedging relationship if an entity “removes the designation of the cash flow hedge.” An entity may discontinue a hedging relationship at any time even if (1) the hedging instrument and the hedged item remain unchanged and are not sold, terminated, expired, or executed or (2) it is still probable that the hedged transaction will occur (in the case of a forecasted transaction). When voluntarily discontinuing a hedging relationship, an entity should formally document dedesignation of the relationship and discontinue applying hedge accounting to the relationship on the date of the documentation.

4.1.5.1.3.1 Proportional Dedesignations

As discussed in Section 3.5.1.3.1, an entity may want or be required to dedesignate a proportion of a hedging relationship. For example, if the entity is hedging a series of forecasted transactions and it is no longer probable that a proportion of those transactions will occur (see Section 4.1.5.1.2.2), the entity would be required to dedesignate at least the proportion of the hedging relationship that is related to those forecasted transactions that are no longer probable. The ability to dedesignate a proportion of a hedging relationship is equally available to all types of hedging relationships, including cash flow hedges.

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

After a dedesignation, the entity would only assess the remaining proportion of the hedging relationship to determine whether it qualified for hedge accounting. In other words, the entity would compare (1) the proportion of the changes in the derivative’s fair value that are related to the proportion that is still designated as the hedging instrument and included in the assessment of hedge effectiveness with (2) changes in the cash flows of the newly designated proportion of the hedged item that are attributable to changes in the designated risk.

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

	Before Date of Dedesignation		After Date of Dedesignation
	Hedge Is Highly Effective	Hedge Is Not Highly Effective	Hedge Is Highly Effective	Hedge Is Not Highly Effective
Proportion of Derivative Still Designated	Change in fair value recorded in OCI1	Change in fair value recorded in earnings	Change in fair value recorded in OCI2	Change in fair value recorded in earnings
Proportion of Derivative Dedesignated	Change in fair value recorded in OCI1	Change in fair value recorded in earnings	Change in fair value recorded in earnings

Amounts in AOCI (including amounts related to excluded components) are reclassified into earnings when the hedged item affects earnings regardless of whether hedge accounting is discontinued in part or in full unless (1) it is probable that the forecasted transaction will no longer occur or (2) there will be a significant delay in the transaction (see the next section).

4.1.5.2 Accounting for a Discontinued Cash Flow Hedge

ASC 815-30

Discontinuing Hedge Accounting

40-2 In the circumstances discussed in paragraph 815-30-40-1, the net gain or loss shall remain in accumulated other comprehensive income and be reclassified into earnings as specified in paragraphs 815-30-35-38 through 35-41. Example 16 (see paragraph 815-30-55-94) illustrates the application of paragraph 815-30-35-3 if a hedging relationship is terminated.

40-4 The net derivative instrument gain or loss related to a discontinued cash flow hedge shall continue to be reported in accumulated other comprehensive income unless it is probable that the forecasted transaction will not occur by the end of the originally specified time period (as documented at the inception of the hedging relationship) or within an additional two-month period of time thereafter, except as indicated in the following sentence. In rare cases, the existence of extenuating circumstances that are related to the nature of the forecasted transaction and are outside the control or influence of the reporting entity may cause the forecasted transaction to be probable of occurring on a date that is beyond the additional two-month period of time, in which case the net derivative instrument gain or loss related to the discontinued cash flow hedge shall continue to be reported in accumulated other comprehensive income until it is reclassified into earnings pursuant to paragraphs 815-30-35-38 through 35-41.

40-5 If it is probable that the hedged forecasted transaction will not occur either by the end of the originally specified time period or within the additional two-month period of time and the hedged forecasted transaction also does not qualify for the exception described in the preceding paragraph, that derivative instrument gain or loss reported in accumulated other comprehensive income shall be reclassified into earnings immediately. 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.

40-6A When applying the guidance in paragraph 815-20-25-83A, if the hedged forecasted transaction is probable of not occurring, any amounts remaining in accumulated other comprehensive income related to amounts excluded from the assessment of effectiveness shall be recorded in earnings in the current period. For all other discontinued cash flow hedges, any amounts associated with the excluded component remaining in accumulated other comprehensive income shall be recorded in earnings when the hedged forecasted transaction affects earnings.

Upon the discontinuation of hedge accounting for a cash flow hedging relationship, any amounts in AOCI related to that relationship, including amounts associated with any components of the derivative that were excluded from the hedge effectiveness assessment (see ASC 815-30-40-6A), are still associated with the hedged transaction and should affect earnings at the same time and in the same manner in which the hedged transaction affects earnings.

The table below illustrates the method of reclassifying amounts from AOCI to income for a few potential hedged forecasted transactions.

Hedged Transaction	Recognition of AOCI in Income
Forecasted purchase of a machine in a foreign currency	Adjustment of depreciation over the useful life of machine
Forecasted sale of an AFS debt security	Adjustment of gain or loss on sale of the security when sold
Forecasted debt issuance	Adjustment of interest expense over term of debt
Forecasted purchase of raw materials	Adjustment of the cost of sales when related inventory is sold

For a more detailed discussion of the reclassification of amounts from AOCI, see Section 4.2.5 for hedges of transactions involving financial instruments and Section 4.3.5 for hedges of transactions involving nonfinancial assets.

If an entity discontinues a hedging relationship involving a series of forecasted transactions but it is still probable that the hedged transactions will occur, the amounts in AOCI should be reclassified into earnings as those forecasted transactions affect earnings (i.e., over the remaining term of the hedging relationship). ASC 815 does not specify what method an entity should use to determine the amount in AOCI related to each of the remaining previously hedged transactions, but we believe that it is acceptable to apply either (1) the caplet/swaplet method or (2) a systematic and rational method of amortization of the amount in AOCI. Under the caplet/swaplet method, an entity determines how much of the change in fair value that was recognized in OCI is related to each individual component of the derivative that was hedging each individual forecasted transaction. Under the systematic and rational amortization method, the amount in AOCI is allocated to the remaining transactions. For example, an entity may determine the allocation by dividing the amount in AOCI by the number of remaining transactions.

In some circumstances, all or some of the amounts in AOCI related to a specific discontinued hedging relationship need to be reclassified into earnings before the forecasted transaction affects earnings. Specifically, if it becomes probable that the forecasted transaction either will not occur at all or will not occur without significant delay, the entity must immediately reclassify amounts into earnings. ASC 815-30-40-5 generally requires amounts in AOCI to be reclassified into earnings if it becomes probable that a designated forecasted transaction will not occur within two months of the time period specified in the original hedge designation documentation. However, ASC 815 is silent on the income statement classification of amounts that are reclassified out of AOCI in accordance with ASC 815-30-40-5. The exposure draft for ASU 2017-12 would have required amounts to be reported in the same line item in which the earnings effect of the forecasted transaction would have been reported, but the Board decided to remove that requirement when it issued the final ASU. Paragraph BC140 of ASU 2017-12 explains the basis for that decision:

In the feedback received from stakeholders, both preparers and users emphasized that such presentation would not provide decision-useful information because of the potentially distortive effects on individual income statement line items. In a missed forecast, only the earnings effect of the hedging instrument would have been recorded in the line item intended to be hedged, but there would have been no offsetting earnings effect from a hedged item. For example, in a missed forecasted sales transaction, an entity would record the change in the fair value of the hedging instrument in revenue, but there would be no corresponding revenue from the sale. The Board concluded that financial reporting would not be improved by requiring that the gain or loss of the hedging instrument that had been deferred in accumulated other comprehensive income be recorded in a line item in which there is no offset from the hedged item. Therefore, the Board decided to retain current GAAP by not providing specific presentation guidance for missed forecasts.

In the absence of guidance, we believe that an entity should exercise judgment in deciding where to report amounts that are reclassified out of AOCI into earnings when it becomes probable that a forecasted transaction will not occur within two months of the originally specified time frame. An entity should disclose where such amounts are reported and consistently apply any policy that it develops. Even though the FASB decided not to require such amounts to be recognized in the same line item in which the earnings effect of the forecasted transaction would have been reported, an entity is not precluded from doing so.

ASC 815-30-40-4 states, in part, that “[i]n rare cases, the existence of extenuating circumstances that are related to the nature of the forecasted transaction and are outside the control or influence of the reporting entity may cause the forecasted transaction to be probable of occurring on a date that is beyond the additional two-month period of time, in which case the net derivative instrument gain or loss related to the discontinued cash flow hedge shall continue to be reported in accumulated other comprehensive income until it is reclassified into earnings pursuant to paragraphs 815-30-35-38 through 35-41.” Because this exception is available only in “rare” cases, an entity should document the extenuating circumstances and explain why the transaction would meet this rare exception.

Connecting the Dots

At its April 8, 2020, meeting, the FASB staff stated that the guidance in ASC 815-30-40-4 (i.e., on delays of a forecasted transaction caused by extenuating circumstances that are related to the nature of the forecasted transaction and that are outside the control or influence of the entity) may be applied to delays in the timing of forecasted transactions if those delays are attributable to the COVID-19 pandemic. In a Q&A released on April 28, 2020, the FASB staff reiterated and expanded on this view. According to the Q&A, if an entity concludes that it is still probable that the forecasted transactions associated with a discontinued hedge will occur after the additional two-month period, it should retain in AOCI those amounts associated with the discontinued hedge and reclassify them into earnings in the same period(s) in which the forecasted transaction affects earnings.

The FASB staff also cautioned that an entity would need to exercise judgment and consider the specific facts and circumstances related to the forecasted transaction in determining whether (1) the forecasted transaction delays were caused by the effects of the COVID-19 pandemic and (2) it is probable that the forecasted transaction still will occur after the additional two-month period. As noted in the Q&A, when assessing a forecasted transaction’s probability of occurrence, an entity “should consider whether the forecasted transaction remains probable over a time period that is reasonable given the nature of the entity’s business, the nature of the forecasted transaction, and the magnitude of the disruption to the entity’s business related to the effects of the COVID-19 pandemic.” If an entity determines that it is no longer probable that the forecasted transaction will occur within the “reasonable time period beyond the additional two-month period,” it should immediately reclassify all AOCI amounts related to the discontinued hedge into earnings and provide appropriate disclosures in its interim and annual financial statements.

The Q&A also clarifies that when an entity determines that amounts deferred in AOCI should be reclassified into earnings because of a missed forecast as a result of the COVID-19 pandemic, the entity need not consider that missed forecast in its assessment of whether it has exhibited a pattern of missed forecasts that would call into question its ability to apply cash flow hedge accounting to similar transactions in the future. An entity would need to exercise judgment and consider its specific facts and circumstances when making its determination that the missed forecast is related to the effects of the COVID-19 pandemic.

The table below summarizes the treatment of the changes in the fair value of a derivative designated in a cash flow hedging relationship on the basis of the likelihood that the forecasted transaction will occur. It is assumed that all the other criteria for hedge accounting are met.

Likelihood of Transaction Occurring	Treatment of Changes in Derivative’s Fair Value	Hedge Accounting Status
Probable	Retain in AOCI; recognize subsequent changes in fair value through OCI	Continues
Reasonably possible	Freeze amounts in AOCI; recognize subsequent changes in fair value through earnings	Ceases
Probably not	Immediately reclassify amounts from AOCI into earnings; recognize subsequent changes in fair value through earnings	Ceases

Example 4-4

Hedge Discontinued but Forecasted Transaction Still Probable

Assume that on February 3, 20X1, Maize Company expects that it will purchase 100,000 bushels of corn on May 20, 20X1. On February 3, 20X1, it enters into 20 futures contracts, each for the purchase of 5,000 bushels of corn (100,000 in total) on May 20, 20X1. The price of the futures contracts is $2.6875 per bushel (a total price of $268,750 for 100,000 bushels). Maize immediately designates those contracts as a hedge of the forecasted purchase of 100,000 bushels of corn. It measures effectiveness by comparing the entire change in the futures contracts’ fair value with changes in the cash flows on the forecasted transaction.

On May 1, 20X1, Maize dedesignates the futures contracts and closes them out by entering into offsetting contracts on the same exchange. As of that date, it has recognized gains of $26,250 on the futures contracts in AOCI. Because Maize still plans to purchase 100,000 bushels of corn on May 20, 20X1, the gains that occurred before the dedesignation will remain in AOCI until the finished product is sold. If Maize had not closed out the futures contracts when it dedesignated them, any subsequent gains or losses on those contracts would have been recognized in earnings, but amounts in AOCI would have remained in AOCI until the finished product was sold.

Example 4-5

Hedge Discontinued and Forecasted Transaction Is Delayed

Alaskan Crude enters into a cash flow hedge of the forecasted sale of 100 barrels of oil inventory on April 30. Gains and losses on the hedging instrument are recognized in OCI and will be reclassified from AOCI into earnings as sales occur. After the initiation of the hedging relationship, Alaskan Crude determines that it is no longer probable that the 100 barrels will be sold on April 30 and the cash flow hedge is discontinued. However, it believes that the forecasted sales will occur by June 30. Alaskan Crude should continue to report the gains and losses on the hedging instrument associated with the discontinued cash flow hedge in AOCI because it is not probable that the forecasted sale will not occur within the additional two-month period after the transaction date specified in the original hedge documentation.

If Alaskan Crude instead concludes that (1) it is probable that the sale will not occur by June 30 (i.e., within two months after the sale date forecasted in the original hedge documentation) and (2) the circumstances related to the sale did not constitute one of the rare cases in which an additional extension (as described above) is warranted, it will immediately recognize in income the amounts in AOCI that are associated with the discontinued cash flow hedge.

4.1.5.2.1 Impact of Missed Forecasts on Future Forecasts

As previously discussed, ASC 815-30-40-5 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.”

Connecting the Dots

At the 2000 AICPA Conference on Current SEC Developments, the SEC staff said that it will challenge the credibility of management’s previous and future assertions about forecasted transactions if the entity displays a pattern of determining that it is no longer probable that its hedged forecasted transactions will occur: “One instance is not a pattern, but a recurrence will quickly raise a red flag that could result in a revision in the accounting for cash flow hedging relationships.”

The SEC staff believes that this issue is a matter of judgment based on individual facts and circumstances. However, there are several questions that are useful for evaluating whether an entity has a pattern of determining that forecasted transactions are no longer probable. These include:

What were the business or operating circumstances that led the entity to its conclusion?
Has the entity experienced other instances with similar forecasted transactions?
If so, when did the other instance(s) occur and what were the business or operating circumstances?
Do the current circumstances differ, if at all, from the previous instance(s)?
Were the circumstances or events that led to the conclusion(s) within the entity’s control?
Is the entity expecting a similar forecasted transaction within the near future?

4.1.5.2.2 Hedged Forecasted Transaction Is Impaired

The cash flow hedging guidance in ASC 815-30-35-43 (as amended by ASU 2019-04) states, in part, that “[i]f, under existing requirements in GAAP, an asset impairment loss or writeoff due to credit losses is recognized on an asset or an additional obligation is recognized on a liability to which a hedged forecasted transaction relates, any offsetting or corresponding net gain related to that transaction in accumulated other comprehensive income shall be reclassified immediately into earnings.”

Paragraph 498 of Statement 133 explains that the FASB’s rationale for establishing this requirement was to ensure that “a derivative gain or loss recognized in accumulated other comprehensive income as a hedge of a variable cash flow on a forecasted transaction is . . . reclassified into earnings in the same period or periods as the offsetting loss or gain on the hedged item.” Therefore, “a derivative gain that offsets part or all of an impairment loss on a related asset or liability should be reclassified into earnings in the period that an impairment loss is recognized.”

Accordingly, for an impaired asset to be considered “related” to the cash flow hedging relationship, there should be a clear and direct link between (1) the hedged exposure(s) identified in the documentation for the hedging relationship and (2) the impaired asset. Without a direct link, there is no conceptual basis for offsetting AOCI amounts against the impairment loss.

Example 4-6

Weekapaug Regional Bank decides to sell a fixed-rate AFS debt security to fund the purchase of new equipment that will be delivered in six months, and it enters into a forward sale contract to hedge the probable forecasted sale of the security. At the inception of the hedge, the fair value of the AFS debt security equals its amortized cost. Three months later, because of an increase in interest rates, the fair value of the forward sale contract increases to $10 million, with an offset recorded in OCI to reflect hedge accounting, and the fair value of the AFS security decreases by $10 million. Because Weekapaug intends to sell the security, it must recognize an impairment loss for the security in accordance with ASC 326-30-35-10. In this scenario, there is a clear and direct link between the hedged forecasted sale and the impaired security; therefore, the two are “related” and Weekapaug should reclassify $10 million of the AOCI balance associated with the hedged sale to income to offset the $10 million impairment loss on the security.

Example 4-7

Mercury Provisions is hedging the forecasted sales of its products, and therefore it cannot assert that amounts recorded in AOCI in connection with the hedge are related to the impairment of equipment used to manufacture those products. In that scenario, the hedged items are the sales of the products, which would be distinct from the impairment of the equipment. Such an impairment would not be directly related to the hedged cash flows specified in the hedge documentation because cash flows from the sales of products would not yet have occurred. Therefore, offsetting the amounts in AOCI that are attributable to the hedged forecast sales against the impairment would be inconsistent with the FASB’s objective of recognizing the earnings effects of the hedging instrument and the hedged items in the same period(s). In addition, such accounting would not achieve Mercury’s intended purpose of recognizing a fixed price for the forecasted sale because after the impairment was offset, there would be fewer (or no) amounts left in AOCI to offset against the spot price of the forecasted sales when they actually occur.

Further, in such a case it would be difficult to argue conceptually that the entire amount recorded in AOCI that is attributable to specific hedged sales should be offset against the impairment. Under both steps of the impairment test in ASC 360-10-35-17 (i.e., assessment of recoverability and measurement of impairment), Mercury would consider all future cash flows of the equipment, not just those cash flows identified as the hedged sales. Because the impairment would be indirectly related to all the future products created by the equipment, it would seem inconsistent to offset the entire amount of the impairment loss on the equipment against the amounts in AOCI that were only attributable to the specified hedged cash flows. In addition, even if the hedged forecasted sales span the entire period of expected production from the equipment, it still would not be appropriate for Mercury to remove from AOCI amounts related to those sales to offset the impairment of the equipment because the cash flows of each are distinct and not related.

4.1.6 Excluded Components of a Derivative

As discussed in Section 2.5.2.1.2.1, an entity may exclude components of a derivative’s fair value (and the resulting changes in the fair value of the excluded components) from the assessment of hedge effectiveness. In such a case, if the entity recognizes the excluded amounts in earnings by using a systematic and rational method over the life of the hedging instrument, any difference between the change in the fair value of those components and the amount recognized in earnings should be recognized in OCI. An entity may also elect to recognize the changes in the excluded components’ fair value in earnings as they occur.

See Example 4-20 for a detailed illustration of a hedging relationship that involves excluding an option’s time value from the assessment of a hedging relationship.

Footnotes

If any component of the derivative is excluded from the hedge effectiveness assessment and the difference between the changes in that component’s fair value and the amount recognized in earnings under a systematic and rational method are recorded in OCI as permitted by ASC 815-20-25-83A, only the proportion of the derivative that is still in a hedging relationship qualifies for this treatment after the date of the proportional dedesignation.

See footnote 1.

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 LIBOR). 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 LIBOR 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 LIBOR). 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 LIBOR). 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 LIBOR 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 LIBOR 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 LIBOR (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., LIBOR) 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 LIBOR). 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 LIBOR 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 LIBOR, it would need to consider all the different tenor or reset frequency options for LIBOR 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 LIBOR interest rate swap), the hedged cash flows could be based on several different tenors of LIBOR 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 LIBOR), 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.

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 LIBOR	3.50%	1 month
Three-month LIBOR	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 LIBOR 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 LIBOR. 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 LIBOR. 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 LIBOR and (2) Esquandolas could ignore the ineffectiveness associated with the option to choose one-month LIBOR 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 LIBOR. 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 LIBOR, 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 LIBOR) 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 LIBOR). 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 LIBOR (Approach 1).
Changes in cash flows that are attributable to changes in the contractually specified LIBOR 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 LIBOR with a monthly basis while the hedging interest rate swap would still be valued on the basis of three-month LIBOR 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 LIBOR and assert that it will always choose LIBOR 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 LIBOR 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 LIBOR but the hedged interest payments could be based on either one- or three-month LIBOR. 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 LIBOR, three-month-LIBOR, 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 LIBOR). 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 LIBOR 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 LIBOR) 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 LIBOR-indexed variable-rate loans (i.e., the contractually specified interest rate is three-month LIBOR). 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 LIBOR-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 LIBOR-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 LIBOR-indexed variable-rate loans. After Weekapaug has received payments on $100 million aggregate principal during the four-week period, any additional three-month LIBOR-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 LIBOR-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, LIBOR, 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 LIBOR.” 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 LIBOR, 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 LIBOR 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 LIBOR 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 LIBOR
Reset or 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 LIBOR). 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 LIBOR 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 LIBOR 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 LIBOR 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 LIBOR 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 4-19

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 LIBOR 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 LIBOR 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 LIBOR
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 LIBOR (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 LIBOR 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 LIBOR plus 2.5 percent on an annual basis reset on December 31. On January 1, 20X1, 12-month LIBOR was 2.25 percent.

Seeking to hedge its exposure to interest rate risk above 5.5 percent (12-month LIBOR of 3.0 percent + 2.5 percent), Ocelot Spot enters into an interest rate cap that (1) is indexed to 12-month LIBOR, (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 LIBOR if 12-month LIBOR 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 LIBOR 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 LIBOR 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 LIBOR (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 LIBOR 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 LIBOR) 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 LIBOR-based cap and 12-month LIBOR 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.

4.3 Nonfinancial Assets

4.3.1 Overview

As discussed in Chapter 2, for a cash flow hedge of a nonfinancial asset, an entity designates a derivative instrument as a hedge of a specific risk related to the forecasted purchase or sale of such an asset. The types of risks that may be hedged in a cash flow hedge involving a nonfinancial asset include:

Foreign currency risk.
Contractually specified component risk.
Total cash flow risk.

In many cash flow hedges involving the purchase or sale of nonfinancial assets, the hedging derivative is not perfectly effective at offsetting the total changes in the cash flows related to the hedged item. However, as discussed in Section 2.5, the ability to designate components of the purchase or sale price (i.e., specific hedged risks) affects the hedge effectiveness assessment and, therefore, thoughtful designation of the hedged risk can make the difference between a hedging relationship that qualifies for hedge accounting and a relationship 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 assessment of hedge effectiveness are recorded in OCI (see Section 2.5 for a discussion of hedge effectiveness assessments). In contrast to the treatment of qualifying fair value hedges, ineffectiveness is not recognized currently in the income statement. See Section 4.3.5 for a discussion of the reclassification of amounts out of AOCI related to cash flow hedges of nonfinancial assets.

Conceptually, hedging the overall cash flows related to the forecasted purchase or sale of a nonfinancial asset is fairly simple. If an entity designates overall cash flows of the nonfinancial asset being purchased or sold in a forecasted transaction, it must use a hedging derivative that is highly effective at offsetting all changes in the purchase or sale price of the nonfinancial asset. In some cases, this is the only risk that an entity may select. For example, if the purchase or sale of the asset will occur in the functional currency of the entity and there is not a contractually specified component to the asset’s price, the only risk that may be designated is the risk of changes in the overall cash flows of the purchase or sale.

Even if the purchase or sale of the nonfinancial asset will occur at a price denominated in a foreign currency, as discussed in Section 2.3.2.3, an entity may exclude foreign currency risk from its designation of the hedged risk in an overall cash flow hedging strategy. In other words, an entity may hedge the overall price denominated in the foreign currency. An entity may also hedge the variability in the cash flows that are attributable to changes in foreign currency risk for a forecasted purchase or sale of a nonfinancial asset if the price will be denominated in a foreign currency. Such hedges are very common for organizations that have significant multinational operations and only want to hedge the risks of changes in foreign currency exchange rates. Foreign currency hedging is discussed in detail in Chapter 5.

As discussed in Section 2.3.2.1, ASU 2017-12 gave entities the ability to hedge the risk of changes in a contractually specified component of the price of a forecasted purchase or sale of a nonfinancial asset. However, even after the issuance of ASU 2017-12, many entities have been slow to move to these types of hedges, sometimes because their established hedging strategies are already highly effective. In addition, as discussed in Section 2.3.2.1.2, there are still many questions about whether transactions in the spot market actually have a contractually specified component to the price.

4.3.2 Partial-Term Hedging

As is the case with hedges of forecasted transactions involving financial instruments (see Section 4.2.1.2.3), when hedging the forecasted purchase or sale of a nonfinancial asset, an entity is not required to hedge changes in cash flows that are attributable to the hedged risk for the entire period leading up to the actual date of the forecasted transaction.

Example 4-23

Hedging Forecasted Purchase With Derivative That Settles Before Forecasted Purchase

Golden Age plans to make a large gold purchase in one year but is only really interested in hedging the price of gold for the next three months. It decides to enter into a futures contract to purchase gold that settles in three months and designate the contract as a hedge of the changes in cash flows over the next three months related to its forecasted purchase of gold in one year.

If Golden Age excludes time value from its assessment of hedge effectiveness, it would compare the changes in the spot price of gold underlying the futures contract with the spot price of gold in the market in which it expects to purchase the gold in one year. If it does not exclude any components of the futures contract from its assessment, it could compare the change in the actual derivative’s fair value (the three-month futures contract) with the change in the fair value of a hypothetical forward that settles in one year at the same location in which it expects to purchase the gold. For example, if Golden Age performed effectiveness assessments on a monthly basis, it would do the following comparison at the end of the first month:

Derivative	Beginning of Period	End of Period
Actual	Three-month futures	Two-month futures
Hypothetical	Twelve-month forward settling at expected purchase location	Eleven-month forward settling at expected purchase location

Note that even if the underlying spot price of the forecasted transaction is the same as the underlying price of the derivative (i.e., the underlying location and grade of the nonfinancial asset is the same), if an entity does not exclude any components of the derivative from its hedge effectiveness assessment, it cannot assume that the critical terms match in a partial-term hedging relationship because the settlement date of the derivative does not match the settlement date of the forecasted transaction.

4.3.3 Changes in Terms of Forecasted Transaction Other Than Timing

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 forecasted transaction no longer meets that definition, the entity must discontinue hedge accounting and reclassify amounts from AOCI into earnings (see Section 4.1.5). However, if the revised forecasted transaction still meets the definition in the hedge designation documentation, the entity should perform a revised hedge effectiveness assessment to determine whether it is appropriate to continue hedge accounting.

ASC 815-20

Contractually Specified Component in a Not-Yet-Existing Contract

55-26B This guidance discusses the implementation of paragraphs 815-20-25-22B and 815-30-35-37A. Entity A’s objective is to hedge the variability in cash flows attributable to changes in a contractually specified component in forecasted purchases of a specified quantity of soybeans on various dates during June 20X1. Entity A has executed contracts to purchase soybeans only through the end of March 20X1. Entity A’s contracts to purchase soybeans typically are based on the ABC soybean index price plus a variable basis differential representing transportation costs. Entity A expects that the forecasted purchases during June 20X1 will be based on the ABC soybean index price plus a variable basis differential.

55-26C On January 1, 20X1, Entity A enters into a forward contract indexed to the ABC soybean index that matures on June 30, 20X1. The forward contract is designated as a hedging instrument in a cash flow hedge in which the hedged item is documented as the forecasted purchases of a specified quantity of soybeans during June 20X1. As of the date of hedge designation, Entity A expects the contractually specified component that will be in the contract once it is executed to be the ABC soybean index. Therefore, in accordance with paragraph 815-20-25-3(d)(1), Entity A documents as the hedged risk the variability in cash flows attributable to changes in the contractually specified ABC soybean index in the not-yet-existing contract. On January 1, 20X1, Entity A determines that all requirements for cash flow hedge accounting are met and that the requirements of paragraph 815-20-25-22A will be met in the contract once executed in accordance with paragraph 815-20-25-22B. Entity A also will assess whether the criteria in 815-20-25-22A are met when the contract is executed.

55-26D As part of its normal process of assessing whether it remains probable that the hedged forecasted transactions will occur, on March 31, 20X1, Entity A determines that the forecasted purchases of soybeans in June 20X1 will occur but that the price of the soybeans to be purchased will be based on the XYZ soybean index rather than the ABC soybean index. As of March 31, 20X1, Entity A begins assessing the hedge effectiveness of the hedging relationship on the basis of the changes in cash flows associated with the forecasted purchases of soybeans attributable to variability in the XYZ soybean index. Because the hedged forecasted transactions (that is, purchases of soybeans) are still probable of occurring, Entity A may continue to apply hedge accounting if the hedging instrument (indexed to the ABC soybean index) is highly effective at achieving offsetting cash flows attributable to the revised contractually specified component (the XYZ soybean index). On April 30, 20X1, Entity A enters into a contract to purchase soybeans throughout June 20X1 based on the XYZ soybean index price plus a variable basis differential representing transportation costs.

55-26E If the hedging instrument is not highly effective at achieving offsetting cash flows attributable to the revised contractually specified component, the hedging relationship must be discontinued. As long as the hedged forecasted transactions (that is, the forecasted purchases of the specified quantity of soybeans) are still probable of occurring, Entity A would reclassify amounts from accumulated other comprehensive income to earnings when the hedged forecasted transaction affects earnings in accordance with paragraphs 815-30-35-38 through 35-41. The reclassified amounts should be presented in the same income statement line item as the earnings effect of the hedged item. Immediate reclassification of amounts from accumulated other comprehensive income to earnings would be required only if it becomes probable that the hedged forecasted transaction (that is, the purchases of the specified quantity of soybeans in June 20X1) will not occur. As discussed in paragraph 815-30-40-5, 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 applying cash flow hedge accounting in the future for similar forecasted transactions.

In the example in ASC 815-20-55-26B through 55-26E, Entity A is hedging the contractually specified component of a not-yet-existing contract, and the expected contractually specified component changes before the contract exists. This example reinforces a few key concepts, one of which is that when the forecasted transaction changes, the entity needs to assess whether the designated transaction is still probable.

In this example, Entity A documents the hedge as follows:

Forecasted Transaction	Designated Risk
Purchase of specified quantity of soybeans on various dates during June 20X1	Variability in cash flows attributable to changes in the contractually specified ABC soybean index in the not-yet-existing contract

After designating the hedge, Entity A observes that the price of soybeans it will purchase will be based on the XYZ soybean index, not the ABC soybean index. Regardless of the price exposure change, Entity A determines that it is still probable that it will purchase the specified quantity of soybeans on various dates during June 20X1. This is important because if it becomes no longer probable that a forecasted transaction will occur, an entity must discontinue hedge accounting. In addition, if it becomes probable that the forecasted transaction will not occur, the entity must reclassify amounts previously recorded in AOCI into earnings. However, in this case, Entity A can maintain hedge accounting if the hedging relationship is still highly effective.

In evaluating this next step after a change in the terms of the forecasted transaction, Entity A needs to assess whether its derivative contract (the forward contract based on the ABC soybean index) is highly effective at offsetting the change in cash flows related to the forecasted purchases of soybeans based on the revised contractually specified component (the XYZ soybean index). If Entity A is using the hypothetical-derivative method to assess hedge effectiveness, the hypothetical forward contract would be a forward to purchase XYZ soybeans with a market-based strike price at the inception of the hedging relationship (i.e., the hypothetical forward would have a fair value of zero as of January 1, 20X1).

While this example deals with a hedge of the contractually specified component of a not-yet-existing contract, the same sort of analysis would be performed for hedges that involve total cash flow risk or foreign-currency risk if there are changes in the terms of the forecasted transaction. The first step of the analysis (i.e., assessing the probability that the forecasted transaction will occur) is the same regardless of the designated risk. However, if the second step is necessary (i.e., the forecasted transaction is still probable), the revised hedge effectiveness assessment is only affected if the change in the forecasted transaction’s terms have an impact on the designated risk. In a manner similar to the example above, if the derivative is still highly effective at offsetting changes in the cash flows that are attributable to the hedged risk of the revised transaction, the entity may continue hedge accounting. If the hedging relationship is no longer highly effective, hedge accounting should be discontinued but amounts previously recorded in AOCI would remain in AOCI until the forecasted transaction affects earnings.

4.3.4 Delay of Forecasted Transaction

As discussed in Section 4.1.4.1, if the timing of a hedged forecasted transaction changes, an entity is required to consider whether it is still probable that the forecasted transaction will occur within the timing established in the hedge designation documentation.

4.3.4.1 Designated Transaction Is Single Transaction

If an entity is hedging a single forecasted transaction and the timing of that transaction changes, the impact of that change in timing on the hedging relationship depends on whether it is still probable that the transaction will occur within the period specified in the designation documentation (see Section 4.1.5.1.2.3 for further discussion). If hedge accounting needs to be discontinued, the hedging relationship should be dedesignated.

4.3.4.2 Designated Transaction Is a Group of Transactions

Most hedges of purchases or sales of nonfinancial assets involve multiple transactions, as opposed to one singular transaction. For example, if an entity is hedging monthly purchases of raw materials and there is a reduction in the expected purchases for the given month, some but not all of the forecasted transactions may still be probable. In that case, the entity is not required to dedesignate the entire hedging relationship, although it is permitted to do so. If some of the transactions are still probable, the entity could dedesignate a proportion of the hedging relationship that represents transactions that are no longer probable (see Section 4.1.5.1.3.1).

Example 4-24

Alaskan Crude expects to sell 120 barrels of oil to customers in Idaho in June 20X1. To protect itself against the risk of decreases in oil prices, Alaskan Crude enters into a futures contract in January 20X1 to hedge the forecasted sale of the first 100 barrels of oil in Idaho in June 20X1. Assume that the futures contract is highly effective at hedging the change in the total cash flows from those sales. In May 20X1, some of Alaskan Crude’s customers notify the company that they would like to delay their June oil deliveries until July. Accordingly, Alaskan Crude reduces its estimated June sales volume in Idaho to 90 barrels of oil and expects to sell the remaining 30 barrels in July.

Given the reduction in projected oil sales in June, it is no longer probable that Alaskan Crude will sell all of the 100 barrels that month as originally forecasted; it projects a sales shortfall of 10 barrels. Alaskan Crude could dedesignate 10 percent of the futures contract from the hedging relationship and maintain 90 percent of the original relationship. Because it is still probable that the 10 barrels will be sold within two months of the documented timeframe, 10 percent of the amounts in AOCI as of the date the change in projections occurred should be “frozen” and released when those sales occur (July 20X1). Alaskan Crude should prospectively recognize 10 percent of the change in the futures contract’s fair value in earnings and the other 90 percent in OCI. All amounts remaining in AOCI related to the 90 barrels sold in June 20X1 would be reclassified into revenues when they are sold.

Alternatively, Alaskan Crude could dedesignate the entire hedging relationship in May 20X1. Such a dedesignation would not affect the treatment of amounts in AOCI that are reclassified into revenues in June 20X1 (90 percent of the amount in AOCI as of the date of dedesignation) and July 20X1(10 percent of the amount in AOCI at the date of dedesignation) because the reclassifications are based on when those forecasted sales affect earnings. If Alaskan Crude does not redesignate any portion of the futures contract in a new hedging relationship, all future changes in the futures contract’s fair value will be recognized in earnings.

4.3.4.3 Simultaneous Hedges of Groups of Transactions

Entities that buy or sell nonfinancial assets in connection with their operations often seek to hedge the price risk related to recurring transactions on a monthly basis. In fact, it is not uncommon for an entity to enter into 12 separate hedging relationships to cover a portion of its monthly purchases or sales over the entire year. For example, an entity may have a policy of entering into forward contracts to cover 75 percent of its projected monthly purchases of raw materials one year in advance. In such a case, it would always have 12 active hedging relationships since each month it would enter into a new 12-month forward and settle the forward contract it entered into 12 months earlier.

In these types of hedges, it is important to have a strategy for dealing with probable shortfalls of forecasted transactions in any given month. Entities should have a documented policy for identifying any transactions in a given month that are actually delayed transactions from the prior month. Note that the same transaction cannot simultaneously be the forecasted transaction in more than one hedging relationship for the same designated risk.

Example 4-25

Delayed Forecasted Transactions Occur in Periods Already Hedged

Alaskan Crude sells oil to its customers in Nebraska on a monthly basis. It has a policy of entering into forward sales contracts to hedge 90 percent of its estimated monthly sales one year in advance. In July, one of its major customers in Nebraska notifies Alaskan Crude that it is temporarily shutting down operations in October to retrofit furnaces and related equipment. Below are the original and revised projections of oil sales in Nebraska for October through December:

Alaskan Crude’s policy stipulates that a shortfall in transactions in a given month can only be applied to previously unhedged transactions that are forecasted for the following months. The revised estimate of sales indicates that Alaskan Crude is now overhedged by 100 barrels for October (900 barrels – 800 barrels). However, for November, its forecasted sales exceed its hedged sales, and it is underhedged by 120 barrels (1,080 barrels – 1,200 barrels). Alaskan Crude believes that it is probable that the 100 barrels of sales that were originally expected in October will instead occur in November. Accordingly, in July it will dedesignate 100 barrels worth of the notional amount of its forward contracts from the hedging relationship for October’s forecasted sales. However, amounts in AOCI related to those 100 barrels will remain in AOCI and be reclassified into revenues when the delayed sales occur in November.

4.3.5 Reclassifications From AOCI

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

Hedged Item	Income Statement Classification
Forecasted purchase of raw materials	Cost of sales
Forecasted sales of products	Revenues
Forecasted purchase of equipment	Depreciation

Because of the nature of hedging relationships that involve nonfinancial assets, the amounts in AOCI are not typically reclassified into earnings before the derivative is settled and the relationship is terminated. For example, if the hedged item is related to the acquisition of raw materials, amounts will remain in AOCI until that related inventory is sold. Note that the amounts in AOCI are not reclassified to adjust the basis of the items acquired through a forecasted purchase. However, the income statement effects should be the same as if the basis of the underlying item were adjusted for the results of hedge accounting. In other words, if the forecasted transaction is the acquisition of raw materials or inventory, an entity should reclassify amounts from AOCI into earnings in a manner consistent with the method it uses to recognize inventory costs (e.g., LIFO, FIFO, or average cost). For example, if the entity uses LIFO to determine the costs of its inventory, the gain or loss on the derivative included in AOCI should (1) be matched with a particular LIFO layer when incurred and (2) recognized in the cost of sales when the LIFO layer is relieved. The entity should include its method of reclassifying AOCI into earnings in its formal documentation of the hedge at inception.

In addition, if an asset that was part of a hedged forecasted purchase becomes impaired, the entity should immediately reclassify all or some amounts from AOCI into earnings. For example, if an entity hedges the forecasted purchase of equipment, the entire change in the hedging instrument’s fair value is recorded in OCI and released into earnings as the company depreciates the equipment (after the equipment is purchased). If the asset becomes impaired, any net gain in AOCI should be reclassified from AOCI into earnings in an amount equal to the lesser of (1) the impairment loss or (2) the amount remaining in AOCI. Note that those amounts will be reclassified into earnings in the same income statement line item that is used to present the earnings effect of the impairment of the equipment.

Example 4-26

Hedged Item Subsequently Becomes Impaired

Fluff Heads hedges the forecasted purchase of cotton by entering into a forward contract on January 1, 20X1. On June 30, 20X1, it takes delivery of the cotton and closes out the forward contract, which currently has a fair value of $2 million. Fluff Heads properly leaves the $2 million gain in AOCI pending the sale of the cotton. On December 31, 20X1, the company determines that the cotton inventory is impaired, and the amount of impairment is calculated as $1.5 million. In this case, Fluff Heads should reclassify $1.5 million of the gain remaining in AOCI into earnings to directly offset the impairment loss on the inventory at the income statement line-item level.

Alternatively, assume that Fluff Heads hedges the forecasted sale of cotton by entering into a futures contract on January 1, 20X2. On April 1, 20X2 (three months before the sale), the futures contract has a fair value of $2 million and Fluff Heads determines that its cotton was impaired by $1 million. Fluff Heads records an impairment loss of $1 million. The derivative gain that offsets part or all of the loss should be reclassified into earnings in the same period and income statement line-item in which the impairment is recorded. Thus, Fluff Heads should reclassify $1 million of the gain on the futures contract from AOCI into earnings to offset the $1 million impairment loss on the cotton.

Section 4.1.5 discusses the accounting for discontinued cash flow hedging relationships, including the treatment of amounts in AOCI. Examples 4-28 and 4-29 provide detailed illustrations that address both the initial recognition of gains and losses in OCI and the reclassification of amounts out of AOCI after the hedging relationship is discontinued.

4.3.6 Illustrative Examples

Example 4-27

Futures Hedging Forecasted Purchase of Materials for Overall Changes in Cash Flows

Mercury Provisions is a producer of high-quality outdoor equipment. It is starting a new line of “unbreakable” nets made of galvanized steel. On January 2, 20X1, Mercury enters into futures contracts to purchase 1,000 tons of U.S. Midwest Domestic Hot-Rolled (HR) Coil Steel on March 15, 20X1, at a price of $503 per ton. It designates the futures contracts as a hedge of its forecasted purchase of 1,000 tons of hot-dipped galvanized (HDG) coil steel in the spot market on March 15, 20X1, for changes in cash flows that are attributable to changes in the overall purchase price of the HDG coil steel. The price of HDG coil steel is higher than that of HR coil steel, but there is a high volume of futures contracts on HR coil steel and Mercury believes that the futures contract will be highly effective at hedging changes in the price of the HDG coil steel it is purchasing. Mercury will assess the effectiveness of the hedge by using the hypothetical-derivative method to compare the changes in the fair value of a forward to purchase HDG coil steel to the changes in the prices of its futures contract on HR coil steel.

For this example, assume that the creditworthiness of Mercury does not call into question whether it is probable that it will perform under the futures contract. Because of the nature of a futures contract (i.e., it is entered into with a regulated exchange), counterparty performance risk is minimal. Also assume that it remains probable throughout the hedging relationship that the forecasted purchase of HDG coil steel will occur.

The table below shows (1) the spot and futures rates for both HR coil steel and HDG coil steel, (2) the fair value of the futures contract at the end of each period, and (3) the results of hedge effectiveness testing for the life of the hedging relationship.

The journal entries for the life of the hedging relationship are as follows:

January 2, 20X1

No entry is required because the futures contracts were entered into at-market and have an initial fair value of zero.

January 31, 20X2

February 28, 20X2

March 15, 20X2

Note that the $35,000 loss in AOCI will be reclassified into cost of sales when the steel inventory affects earnings (see Section 4.3.5).

Example 4-28

Futures Hedging Contractually Specified Component of Monthly Forecasted Purchases of Materials From Annual Supply Contract

Fuego Power operates a coal-fired power plant. On the basis of its average usage, it appears to have the capacity to store about 46 days’ worth of coal. Fuego likes to maintain some excess inventory, so it orders monthly deliveries of coal on the basis of its expected usage during the following month. In November of each year, Fuego enters into a variable-price supply contract for the upcoming year with Fordham Industries. The contract has monthly scheduled deliveries with specified minimum purchases for each month, but Fuego notifies Fordham of the actual quantity needed for a given month on the first day of the prior month. On November 15, 20X1, Fuego enters into the supply contract with Fordham for 20X2 in which each month it will pay a price per ton based on the monthly average Platts CAPP rail (CSX) OTC price plus $4.00. The supply contract is not accounted for as a derivative because Fuego elects to apply the normal purchases and normal sales scope exception in ASC 815-10-15-22 (see Section 2.3.2 of Deloitte’s Roadmap Derivatives).

Fuego’s risk management policy is to enter into financially settled futures contracts for the minimum quantities that must be purchased under the contracts, which is 80 percent of the forecasted purchase amounts. The futures contracts are indexed to the final monthly average CSX price (the same one in the supply contract). Fuego’s policy is to enter into the futures contracts by the end of November for all of the months in the following year.

Accordingly, Fuego enters into futures contracts for 20X2 on November 30, 20X1, and documents that the contracts are hedging the first number of tons of forecasted monthly purchases of coal for each month in 20X2 that matches the notional amount of the monthly futures. The hedged risk is the changes in the cash flows that are attributable to the contractually specified monthly average CSX price component. Estimated cash flows for the forecasted purchases of coal will be based on changes in the forward prices (i.e., in the same manner as the futures prices). Fuego will assess hedge effectiveness by using the hypothetical-derivative method; however, because the critical terms of the futures contracts match those of the forecasted purchases of coal (see Section 2.5.2.2.2), as long as there is no change in the terms of the forecasted purchases, the hedge is assumed to be perfectly effective and the analysis is qualitative. The table below shows (1) the expected quantities to be purchased each month, (2) the notional amount of the futures contracts for each month, and (3) the futures price per ton.

For this example, assume that the creditworthiness of Fuego does not call into question whether it is probable that it will perform under the futures contract. Because of the nature of a futures contract (i.e., it is entered into with a regulated exchange), counterparty performance risk is minimal. Also assume that it remains probable throughout the hedging relationship that the forecasted purchases of coal will occur.

In the monthly journal entries below, it is assumed that the turnover of coal inventory is one month, meaning that coal purchased in January is used in February. For simplicity, all entries for the month are shown on the last day of the month. Entries for revenues and the other costs of power production are not included. Also note that Fuego’s inventory purchases in November and December 20X1 are not subject to the hedging program illustrated here, so entries for those activities are not shown.

No entry is required in November 20X1 because the new supply contract signed on November 15 is an executory contract that is not in the scope of ASC 815 and the futures contracts that are entered into on November 30 have an initial fair value of zero.

December 31, 20X1

The table below shows a rollforward of the fair value of the futures contracts. No contracts are settled in December and none of the forecasted purchases have yet occurred.

January 31, 20X2

The table below shows (1) a rollforward of the fair value of the futures contracts, (2) the monthly futures settlement, and (3) the monthly purchase of inventory. The fair value of the futures contracts at the end of the period is related only to contracts that are still outstanding (i.e., any futures contracts that settled during the month are no longer included in the balance). Accordingly, the amount recorded in OCI related to the change in the futures contracts’ fair value that is attributable to changes in the forward rates is calculated before any settlement that occurs during the month (i.e., the monthly settlement is added back to the ending fair value for calculation purposes).

February 28, 20X2

The table below shows (1) a rollforward of the fair value of the futures contracts, (2) the monthly futures settlement, and (3) the monthly purchase of inventory. The fair value of the futures contracts at the end of the period is related only to contracts that are still outstanding (i.e., any futures contracts that settled during the month are no longer included in the balance). Accordingly, the amount recorded in OCI related to the change in the futures contracts’ fair value attributable to changes in the forward rates is calculated before any settlement that occurs during the month (i.e., the monthly settlement is added back to the ending fair value for calculation purposes).

March 31, 20X2

The table below shows (1) a rollforward of the fair value of the futures contracts, (2) the monthly futures settlement, and (3) the monthly purchase of inventory. The fair value of the futures contracts at the end of the period is related only to contracts that are still outstanding (i.e., any futures contracts that settled during the month are no longer included in the balance). Accordingly, the amount recorded in OCI that is related to the change in the futures contracts’ fair value attributable to changes in the forward rates is calculated before any settlement that occurs during the month (i.e., the monthly settlement is added back to the ending fair value for calculation purposes).

April 30, 20X2

The table below shows (1) a rollforward of the fair value of the futures contracts, (2) the monthly futures settlement, and (3) the monthly purchase of inventory. The fair value of the futures contracts at the end of the period is related only to contracts that are still outstanding (i.e., any futures contracts that settled during the month are no longer included in the balance). Accordingly, the amount recorded in OCI related to the change in the futures contracts’ fair value attributable to changes in the forward rates is calculated before any settlement that occurs during the month (i.e., the monthly settlement is added back to the ending fair value for calculation purposes).

May 31, 20X2

The table below shows (1) a rollforward of the fair value of the futures contracts, (2) the monthly futures settlement, and (3) the monthly purchase of inventory. The fair value of the futures contracts at the end of the period is related only to contracts that are still outstanding (i.e., any futures contracts that settled during the month are no longer included in the balance). Accordingly, the amount recorded in OCI related to the change in the futures contracts’ fair value attributable to changes in the forward rates is calculated before any settlement that occurs during the month (i.e., the monthly settlement is added back to the ending fair value for calculation purposes).

June 30, 20X2

The table below shows (1) a rollforward of the fair value of the futures contracts, (2) the monthly futures settlement, and (3) the monthly purchase of inventory. The fair value of the futures contracts at the end of the period is related only to contracts that are still outstanding (i.e., any futures contracts that settled during the month are no longer included in the balance). Accordingly, the amount recorded in OCI related to the change in the futures contracts’ fair value attributable to changes in the forward rates is calculated before any settlement that occurs during the month (i.e., the monthly settlement is added back to the ending fair value for calculation purposes).

July 31, 20X2

The table below shows (1) a rollforward of the fair value of the futures contracts, (2) the monthly futures settlement, and (3) the monthly purchase of inventory. The fair value of the futures contracts at the end of the period is related only to contracts that are still outstanding (i.e., any futures contracts that settled during the month are no longer included in the balance). Accordingly, the amount recorded in OCI related to the change in the futures contracts’ fair value attributable to changes in the forward rates is calculated before any settlement that occurs during the month (i.e., the monthly settlement is added back to the ending fair value for calculation purposes).

August 31, 20X2

The table below shows (1) a rollforward of the fair value of the futures contracts, (2) the monthly futures settlement, and (3) the monthly purchase of inventory. The fair value of the futures contracts at the end of the period is related only to contracts that are still outstanding (i.e., any futures contracts that settled during the month are no longer included in the balance). Accordingly, the amount recorded in OCI related to the change in the futures contracts’ fair value attributable to changes in the forward rates is calculated before any settlement that occurs during the month (i.e., the monthly settlement is added back to the ending fair value for calculation purposes).

September 30, 20X2

The table below shows (1) a rollforward of the fair value of the futures contracts, (2) the monthly futures settlement, and (3) the monthly purchase of inventory. The fair value of the futures contracts at the end of the period is related only to contracts that are still outstanding (i.e., any futures contracts that settled during the month are no longer included in the balance). Accordingly, the amount recorded in OCI related to the change in the futures contracts’ fair value attributable to changes in the forward rates is calculated before any settlement that occurs during the month (i.e., the monthly settlement is added back to the ending fair value for calculation purposes).

October 31, 20X2

The table below shows (1) a rollforward of the fair value of the futures contracts, (2) the monthly futures settlement, and (3) the monthly purchase of inventory. The fair value of the futures contracts at the end of the period is related only to contracts that are still outstanding (i.e., any futures contract that settled during the month are no longer included in the balance). Accordingly, the amount recorded in OCI related to the change in the futures contracts’ fair value attributable to changes in the forward rates is calculated before any settlement that occurs during the month (i.e., the monthly settlement is added back to the ending fair value for calculation purposes).

November 31, 20X2

The table below shows (1) a rollforward of the fair value of the futures contracts, (2) the monthly futures settlement, and (3) the monthly purchase of inventory. The fair value of the futures contracts at the end of the period is related only to contracts that are still outstanding (i.e., any futures contracts that settled during the month are no longer included in the balance). Accordingly, the amount recorded in OCI related to the change in the futures contracts’ fair value attributable to changes in the forward rates is calculated before any settlement that occurs during the month (i.e., the monthly settlement is added back to the ending fair value for calculation purposes).

December 31, 20X2

The table below shows (1) a rollforward of the fair value of the futures contracts, (2) the monthly futures settlement, and (3) the monthly purchase of inventory. The fair value of the futures contracts at the end of the period is related only to contracts that are still outstanding (i.e., any futures contracts that settled during the month are no longer included in the balance). Accordingly, the amount recorded in OCI related to the change in the futures contracts’ fair value attributable to changes in the forward rates is calculated before any settlement that occurs during the month (i.e., the monthly settlement is added back to the ending fair value for calculation purposes).

January 31, 20X3

Example 4-29

Exchange-for-Physical Transaction — Hedging Forecasted Purchase of Materials

On January 1, 20X1, Fluff Heads enters into a futures contract to buy cotton as a hedge of its expected purchase of cotton for production in December. In the cotton industry, brokers generally are unwilling to enter into forward delivery contracts before the given year’s cotton crop has been planted unless the buyer pays a premium over the futures price. Futures contracts do not qualify for the normal purchases and normal sales scope exception because they require cash settlements of gains and losses (see Section 2.3.2 of Deloitte’s Roadmap Derivatives), so Fluff Heads designates the futures contract as a cash flow hedge of the forecasted purchase of cotton in December 20X1 for changes in cash flows that are attributable to changes in the overall purchase price of cotton.

Entering into this type of a derivative transaction is in compliance with Fluff Heads’s overall risk management policy. Under that policy, Fluff Heads must assess hedge effectiveness quarterly by using a regression analysis to compare the change in the futures contracts’ fair value with the change in the cash flows of the forecasted purchase of cotton based on the forward prices of cotton at the location in which it will be purchased. Fluff Heads management performs a quantitative assessment at inception that shows that the basis differential between the futures contract and the entire purchase price of the cotton is not expected to cause the relationship to be outside the 80 to 125 percent regression parameters. Therefore, it expects the hedge to be highly effective.

On May 1, 20X1, when the acreage of cotton planted is known and the weather patterns are forecasted, brokers are willing to enter into fixed-price contracts to sell cotton without requiring buyers to pay a premium. Fluff Heads assigns the futures contract to a broker, who “steps into” Fluff Heads’s position and simultaneously enters into a forward contract with Fluff Heads to deliver cotton in December. Fluff Heads is relieved of all rights and obligations under the original futures contract and, therefore, it cannot continue to account for the futures contract after the assignment date. Because the price of cotton increased between January 1 and May 1, the futures contract has a positive fair value. The inherent gain in the futures contract is assumed by the broker, and Fluff Heads receives no cash premium from the broker. However, the price under the fixed-price forward agreement is adjusted so that the forward contract has a positive fair value that approximately equals the fair value of the futures contract surrendered. Transactions in which a futures contract is exchanged for a forward contract are typically called “exchange-for-physical” (EFP) arrangements.

Fluff Heads designates the forward contract it entered into in May as a normal purchase contract under ASC 815-10-15-22 because (1) delivery under the contract is probable and (2) the cotton to be delivered under the contract will be used in production. Assume that the purchase of cotton remains probable until it is purchased on December 31, 20X1, for $1.5 million and that the shirts made from the cotton purchased are sold on March 31, 20X2, for total revenues of $2.2 million.

The table below shows (1) the expected discounted future cash flows from the forecasted purchase of cotton, (2) the fair values of the futures contract, (3) the results of the prospective and retrospective qualitative assessments, and (4) the likelihood that the forecasted transaction will occur as of January 1, March 31, and May 1.

Fluff Heads records the following journal entries until the forecasted purchases affect earnings:

January 1, 20X1

No journal entry is required because the futures contract has a fair value of zero at inception.

March 31, 20X1

Fluff Heads can apply hedge accounting because both the initial hedge effectiveness assessment performed at inception and the subsequent retrospective hedge effectiveness performed as of March 31 indicate that (1) the hedging relationship is highly effective and (2) it is still probable that the forecasted purchase of cotton will occur.

May 1, 20X1

Fluff Heads can apply hedge accounting because both the prospective hedge effectiveness assessment performed as of March 31 and the subsequent retrospective hedge effectiveness performed as of May 1 indicate that (1) the hedging relationship is and was highly effective and (2) it is still probable that the forecasted purchase of cotton will occur.

June 30, 20X1, and September 30, 20X1

No entries are required because the forward contract is not subject to ASC 815 since it meets the normal purchases and normal sales scope exception. The forecasted purchase of cotton that was previously hedged is still probable and has not yet affected earnings, so amounts in AOCI will remain in AOCI.

December 31, 20X1

March 31, 20X2

Example 4-30

Qualifying Hedge of Forecasted Sale of Inventory Is No Longer Highly Effective

On January 1, 20X1, FarmHouse Inc. enters into a futures contract to sell corn inventory on December 31, 20X1. It designates the futures contract as a cash flow hedge of the forecasted sale of its corn inventory for overall changes in cash flows. Entering into this type of a derivative transaction is in compliance with its overall risk management policy. At the inception of the hedge, FarmHouse formally documents the hedging relationship and indicates that it will assess hedge effectiveness quantitatively every quarter by using regression analysis. It also uses regression to perform an initial quantitative prospective assessment of hedge effectiveness, which supports its expectation that the hedging relationship will be highly effective over future periods at offsetting changes in cash flows. FarmHouse elects not to exclude any portion of the change in the hedging derivative’s fair value from its hedge effectiveness assessment.

The table below shows (1) the expected discounted future cash flows from the forecasted sales of the corn inventory, (2) the fair values of the futures contracts, (3) the results of the prospective and retrospective regression analyses, and (4) the likelihood of the forecasted transaction occurring as of January 1, March 31, June 30, and September 30, 20X1.

The journal entries as of January 1, 20X1, March 31, 20X1, June 30, 20X1, and September 30, 20X1 are as follows:

January 1, 20X1

No journal entry is required because the futures contract has a fair value of zero at inception.

March 31, 20X1

FarmHouse can apply hedge accounting in the first quarter because both the initial hedge effectiveness assessment performed at inception and the subsequent retrospective hedge effectiveness performed as of March 31 indicate that (1) the hedging relationship is highly effective and (2) it is still probable that the forecasted sale of corn will occur.

June 30, 20X1

FarmHouse can apply hedge accounting in the second quarter because both the prospective effectiveness assessment performed as of March 31 and the retrospective effectiveness assessment performed as of June 30 indicate that (1) the hedging relationship is highly effective and (2) the forecasted sale of corn is still probable.

September 30, 20X1

FarmHouse cannot apply hedge accounting in the third quarter because although the prospective regression analysis performed as of June 30, 20X1, indicated that the hedging relationship was expected to be highly effective in that quarter, the retrospective regression analysis performed as of September 30, 20X1, indicated that the hedging relationship is no longer highly effective. Accordingly, FarmHouse should record the entire change in the futures contract’s fair value in earnings. In addition, the prospective regression analysis performed as of September 30, 20X1, shows that the hedge is not expected to be effective for the last quarter of the futures contract, so the hedging relationship should be discontinued.

FarmHouse will (1) continue to report the $105,000 net loss on the futures contract related to the discontinued hedge in AOCI and (2) recognize that amount in earnings when the corn inventory sale occurs (unless it becomes probable that the forecasted corn inventory sale will not occur, in which case the related amounts in AOCI would be immediately recognized in earnings).

Example 4-31

All-in-One Hedge of Forecasted Purchase of Commodity

On January 1, 20X1, Golden Age enters into a forward to purchase 1,000 ounces of gold for $1,450 per ounce on March 31, 20X1. The current price of gold is $1,320 per ounce. The forward contract meets the definition of a derivative, and Golden Age chooses not to elect the normal purchases and normal sales scope exception from derivative accounting (see Section 2.3.2 of Deloitte’s Roadmap Derivatives). Accordingly, it will account for the forward contract as a derivative, but it will use the contract as a hedge of the forecasted purchase of the 1,000 ounces of gold underlying the contract (i.e., it is an all-in-one hedging relationship). Golden Age is hedging the changes in the cash flows of the forecasted purchase for the risk of changes in the overall purchase price of gold. It will assess those changes in the cash flows on the basis of the changes in the forward price of gold. The critical terms of the forward match those of the forecasted transaction, so Golden Age expects the hedge to be perfectly effective.

For this example, assume that the creditworthiness of both Golden Age and the counterparty to the forward contract do not call into question whether it is probable that they will perform under the contract. Accordingly, it remains probable throughout the hedging relationship that the forecasted purchases of gold will occur.

When the forward contract settles, the spot price of gold is $1,500 per ounce. The journal entries for the hedging relationship are as follows:

January 2, 20X1

No entry is required because the forward contract has a fair value of zero at inception.

March 31, 20X1

The $50,000 gain in AOCI will be reclassified into cost of sales when the gold inventory or related products are sold, effectively creating a cost of $1.45 million for this gold inventory. If the 1,000 ounces of gold inventory is impaired before the sale, an amount equal to the lesser of the amount of the impairment or $50,000 should be reclassified out of AOCI and into impairment charges.

Example 4-32

Purchased Option Hedging Forecasted Purchase of Inventory (Terminal Value Method)

On January 1, 20X1, Golden Age enters into an option contract that gives it the right to purchase 1,000 ounces of gold at $1,275 per ounce on December 31, 20X1 (the option’s expiration date). Golden Age pays $10,000 (fair value) for the option, which cannot be exercised before its maturity. Golden Age designates the option as a cash flow hedge of its forecasted purchase of 1,000 ounces of gold on December 31, 20X1. Its overall risk management policy permits the use of a purchased option to hedge its exposure to changes in the price of gold. Golden Age formally documents the hedging relationship at the inception of the hedge. In accordance with its policy, it will assess hedge effectiveness (1) on the basis of the total changes in the hedging option’s cash flows (i.e., it will not exclude any components of the option contract from its assessment) and (2) by comparing the option’s terminal value (i.e., the expected future pay-off amount on the maturity date) with the expected change in the cash flows when gold prices exceed $1,275 per ounce.

Golden Age may assume that this cash flow hedge will be perfectly effective because all of the criteria in ASC 815-20-25-126 and ASC 815-20-25-129 are met, specifically:

The hedging instrument is a purchased option.
The exposure being hedged is the variability in the expected future cash flows attributed to a price beyond a specified level (i.e., $1,275 per ounce).
The assessment of effectiveness will be made on the basis of the total changes in the option’s cash flows (i.e., the total change in the option’s fair value).
The critical terms of the option (e.g., its notional amount, underlying, and maturity date) perfectly match the related terms of the hedged forecasted purchase of gold.
The strike price of the option matches the specified level ($1,275 per ounce) beyond which Golden Age’s exposure is being hedged.
The option’s inflows and outflows on its maturity date will completely offset the change in the cash flows of the forecasted purchase of gold for the risk being hedged (i.e., changes in cash flows that are attributable to changes in the price of gold above $1,275 per ounce).
The option cannot be exercised before its maturity (i.e., it can only be exercised on its contractual maturity date).

Assume that Golden Age makes the forecasted purchase of 1,000 ounces of gold on December 31, 20X1, and that it sells the product made from the gold on March 31, 20X2. The table below shows (1) the market price of gold per ounce and (2) the fair values of the option as of January 1, March 31, June 30, September 30, and December 31, 20X1.

The journal entries are as follows:

January 1, 20X1

March 31, 20X1

June 30, 20X1

September 30, 20X1

December 31, 20X1

March 31, 20X2